So the government has cut taxes, crashed the pound and shocked investors and financial institutions around the world.

Amongst the jitters that Kwasi Kwarteng’s mini-budget sent though the markets, the announcement that Solvency II would be “scrapped” was easily overlooked.

Boosting investment in the UK a key objective of the Truss government’s economic policy. In previous speeches she has been critical of Solvency II for tying up insurers’ capital in assets that do little to boost growth. This article outlines some of the possible reforms we might see coming down the road to release that capital, together with the challenges that the government might face in its desire for wholesale reform.

Risk margin - an “oven-ready” reform

Before the summer’s political upheaval, the Treasury had already announced plans to change to the risk margin and to the matching adjustment, both of which many insurers consider to be excessively prudent. A PRA discussion paper on this subject closed to responses on 21 July. Changing how these provisions are set could free up financial resources to be invested elsewhere, especially for insurers with long term liabilities.

Implementing these changes could be a quick win for Truss. As a result of the previous consultation, it is likely that the government could implement them in the near future without significant further debate. Additionally, as the EU is implementing similar  changes in these areas, it should be possible for the UK to act without losing regulatory equivalence with the EU. This would be politically expedient, as the UK government is on a collision course with the EU in a number of other areas already.

How much further might Truss and Kwarteng go?

Whilst changes to the risk margin and matching adjustment would likely be welcomed by insurers, the government will need to go further to significantly increase investment by insurers in the UK and improve the competitiveness of the UK market. Two examples of changes insurers might welcome include:

Internal models: the government might also seek to significantly simplify the internal model regime. For many smaller insurers, the internal model approval process and ongoing model management requirements are simply too onerous. Currently, these firms are, on the whole, forced to adopt the standard formula and lose much of the control over capital setting that larger firms enjoy. A relaxation of the rules might lead to smaller firms moving to internal models. This in turn might, (a) lower their capital requirements, and (b) make the market more competitive for smaller firms, insurtech providers and start-ups.

Regulatory reporting: Truss might look to streamline the onerous Solvency II reporting requirements. This would be welcomed by insurers of all shapes and sizes and, if done carefully, would be unlikely to compromise policyholder protection. For example, quarterly reporting templates could be reduced in frequency (eg to being submitted annually) and reduced in number. Such reforms would not free up investment, but could ultimately reduce insurers’ expenses and hence policyholder costs and would be consistent with the promised “bonfire of red tape”.

What’s stopping more aggressive reform?

Truss and Kwarteng may wish to slash regulatory red tape, but in the short term, doing so may prove challenging for a number of reasons.

Firstly, significant watering down of Solvency II would put at risk the UK’s chances of securing regulatory equivalence with the EU. This would make the reinsurance of EU insurance business into the UK more complex, and (ironically) add further red tape to the supervision of UK insurance groups with operating companies in EU member states. Lack of equivalence would make the UK market an international outlier against other large insurance markets, not merely when judged against the EU’s rules.

Secondly, Solvency II regulation exists to protect policyholders and promote financial stability. Any change to the rules is a trade-off between the two. Loosening capital constraints would lead to lower policyholder protection and risk a PR challenge for the government from those lobbying on behalf of homeowners, motorists, and small businesses. Depending on the extent of any watering down, insurers may find themselves less able to settle unexpected claims in the future, eg in a future Covid-19-like scenario.

Thirdly, regulation change takes time. Solvency II was introduced in 2016, but the design of the rules began many years earlier, and some transition arrangements remain until 2025. The more aggressively the UK government wishes to depart from the existing framework, the longer the process of transition will take.

Do we even need reform?

There is wide agreement across the insurance industry that aspects of Solvency II are too complex and place an onerous burden on.

First published in the October 2022 edition of the Actuarial Post.