The Solvency II Directive and its impact on the UK Insurance Industry Contents

3Solvency II and the way it has been implemented in the UK

The Strengths of Solvency II

53.Evidence gathered by the previous Treasury Committee suggested that Solvency II is a fundamentally sound regime, but that the legislation has been developed within a legalistic and rules-based framework which at times is interpreted as rigid truth instead of on the merits of the case. Furthermore, the implementation in the UK has, arguably, lacked proportionality. More work therefore needs to be done to develop a sound prudent regime, but one which promotes diversity and innovation in order to meet the long term needs of UK consumers.

54.Evidence gathered by the previous Treasury Committee suggested that, while the PRA is held in high regard by the insurance industry, there is a disconcerting level of disconnect between its views and those of the industry, which might be indicative of a breakdown in effective communication. It also identified several areas where Solvency II is believed to be inhibiting competition and/or competitiveness. The Committee recommends that the PRA and industry should review how they can communicate more closely with each in addition to the more formal consultation procedures. Earlier, more frequent and possibly more informal communication might have resolved the current difficulties at an earlier stage. A widely quoted example was the annuity market, where difficulties relating to the Risk Margin and the Matching Adjustment have led some firms to exit the market, and others to reinsure significant amounts of business overseas. Specific areas of concern such as these are discussed in later sections of this Report. This section considers respondents’ higher level view of Solvency II’s effectiveness overall.

55.The overwhelming view of those who provided evidence to the previous Committee was that a huge amount of time, effort and cost has been put into implementing Solvency II, and the industry does not want to throw it away and start again. Cooley LLP, representing several large insurers, commented that it would be “a shameful waste of money” and “utter madness”61 to try to change now, pointing out that further fundamental change will create significant risk: “Brexit will bring enough change. It would be reckless to ask for more”.62

56.There was also general consensus that Solvency II is a sound regime; this is not surprising as much of it builds on the ICAS regime, which was well regarded.

57.Many respondents commented that Solvency II has had a positive impact on raising the standard of risk management and governance in the industry. The Association of British Insurers (ABI) stated that: “Concepts such as the Own Risk and Solvency Assessment (ORSA) and improved management information…have increased the level and frequency of Board engagement and understanding of the firm’s risk profile”.63 They also praised “the rigour with which [Solvency II] requires firms to identify, model, manage and mitigate the risks that it faces, recognising that holding capital is not the only and indeed often not even the best way to mitigate risk”.64

58.Several responses referred to the benefits of having a common regime across many countries. PwC for example stated that: “creating a regime that diverged from [the general direction of the International Association of Insurance Supervisors in Common Framework and Insurance Capital Standards,] would seem unwise. It has created a more level playing field across the EU, and it is recognised across the world as a robust regime.”65

59.Separately, PwC noted that all UK insurers should benefit from Solvency II’s global recognition as a strong regime: “There are also advantages in a regime that is known to be more robust and rigorous in terms of reputation and policyholder protection”.66 This echoes Andrew Bailey’s comment, made in 2013: “Not all local regimes are in our view appropriately prudent, and insurers compete on the security of their promise as well as on price”.67

Significant improvements can be made

60.While there is no appetite to start again, there was a unanimous view there are significant weaknesses that could be improved. People giving evidence to the previous Committee argued that these problems arise both from the legalistic and rules-based nature of the directive and the manner in which it was implemented in the UK. A typical response was Aviva’s comment that: “there are problems with some of the technical aspects of Solvency II, and the way that it is implemented in the UK, that create unnecessary costs, reduce the competitiveness of UK insurers, and hamper the UK insurance industry’s role in providing stable long-term investment”.68

61.The ABI suggested that now is an opportune time to work towards improving the regime for UK insurers, as set out in the ABI’s response: “The regime has now been implemented, the PRA is more familiar with it and the UK industry is facing the added pressures and uncertainties associated with UK exit from the EU. Given the greater understanding of Solvency II by all parties, and the changed circumstances as a result of Brexit, we suggest it would now be timely to reassess the UK implementation of Solvency II, to ensure it is sufficiently proportionate and flexible enough to be appropriate for the UK market”, and does not put the UK at a competitive disadvantage in respect of other countries.69

62.The Committee believes that this will be best achieved by a joint effort from industry representatives and the regulator. While the parties may come from different starting points, there appears to be considerable common ground. For example: “The ABI supports the objectives of the PRA in maintaining financial stability and protecting consumers in the UK market. We recognise the importance of robust supervision and are not calling for a watering down of the PRA’s objectives. The disruption caused by Brexit puts these objectives at a premium”.70

63.As noted above, witnesses identified two main drivers that may be eroding competition and competitiveness: the legalistic and rules-based nature of Solvency II legislation, and the implementation of Solvency II legislation by the PRA.

64.The IFoA commented: “SII has encouraged a rules-based and bureaucratic implementation, partly because of the Lamfalussy process followed: with the Directive set in stone early on, and Level 2 text (providing detail) following much later. This has meant, at times, that decisions have been made in terms of interpreting the Directive text as a rigid truth rather than on the merits of the case.”71

65.Concern was expressed that the legislation is “hampering firms’ ability to innovate and provide customers with a broad range of products”72 while higher capital requirements are “driving some areas of activity off shore (outside the EU)”,73 such as “the reinsurance of risks to territories”74 with less “rigid rules”75 than Solvency II.

66.This led Lord Turnbull to speculate that London would become “more attractive to some insurance companies if it was outside the EU”76 because a “European-based and regulated insurance company is at a disadvantage relative to a Canadian or American insurance company”.77 However, the overwhelming majority of evidence did not call for wholesale change or the repealing of Solvency II, particularly given the cost of its implementation. Nevertheless, as described in later sections, respondents had serious concerns.

67.Respondents also argued that the PRA has not been proportional in its implementation of the Directive. The role of the UK regulator, and its supervisory approach in particular are “as important as the actual rules in terms of impact on the insurance industry”.78

68.Some felt that the PRA could adopt a more pragmatic approach without contravening the existing rules. KPMG noted that “it is also clear that other countries, when updating their regimes to one which follows similar lines to Solvency II, are not adopting all aspects of Solvency II. In particular, they are implementing less prescriptive measures and disclosure requirements, and/or allowing the requirements to factor in sensibly the specifics of the local market”.79

69.The industry recognises that the nature of the Directive makes the PRA’s job difficult. “In practice the regime and its requirements are overly complex and detailed…The volume of text alone is indicative of this: approximately 300 pages of level 1 text, approximately 2000 pages of level 2 text, with approximately 975 more pages of EIOPA guidelines—totalling over 3,200 pages”.80

70.Although in theory the Solvency II legislation allows for ‘proportionality’, in practice it encourages a detailed rules-based approach to implementation, which a cautious and professional regulator such as the PRA found it difficult to avoid. Some evidence to the Committee suggests that the PRA’s approach to the implementation of Solvency II in the UK has meant that “the level of policyholder protection […] is probably significantly above that of most EU insurers” and that the higher cost of capital that follows from it “may make the UK a less attractive place to carry out insurance business”.81

71.While it is difficult to compare the implementation of Solvency II in different EU states, the impact of a complex rules-based regime has probably been far greater in the UK than other EU states because of the mix of business in UK firms and also the number of firms that have needed to adopt internal models.

72.The UK’s detailed approach to the implementation of the rules-based Solvency II Directive may have erred on the side of caution, enhancing policyholder protection at the expense of increasing the cost of capital for UK insurers. In any event, the PRA should give greater consideration to how it can maximise its application of proportionality.

73.In oral evidence to the previous Committee, the PRA recognised that the level of its prudential supervision is “proportionately high”,82 but noted that firms with a balance sheet below €25 million and less than €5 million income are exempt from complying with Solvency II legislation in its entirety. This amounts to 188 firms, or 40% of the 469 insurance companies supervised by the PRA.83 However, as it covers the smallest firms, it is unlikely to have a material impact on the market. It should also be noted that this exemption is borne from the Solvency II legislation, rather than the PRA’s implementation.

74.The PRA also noted the concern expressed by Lloyd’s of London that Solvency II was “not well fitted for some of the funkier things that go on in that Market” and said that it was working with the industry, Treasury and HMRC on a proposal to improve the working of the market for catastrophe bonds.84

75.The PRA mounted a defence both of the Solvency II regime and the way it had been implemented in the UK. On the specific point of capital requirements, Sam Woods asserted that the difference in capital requirements between the old ICAS regime and Solvency II was only £1 billion out of £126 billion—less than 1%.85 Meanwhile, on the regime as a whole, Mr Woods argued throughout the oral evidence session that the problem did not lie with the framework in its entirety, but rather on specific (albeit numerous) elements, such as the Risk Margin, Matching Adjustment and proportionality of data requirements.86

76.When questioned by the previous Committee on future fundamental reform, Sam Woods made the following statement:

“Basically, Solvency II is a sensible regime and it is a good regime. Why do I say that? It is because it is a regime in which we try to look at the values of assets and liabilities, as they are today and consistent with the market. That is basically the learning from the Equitable. If you do not do that, if you have some other way of valuing liabilities and assets, you may well be caught short if the firm gets into trouble. It is a very UK idea. Then there is this thing of the matching adjustment to encourage longterm investment. That is all good, but there are things about Solvency II that are bugs that need to be fixed and design features that are not good. The biggest and most obvious bug is the risk margin, but there are also design features that I would like to change if I had a free hand.”87

Specific suggestions for improvement

77.Solvency II has been very costly to implement, and there are areas which are defective, partly due to the underlying rules-based directive and partly due to a lack of proportionality in implementing it. London is known for its ability to provide finance and insurance for more esoteric products and the PRA needs to accommodate this. However, most of those costs are sunk costs and it is possible to improve the Directive’s implementation without abandoning it altogether. A well-argued case has been made in evidence to the previous Committee, by individual insurers as well as the ABI and the Institute and Faculty of Actuaries, for a remedy to some of the defects that have been identified. Their views have been supported by industry experts.

78.The ABI presented the PRA with a list of 23 areas where they believe the regulator has the power to act to amend their implementation of the Solvency II regulation for the benefit of the insurance industry, and ultimately, the consumer.88 In oral evidence Sam Woods stated that:

“I disagree with eight. I personally agree with five and see some merit in them. I would have to have views from the rest of the PRA board on that. The rest, the other 10, are in the middle.”

79.He expanded on this comment in a subsequent letter to the previous Committee.89 The five that he agreed with covered model approval processes, the recalculation of the Transitional Measure on Technical Provisions, the costs and benefits of external audit of firms’ Solvency Financial Condition Reports, the amount of information required in notifications to the PRA of longevity risk transfer and hedge arrangements, and the requirement for “Legal Entity Identifier codes” for all entities within a group, including holding and dormant companies. While the PRA was able to agree on only 5 out of 23 suggestions, there appears to be common ground on some of the others.

80.Sam Woods’ subsequent letter90 provided an update on discussions with the ABI and is a helpful summary of developments as far as these items are concerned, although in most cases it showed that discussions are continuing. Nevertheless, the PRA needs to explain its thinking on the industry’s suggestions in more detail than hitherto, and it needs to consider its reactions with more of a post-Brexit mentality.

81.The Committee is concerned by the PRA’s dismissal of many of these suggestions, and by its apparent reluctance quickly to address some of the problems of the Risk Margin. This might suggest that an excessively strict interpretation of the requirements of Solvency II, and of its own obligations, has limited its thinking in a way which could be detrimental to UK plc.

82.The overriding priority is to develop a system of regulation which is right for the UK insurance industry, and which meets all the current and future needs of consumers, providing a prudent regulatory structure without stifling competition and innovation. We would expect the UK regulators, with close input from the industry and HM Treasury, continually to work on this task. It will be desirable to keep in step with the EU and other international initiatives as far as this is possible.

83.The Committee notes that the PRA consults with industry when designing policy in order to ascertain the views of interested stakeholders.91 In 2016 examples of topics covered by consultations relating to Solvency II included group supervision (CP38/16),92 reporting templates (CP40/16),93 the matching adjustment (CP48/16)94 and maintenance of the ‘transitional measure of technical provisions’ (CP47/16).95 The Committee welcomes these efforts and encourages continued consultation, but it wishes to see a more constructive and open dialogue.

84.The insurance industry is in intense negotiations with the PRA on a number of crucial issues. Points of disagreement include the Risk Margin, the Dynamic Volatility Adjustment, the treatment of equity release mortgages and other illiquid assets. These issues are discussed more fully in Chapters 5, 6 and 8.

85.The Committee notes that the PRA said it agrees with only five of the 23 suggestions made by the ABI, and it urges the PRA to make substantive progress on those it does agree with and to take a fresh look at the other eighteen suggestions in the context of the potential greater freedom of regulation that Brexit might bring. It is the Committee’s view, from the evidence presented to its predecessor, that there are many opportunities to improve the Solvency II rules and their oversight by the PRA, and it is to be hoped that the five areas of agreement are just the start.

86.The Committee agrees with PwC’s conclusion that the role of the UK regulator, and its supervisory approach in particular are “as important as the actual rules in terms of impact on the insurance industry”.96 The PRA’s implementation of “rules” has a disproportionate impact on costs, competitiveness of the industry globally, competition with the UK, the ability of the industry to provide long-term investment. The PRA needs to ensure that its supervisory approach reflects a balance between its prudential and competition objectives.

87.In the following chapters, we cover a number aspects of Solvency II and its implementation that appear to have caused problems, and make recommendations on the way forward.

88.By way of a summary of its recommendations which are expanded in subsequent sections, the Committee considers that the PRA, working in close collaboration with the industry, should:

89.Working in close consultation with the insurance industry, the PRA needs to set out clearly what its time constraints are for delivering each of these items over the coming years, including whether it can act unilaterally or needs to wait for EIOPA. In doing so it should consider the end goal, including areas which can be developed after Brexit, rather than confining its thinking to what can be accomplished within the parameters of Solvency II. The goal is a system of regulation which is right for the UK insurance industry and which meets the current and future needs of consumers, providing a prudent regulatory structure without stifling competition and innovation.

90.The Committee expects a progress report, including commentary on the extent to which there has been change or substantive progress and where the industry has agreed the approaches taken, by 31 March 2018. This report should set out clearly how the PRA’s implementation of the directive ensures proportionality and meets its secondary competition objective.

61 SOL003

62 Ibid

63 SOL032

64 Ibid

65 SOL018

66 Ibid

68 SOL023

69 SOL032

70 Ibid

71 SOL026

72 SOL042

73 Ibid

74 SOL008

75 SOL026

77 Lord Turnbull giving oral evidence to the Committee on the UK’s Future Economic Relationship with the European Union, HC483, 28 June 2016, Q23

78 SOL018

79 SOL008

80 SOL032

81 SOL018

82 Q154

83 Q153

84 Ibid

85 Q183

86 Qq152–226

87 Q187

88 SOL050

89 SOL051

90 SLV002

96 SOL018

25 October 2017