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

6Risk Margin

Industry Concerns

123.In Solvency II, the basic capital requirement is that insurers hold enough capital to be 99.5% confident of surviving extreme events over a 12 month period. The Risk Margin is an additional margin which purports to represent the additional capital that a third party would need in order to run off the insurance firm in the case of such an event. The overall intention is to arrive at a market consistent valuation of liabilities (though in practice this is artificial as there is not a liquid market of this type). However the method of calculation of the Risk Margin is prescriptive and was determined when economic circumstances were very different. The Risk Margin is “very sensitive to long term interest rates”,136 meaning that, in certain economic circumstances, such as the unprecedented period of record low interest rates, it is ‘ballooning’ and can cause insurers to hold a high a level of capital. Consequently the Risk Margin is “demonstrably out of line with the market price for transferring risk”,137 and particularly hits insurers who are writing longer term annuities or savings products with any form of guarantee.

124.The Risk Margin is specifically referred to within the Chancellor’s remit letter for the Prudential Regulation Committee. In context of the Government’s commitment to effective regulation, the Chancellor noted that:138

“The PRC supports this vision by working to lower barriers to entry to create a regulatory environment where new entrants and smaller firms can more easily enter, expand and compete with incumbents in a way that acknowledges the impact of their growth on systemic risk.”

The Chancellor went on to note that:

“The government also welcomes the work being undertaken to examine the design of the Risk Margin feature in the insurance regulation to limit the sensitivity to changes in the risk-free interest rates, which will have beneficial macroprudential and financial stability impacts”.139

125.KPMG picked out two areas of specific weakness that should be addressed in the Risk Margin calculation in order to “remove the excessive prudence which it now represents”.140 They suggest that the “fixed 6% per annum cost of capital rate on which the Risk Margin is based could be replaced with a margin (of say 2%pa to 3%pa) over the current risk free rate”.141 This sort of calibration would prevent the over-sensitivity to low interest rates described above. In common with other respondents they also suggested that: “Where there is clear evidence that the risk in question is in practice hedgeable, no Risk Margin component should be needed. Longevity risk is a particular case in point where many actual hedging transactions have taken place. The requirement for a ‘deep and liquid market’ is in our view an unnecessary barrier”.142

126.A specific example of the effect of the Risk Margin was provided by Legal & General:

“To provide a numerical example, we set out below the example of a customer giving us a lump sum of £100 to purchase an annuity. In this example, the firm retains the longevity risk and invests in Matching Adjustment eligible assets. The table below sets out the total amount of capital resources we have to hold which is made up of policy reserves, Risk Margin and capital requirements. The table shows that, under current market conditions, an insurer would have to fund £27 of capital resources in addition to the £100 of premium received, compared to a third of this amount under the “reasonable” requirements, i.e. £8. […]

“In addition to the Solvency I requirements, the UK operated the Individual Capital Assessment (‘ICAS’) regime; the capital requirements under ICAS, including the PRA’s capital guidance, were much more closely aligned to those shown under the “Reasonable View.”143

127.Legal and General went on to illustrate how Solvency II and Solvency I compared with what their own Economic Capital Model considers to be a more appropriate calibration of longevity risk:

Solvency II

Solvency I (Pillar 1)

Reasonable View

Premium (customers £100)




Policy Reserve




Risk Margin




Capital Requirement








Capital funded by insurer




128.The Risk Margin is causing UK firms to transfer risk to other jurisdictions:

“The size of the Risk Margin means that it is uneconomic to retain longevity risk in the UK causing business to be transferred to, amongst others, the United States, Canada and Switzerland. ln the short term, without reform to SII, we expect over 90% of the UK’s longevity reinsurance will be undertaken by non UK insurance companies, whilst in the longer term we expect the whole business activity to be transferred out of the UK”.144

129.This trend, alongside other factors, has ramifications for the macroeconomy. In oral evidence Andrew Chamberlain noted the following:

“I think everybody is aware that people are finding it more and more difficult to retire. It is expensive to get the income from the sums they have managed to accumulate. The implications of that are quite widespread. I am not decrying people who wish to work longer, but a lot of people are having to work longer, because they have no choice. The implications that has around the economy on the availability of jobs for young people, for the behaviours of those people who are working later, are quite widespread. So it has a significant impact.”145

The Regulator’s View

130.The regulator noted in oral evidence that the Risk Margin is “considered as part of a best estimate or fair value of insurance, because it is now being included in the IFRS framework that is due to be discussed later this year”.146 It should be noted however, that while the concept of a ‘risk margin’ is included, its conceptual basis is different, because IFRS is not prescriptive as to how it should be calculated.

131.As with the Matching Adjustment, the regulator accepted that flaws exist in this part of the Solvency II legislation. Sam Woods told the previous Committee that the PRA disagreed with the figures presented by Legal & General (noting a figure of £13 would be more appropriate than their £27 because the figures for the risk margin and the capital requirement were less than the £15 and £20 quoted in L&G’s table), but he agreed that the Risk Margin is “overcooked”147 and “may be dangerously procyclical”.148 Consequently, the regulator took action to dampen the effect of the Risk Margin by encouraging firms to apply for transitional measures to smooth the impact.149 This is clearly sub-optimal as it would be better to get the Risk Margin right than to rely on transitional measures. Consequently, it led Sam Woods to label the Risk Margin as the “biggest and most obvious bug”150, which has “soaked up a lot of capital”151 as it ballooned to £44 billion at the end of Q3 last year for the life industry.152

132.However, where the industry and regulator do diverge is on the course of action to address the Risk Margin. The industry advocates taking action now, arguing that the PRA does not need to wait for Europe to change the enabling legislation. This argument was outlined in supplementary evidence provided by the ABI to the previous Committee:

“2.2.1 In November 2016, the ABI wrote to the PRA to outline industry thinking on steps the PRA could take to address the challenges associated with the Risk Margin, without the need to make amendments at the EU-level to the level 1 (Directive) or level 2 (Delegated Regulation and Implementing Technical Standards) text.

2.2.2 These were to consider:

133.Legal & General also prepared a paper in parallel to the ABI, outlining two options to address the Risk Margin:

“the first being amendment to European legislation and the second (and preferred) being the adoption by a firm of a management action (the Management Action Solution).”154

134.The PRA had considered the idea of a management action, but concluded that “with some reluctance because we are sympathetic to the argument, we decided that it would not be wise to do that and that was for two reasons”.155 Sam Woods went on to explain these reasons:

“One was that we cannot get any castiron reassurance that, if we allow the genie out of the bottle in that way, in relation to the Risk Margin, that same genie cannot be let out of the bottle in all sorts of other parts of the framework, for instance in relation to capital requirements and technical provisions. The collective view of the PRA board was that that would be a very dangerous thing to let loose.

“The second argument was that, if we break glass locally, I am sure it will undercut us in Europe. That seems to be highly likely, and we would therefore be unlikely to be able to fix the thing at source. We would have this imperfect local fix and we might be stuck with it for a while, with something different in Europe. In the meantime, it is very important that we say that transitionals (the Transitional Measure on Technical Provisions—see Chapter 8) get the full benefit for capital purposes here in the UK, because that gives us a bit of time here. That is where the matter rests for now.”156

135.It appears that the PRA is concerned that if we make changes unilaterally, EIOPA will say that we cannot do so and our case for Europe-wide change will be weakened. Instead, the PRA would rather follow the EIOPA process of changing the legislation at source. Victoria Saporta explained that this would be agreed at the end of 2017 and implemented by the end of 2018.157 Sam Woods asserted that the PRA’s ability to negotiate was not “impaired”158 by the UK’s decision to leave the European Union, insisting that “we seem to be making good progress”.159

136.A Risk Margin—that is an additional margin which purports to represent the additional capital that a third party would need in order to run off the insurance firm in the case of an extreme eventmakes conceptual sense. It is included in other solvency and accounting frameworks, for example under the International Financial Reporting Standards. It should continue to form part of the UK’s solvency regime. However, the previous Committee heard widespread criticism of the Solvency II Risk Margin as it is currently formulated. The regulator has acknowledged these criticisms. There is widespread grasp of the problem among regulators and the issue is being reviewed by EIOPA and the European Commission. But in the meantime UK business is being reinsured overseas. The pressure for this trend will continue as the Transitional Measure on Technical Provisions expires (see paragraph 169). For these reasons, many respondents and technical experts are advocating that the PRA take action now, irrespective of the Commission review process. The Committee concurs and asks the PRA for an update on the best approach for improving the risk margin calibration.

136 SOL026

137 SOL009

140 SOL008

141 Ibid

142 Ibid

143 SOL047

144 Ibid

145 Q14

146 Q218

147 Q184

150 Q187

151 Q188

152 Q209

153 SOL050

154 Ibid

155 Q210

156 Ibid

157 Q214

158 Q209

159 Ibid

25 October 2017