EU Insurance Regulation inquiry

The UK insurance industry is a major contributor to both personal and national economic development; a major employer and tax payer; and a major investor and source of market liquidity. The scale of its contribution to the UK economy is often not recognised and it has historically produced few risks to UK Government finances, and far less of a solvency risk than the banking system.

The PRA is highly respected internationally as an insurance regulator, both by the industry that it regulates and by other regulators.

While the PRA and a minority of industry voices argued in favour of the status quo, many respondents advocated a primary competition objective for the PRA to carry as much weight as its solvency objective. The Committee agrees.

The insurance function has implications for solvency in a number of areas, notably market, credit and operational risk, for which they are required to hold capital against under Solvency II. Even taken together, these risks are lower than in the banking sector. For example, AIG was brought down by risks on its balance sheet that were of a banking nature. If so, then insurance solvency issues are less disruptive. Competition was rightly subordinated to systemic risk in banking, but these circumstances do not apply in insurance.

The Treasury should immediately review the PRA’s approach to its competition objective, at least for insurers, and consider giving the secondary competition objective equal primacy with the PRA’s other statutory objectives, introducing primary legislation if necessary.

The industry and the PRA should review their approach to working together (including the conduct of consultations) in order that there can in future be a better and more productive dialogue on issues like Solvency II. Each side may have a different perspective, but there should be more common ground, and greater confidence in each other than the Committee detected during this inquiry. The PRA should set out how it intends to achieve this, as part of the work described in paragraph 88.

The Bank of England can rely on an immense depth of experience in banking regulation. The PRA needs to assess whether it has the skills necessary for effective insurance regulation, particularly at the most senior supervisory and policy levels. The Committee encourages the PRA, in carrying out this review, to consider the skills and experience of its Insurance Directorate to ensure there is a genuine ‘feel’ for the insurance industry. The Committee also suggests that the PRA and industry develop a higher level of staff exchanges so that each can appreciate the objectives of the other.

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

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

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.

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.

Sam Woods’ subsequent letter 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.

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.

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 Solvency II Directive and its impact on the UK Insurance Industry 55 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.

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”. 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.

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: • provide a solution for the risk margin to improve its calibration; • develop proposals for the introduction of forbearance at the national level to deal with procyclicality; • develop proposals for the Matching Adjustment and the Volatility Adjustment which allow more flexibility and a more principles-based approach, and which reduce the requirement for insurers to develop complex structures in order to achieve the regulatory treatment that they warrant; • agree with the industry on an approach to the treatment of illiquid assets, balancing prudential concerns with the desire not to create unreasonable barriers to insurers investing in long term assets; • set out proposals which reduce the amount of data required from firms to the level that the PRA can clearly demonstrate is proportionate and necessary for prudential safety; • develop rules for contract boundaries which reflect their economic substance rather than their legal form; • develop proposals for simplifying the calculation of, and approval process for, the Transitional Measure on Technical Provisions provided for in the Directive; • provide a view of where it might be possible better to align UK regulation post Brexit with IFRS17, weighing the disadvantages of change against the benefits of harmonisation; • develop proposals which remove limitations in the standard formula for both existing and new entrants to the insurance market; • develop proposals for improving the sophistication and usefulness of internal models by (a) maximising the proportionality allowed in the Directive for the approval of internal models and (b) simplifying the approval process for changes to models; and 56 The Solvency II Directive and its impact on the UK Insurance Industry • develop a solution for firms who will lose the legal validity of their contracts after Brexit.

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.

In developing a post-Brexit regulatory model, it is recommended that efforts are made to accommodate regulatory forbearance, where it can be shown to improve macroeconomic stability and improve consumer outcomes. The Committee would expect to see some work on how this is being progressed. In parallel with this, the PRA should develop contingency plans that it can adopt if and when necessary in emergency circumstances, as soon as it is no longer constrained by EU law.

In developing the future regulatory model, specific efforts should be made to avoid creating situations where artificial structures are encouraged to achieve an appropriate regulatory treatment for any class of assets or liabilities.

Reduced competition in the annuity and equity release markets, the extra costs in complying with the rules, and loss of access to some asset types, are leading to poorer value for customers.

UK firms believe that Solvency II makes it harder for them to invest in longer-term illiquid assets, such as infrastructure and equity release mortgages. This is a concern as the disincentive could have negative economic consequences and act as a restraint on UK plc.

To the extent that the rules also discourage insurers from offering annuities, there will be a transfer of risk to Government, and poorer value for consumers.

The Matching Adjustment has given some relief to the industry in that it attempts to reflect the long term nature of assets matching long term liabilities. Nevertheless, the Adjustment is a “workaround” solution, bolted on to the core Solvency II rules, which is cumbersome, and unnecessarily constraining. For these reasons, the PRA needs to conduct a fundamental review of the Matching Adjustment and its eligibility criteria, in order to achieve a more principles-based approach to the Matching Adjustment.

The regulator and industry should work together to ensure that opportunities are taken to develop a more effective long-term approach to the treatment of insurers holding long-term assets to match long-term liabilities.

A robust process will still be needed for approving and maintaining any approach that gives credit to an illiquidity premium. Evidence suggests that there is scope for more pragmatic rules to be agreed, with more flexibility alongside strict criteria to avoid the need for artificial restructuring of firms’ cashflows for purely regulatory The Solvency II Directive and its impact on the UK Insurance Industry 57 purposes. The Committee would expect the PRA’s progress report (requested at paragraph 90) to address the extent to which this is the case, and set out what action it proposes to take.

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 event—makes 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.

The Committee notes the widespread and consistent concerns expressed by firms over the proportionality of the PRA’s approach, particularly with regard to the review and approval of internal Models and amendments to those models. The PRA is urgently asked to review its practices and report to the Committee on proposed changes.

The current EU legislation allows for proportionality in national regulators’ approach to capital models. There should be no reason to wait until the UK has left the EU to take advantage of these provisions. The Committee requires the PRA to note this stipulation and report on intended actions.

The PRA should also assess whether the Standard Formula could be enhanced for the benefit of existing users, especially if an improved version could save some firms from needing, or choosing to upgrade to, an Internal Model. The Committee suggests that the PRA consider the specific ideas for improvement put forward by witnesses in evidence to this inquiry.

There is evidence that the regular reporting requirements are costly and overly detailed. The Committee believes that they could be streamlined, reducing the burden and cost on firms, and reducing the risk that the PRA could miss something. The PRA should review the information collected—both in the EIOPA and national templates—and assess it in the context of both usefulness and cost effectiveness, notably the quarterly data. The merits of exception reporting and/or focusing more on changes to previous information should also be considered.

The Committee agrees with the oral evidence that its predecessor heard from Andrew Chamberlain that the Volatility Adjustment is “fairly crude”. From the oral and written evidence it would appear that there are two main problems with the Volatility Adjustment. First, whether it should require approval from the regulator, and second, whether firms should be allowed to use a ‘dynamic’ Volatility Adjustment. 58 The Solvency II Directive and its impact on the UK Insurance Industry Given the problems of procyclicality examined in Chapter 4, it would seem prudent for the Volatility Adjustment to vary in certain prescribed circumstances, without regulatory approval. Given the actions of other regulators, notably the Dutch, this action seems uncontroversial, and the Committee sees no reason why it should not be undertaken without delay. An update should be included in the PRA’s progress report requested at paragraph 90.

The PRA’s consultation on the calculation of the Transitional Measure on Technical Provisions was welcome, but was limited in scope. Broader issues remain to be addressed including: (i) whether and how the transitional benefit should be allowed to run-off over time; (ii) whether the principal causes of the increase in reserves that accompanied the introduction of Solvency II can be “corrected” when determining the future UK solvency regime issue; (iii) reducing the cost, particularly over the potential need to maintain dual models for sixteen years in case a re-measurement is required; and (iv) developing an approach which is practical to implement.

Agreement on a pragmatic approach to pre-Brexit contracts is vital. In the absence of this, or a comprehensive reciprocal arrangement which addresses the problem of the loss of passporting, there will be substantial additional work for firms and regulators in both the EU and UK, especially the PRA. Wherever possible the PRA should adopt pragmatic approaches such as granting provisional recognition to EU branches prior to Brexit.

The insurance industry should be regarded as a priority sector during the Article 50 negotiations. The Government should consider bespoke reciprocal agreement with the EU, similar to, but far more comprehensive than, the agreements that the EU has with Switzerland and more recently with the United States. Such an agreement could provide a solution for other parts of the financial services sector. At the very least, if the Government wants to meet its objective of a “smooth and orderly exit” from the EU, then it needs to address the urgent issue of pre-Brexit cross border contracts, perhaps through the mutual recognition of pre-Brexit insurance insurance contracts written in UK or EU member states.