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Brexit will not trigger a “bonfire of regulation”, according to Stephen Hammond MP, speaking at the City & Financial conference we hosted at our office in London on 7 June. Mr Hammond is a member of parliament’s Treasury Select Committee, which has been considering Solvency II.

On the other hand, Mr Hammond expressed concern about the cost of capital under Solvency II, for example deriving from the risk margin, as well as the matching adjustment mechanism. The committee asked the PRA to consider how the costly effects of these might be reduced. See "The Solvency II Directive and its impact on the UK Insurance Industry" on for more detail. 

Risk margin

David Rule, Executive Director for insurance supervision at the PRA, admitted the risk margin was especially bad for annuity insurers. The biggest problem with the risk margin is that it is too high at times of low interest rates. Insurers with long-dated liabilities suffer the most – and the risk margin encourages them to reinsure offshore (the risks of which have concerned the PRA for some time). However, the PRA’s position is that it is unable to change the risk margin while the outcome of Brexit remains uncertain – as stated in the PRA’s recent letter to the chair of the Treasury Committee.

This is a disappointment to the industry, given that the risk margin problem has been widely acknowledged. Furthermore, it is a difficulty which hits the UK’s highly developed market for individual annuities (and bulk annuity contracts with pension schemes) particularly hard.

Matching adjustment

As regards the matching adjustment, Mr Rule said that Solvency II was “prescriptive” in confining eligible assets to those with “fixed” cash-flows. That internal ratings of direct (and illiquid) assets drive a greater matching adjustment than for more marketable assets seems to worry the PRA. As in the case of the risk margin, until there is a clear post-Brexit direction for regulation, we are unlikely to see any change to the matching adjustment regime. For our explanatory note on the matching adjustment, see our January 2015 article "Matching adjustments under Solvency II".

Contract Continuity

Another concern raised by Mr Hammond was the continuing lack of clarity about contractual continuity, once the UK leaves the EU. However, this is not something that the PRA (or EIOPA) can fix alone: the draft Withdrawal Agreement would allow UK/EEA contract servicing, but only if it is ratified – and then only until the end of 2020. In case it is not ratified, the UK government’s “backstop” proposal to grant “temporary permission” would allow EEA insurers to continue to operate in the UK, but the duration of this remains unclear. So, overall, political decision-making is key.

Chris Beazley, Chief Executive of the London Market Group, explained that a free trade agreement is what is needed, in order to deal with cross-border sales.  This would be similar to the passporting regime under Solvency II. Accordingly, achievability resides within the realm of politics.

  • EIOPA’s “opinion on service continuity” of December 2017 does not help: it merely encourages insurers to take “necessary steps”, which might include portfolio transfers or setting up a branch. For EEA insurers considering establishing a third country branch in the UK, they face being forced to establish a UK subsidiary instead, given the PRA’s policy that where liabilities within the Financial Services Compensation Scheme exceed £500 million, a branch does not give it enough regulatory power.
  • Furthermore, portfolio transfers are cumbersome procedures, particularly given the need in the UK to follow a court timetable. Both UK regulators (the PRA and FCA) are already reviewing an unusually large number of transfer proposals in the run-up to 29 March 2019, when the UK is scheduled to leave the EU. Meshing a portfolio transfer timetable with possible dates for when clarity will emerge on what the post-Brexit regime will look like is particularly difficult.
  • The concept of “equivalence” under Solvency II is not a solution to cross-border sales or servicing requirements, because this focuses on solvency capital and group supervision instead.
  • EEA regulators have not yet clarified their views on the extent to which an EEA insurer can conduct its EEA operations in the UK (although EIOPA has said it dislikes “brass plate” insurers that outsource everything). On the other hand, Solvency II is clear that a branch of an EEA insurer in a “third country” (as the UK will be post-Brexit) needs to comply with a branch-specific solvency capital requirement. This seems paradoxical, when that branch is operating in the EEA.

PRA’s competition objective

One bone of contention between the Treasury Committee and the PRA is how much the PRA has regard to its competition objective, which is secondary to its general objective of promoting “the safety and soundness” of regulated firms (and in the case of insurers, seeking to secure an “appropriate degree of protection” for policyholders). The problem is that the PRA is tempted to be too conservative when regulating capital requirements, because the promoting competition is not a primary requirement.

The PRA has responded that to make competition a key objective would confuse its main role but, as Mr Hammond pointed out, the Financial Services Authority (predecessor to both the PRA and FCA) had to have regard to the desirability of competition.

Although the PRA cites having authorised 26 “new insurance firms” since 2013 (the year of its birth), the PRA has agreed to consider the extent to which the FSCS should be taken into account when supervising. If the PRA became more relaxed about capital requirements, then there could be more insurers – and a more competitive market, to the benefit of society. On the other hand, failures of insurers lead to FSCS pay-outs (at least where retail customers are concerned) and the resultant risk of levies made against other insurers, so there is a tension between encouraging start-ups (perhaps insuretech specialists) and making the rest of the industry suffer the cost of failures.

In any case, given that insurers can predict the level and timing of their liabilities much better than banks, the risk of any insurer triggering a wider problem to the “stability of the UK financial system” should be of minimal concern to the PRA.

Perhaps, therefore, the competition objective should be promoted in relation to insurance alone.

Brexit creates an opportunity for regulation to be made more pragmatic. The outstanding question is whether the government has the desire or time.

EIOPA opinion on Brexit’s effect on solvency, May 2018:

  • Own risk and solvency assessments should address UK becoming a “third country” under Solvency II
  • UK rating agencies falling outside Credit Rating Agency Regulation: effect on assets under solvency capital requirement (standard formula) and matching adjustment
  • UK reinsurers: need for a rating (step 3 or better) under solvency capital requirement (standard formula), if UK does not obtain "equivalence" status under Solvency II
  • Matching adjustment: fundamental spread automatically greater for third country government bonds
  • Group supervision: UK group supervision will not necessarily be relied on by other Solvency II supervisors, if UK does not obtain "equivalence" status
  • Group internal models approved by PRA to be re-assessed by other supervisors

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