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Bank Of England - Solvency UK: Maintaining The Momentum - Speech By Gareth Truran - Given At Bank Of America Financials Conference

Date 20/09/2023

Introduction

Good morning and thank you for inviting me to speak to you today.

I want to update you today on the reforms to Solvency II, to create a new UK prudential regime for insurers known as Solvency UK. These changes are designed to simplify the regime, adapt it more to the UK market, support new entrants, and help insurers invest more in productive finance. And at the same time, to maintain high enough standards to support safety and soundness and policyholder protection.

 

The PRA has made significant progress this year, with another big milestone coming very shortly. I’ll talk today about what comes next, and also about how our work on these reforms fits in with our broader plans for the new UK regime.

In short, we are maintaining the momentum needed to implement the reforms in 2024, and to adapt our supervision in the future.

Implementing the new UK regulatory framework

But first, a quick update on the new regulatory framework in the UK, which is an important enabler of what we are doing on Solvency UK.

This is a big year for the PRA. Parliament has given us new powers and a new secondary objective. Working with the Treasury, we will use these powers to delete, replace or amend retained EU law to adjust our prudential regimes to the UK’s needs. In doing so, we will seek to maintain strong standards in line with our primary objectives, while seeking to advance our secondary objective for competition, and our new secondary objective for growth and competitiveness.

We are also thinking carefully about how our policymaking can best contribute to growth and competitiveness given our new secondary objective. The links between prudential regulation, growth and competitiveness and how these links might best be measured have not previously been a major focus of external research. We want to change that. In fact the PRA is holding a major conferencefootnote[1] today, bringing together the public sector, firms and academia, to explain our work so far, and to encourage more debate and research to make sure we benefit from a range of perspectives on these issues.

Within this overall framework, our work to implement Solvency UK is a good example of how we intend to use our new powers in practice. So let me move on to how we're taking forward our reform agenda for insurers specifically.

From Solvency II to Solvency UK

The last couple of years have involved significant public debate on potential reforms to Solvency II. The Treasury announced in November 2022footnote[2] the government’s conclusions on the Solvency II Review and how it planned to implement them, including the areas which would fall to the PRA to take forward.

Following the November announcement, we have pivoted our work this year to develop and consult on our detailed policy proposals, to play our part in implementing these reforms as quickly as possible within the framework the Treasury intends to set in legislation.

June consultation package

The PRA’s biggest step so far on this journey this year was in June, when we publishedfootnote[3] an ambitious set of proposals to simplify a number of areas within Solvency II, to improve the scope for flexibility and judgement rather than detailed prescriptive requirements, and to encourage entry to the UK market. The consultation was generally well-received at the time of publication and we are currently analysing the detailed responses. We aim to publish our final policy as soon as possible in 2024.

Investment flexibility and the matching adjustment

Our next big milestone is our forthcoming consultation on reforms to the matching adjustment (MA), designed to help improve investment flexibility. This will be relevant particularly to life insurers with approval to use the MA. We are aiming to publish this around the end of this month.

In its November announcement last year, the government confirmed the PRA would take forward a number of changes to the MA within a framework set in legislation. The PRA’s consultation will cover our detailed proposals to implement these reforms within this framework. You will have to wait a little longer to see the full details. But at a high level, the consultation will cover three main areas.

First, we will set out how we intend to update the regime to improve life insurers’ investment flexibility within the MA. Under Solvency UK, life insurers will in future be able to include in their MA portfolios a wider range of assets, including some assets with ‘highly predictable’ cashflows. The government hopes insurers will respond to the incentives to invest more in long-term productive assets following these changes.

Second, there are a range of areas where we aim to improve the operation of the MA, to simplify the processes we and insurers currently have to apply. Collectively, these can add cost and time on both sides. For example, we see opportunities to streamline parts of the MA approvals, and to introduce an accelerated pathway for new investments into the MA in certain circumstances. We will also set out how we propose to make more proportionate the current severe consequences for insurers who accidentally breach the MA requirements, and to make the regime somewhat more responsive to changes in credit risk by updating the MA calculation to use notched credit ratings.

And finally, we will explain our proposals to implement a range of supervisory measures which will help enhance firms’ responsibility for risk management and help the PRA monitor and control potential risks to safety and soundness and policyholder protection arising from the use of the MA. These measures will be in line with the announcement the Government made in November. I will say a bit more about some of these in a moment.

Collectively, the reforms will enable insurers – if they choose – to obtain an MA benefit for a wider range of assets, and also for a wider range of liabilities. Combined with the forthcoming cut to the risk margin which the government is making, insurers have said this will allow them to enhance their investment in areas such as productive finance.

Over the coming months we will continue to work with industry and other stakeholders to ensure there is a good understanding of our proposals, to allow firms to prepare for implementation, and to ensure the reforms can be used as effectively as possible to support any industry plans for increased productive investment.

MA enhancements

Let me say a bit more about some of the enhancements we will propose to the MA.

As a reminder, the MA is a mechanism to allow insurers to take credit upfront for part of the return they expect to earn on their investment assets, where these are used to closely match insurers’ long-term liabilities. As part of the MA construct, the ‘fundamental spread’ is the allowance insurers must make in their reserves for the risks they retain – for example, credit risk.

In its November announcement, the government decided to retain the current MA construct but recognised some enhancements were needed as part of the Solvency II reforms, to ensure the PRA could manage risks to safety and soundness and policyholder protection. Let me highlight three of those enhancements.

First, we need to update parts of the regime to reflect the government’s decision to expand the assets eligible for the MA to include some assets with highly predictable cashflows. Such cashflows have some uncertainty about their timing and amount that introduces some new risks into the MA, such as prepayment risk, which will need to be controlled and allowed for. Furthermore, as a backstop to ensure assets and liabilities remain well-matched overall, the government has also made clear its expectation that the ‘vast majority’ of assets in the MA portfolio should remain fixed. We will explain in the consultation how we will achieve this.

In updating the regime for highly predictable assets, we have thought carefully about how to ensure the framework recognises the additional risks appropriately, but does not become a barrier to firms adapting their investment approaches over time. We recognise some highly predictable assets will not have sufficient reliable data to allow these additional cashflow risks to be modelled with confidence. So we need some simple and pragmatic approaches to ensure sufficient allowances are made by firms at an asset level, and to ensure firms’ assets and liabilities are still well-matched in aggregate. This combination of approaches will allow us and firms to adapt more quickly to facilitate insurers’ including these assets in MA portfolios, while ensuring the additional risks are captured sufficiently. As experience develops over time, we can consider whether these simpler approaches can usefully be refined further.

Second, we will consult on a new MA attestation framework. We want to ensure insurers’ senior managers take responsibility for the overall MA benefit they are taking, and explain their assessment to us. We will also allow insurers to increase the fundamental spread risk allowance where they think it is appropriate for their portfolios. For example, the standard allowance in legislation is based on the risks in straightforward corporate bonds. Our proposals will set out a framework to help insurers consider where these standard assumptions might not hold, and to respond accordingly.

Finally, we also want to formalise and improve the existing MA reporting we get from firms. We want to put this onto a structured footing to enable us to monitor how insurers’ MA portfolios evolve in future given the significant changes being introduced in these reforms, and given other relevant market trends such as the growth in life insurers’ bulk annuity pension transfers which will also affect firms’ MA portfolios. This information is – and will remain – a vital part of our toolkit to supervise firms effectively.

Implementation

Shortly we will have published details of all the substantive reforms to implement the result of the Solvency II Review, other than our plans for stress testing which I will talk about shortly. We expect our final policy in all these areas to be published during the first half of 2024, in line with the timetable we set out publicly in June.

We will also consult next year on transferring the rest of Solvency II largely unchanged into the PRA rulebook. This will mean we have a single solvency regime for insurers designed for the UK, and accessible to firms in one place. I’ll say a bit more in a moment about what might come after that.

As we said in June, implementation of most of the changes is planned for the end of 2024, although we are working hard with the Treasury to allow our proposed MA reforms to come in sooner, by June 2024.

Alongside our reforms, the Treasury has also confirmed it intends to legislate before the end of 2023 to cut the risk margin for long-term life insurance by around 65% and for non-life insurance by around 30%. This will release a significant amount of financial resources which insurers will also be able to deploy, if they choose, towards more productive investment opportunities even before the rest of the reforms come into effect next year.

In short, we have made very good progress this year in turning the high-level conclusions of the Treasury’s review into detailed proposals. This has been a huge task – there are many hundreds of pages of detailed law and policy material that we have to update. We need to do that carefully to make sure we implement the reforms properly, and to ensure the safeguards we have in the regime work as intended. We will continue to move as quickly as possible to consider feedback and announce our final policy in H1 2024, with full implementation by the end of 2024.

Beyond 2024

Beyond our immediate priority to implement these reforms as quickly as possible, let me also say something about what might come after that. Further ahead, once the regime is fully in our Rulebook rather than locked in legislation, there are other areas we can explore. For example, we could consider whether we can go further to improve the proportionality of the regime for smaller insurers, following similar efforts we are making for banks. In addition, most insurers (including most smaller insurers) use the Solvency II standard formula to calculate their capital requirements rather than internal models, and we have chosen not to prioritise any changes to the standard formula as part of these reforms. But in due course we could consider whether any reforms are warranted here to better suit the UK market. We can return to these questions once the current reforms have been implemented.

But for now I wanted to say a bit about three main areas we are already working on beyond the current consultations. They are:

  • our plans for enhanced stress testing;
  • some longer-term research work on the interaction between our prudential regime and the contribution insurers make to the economy; and
  • how we see our domestic work dovetailing with international developments.

Stress testing

The government’s November announcement noted that as part of the reforms, the PRA’s future supervisory approach would include enhanced stress testing for insurers – drawing on new legal powers to allow us to publish individual insurer results.

Stress testing is an important part of the PRA’s supervisory approach to help test firms’ vulnerabilities to different scenarios, using a different lens to our standard solvency capital framework. We have undertaken stress testing of insurers for many years, so we already have some good foundations to build upon.

The Solvency II Review showed there are important assumptions made within the prudential framework for life insurers, and it will remain important to test these in future. For example, the matching adjustment will continue to be based on some material assumptions which will continue to underpin its calculation as we move to Solvency UK. Stress testing will play a useful role in allowing us to test the resilience of insurers’ balance sheets to different scenarios.

As regulators, it is obviously important we understand firms’ financial resilience and the potential sensitivities and vulnerabilities in firms’ business models in different scenarios where these assumptions might not hold. But this is also important to this audience as external users of insurers’ financial information. As a reminder, the contribution of the MA to insurers’ balance sheets is significant. At year-end 2022, life insurers held around £294 billion of assets in their MA portfolios, conferring an MA benefit on insurers of around
£66 billionfootnote[4]. (As context, the capital base of the life sector at year end 2022 was £98 billion.) By any measure, the MA has a significant impact on the sector’s regulatory balance sheet. Sometimes we hear a view that the MA is too complex for users of financial statements to understand through disclosures. Rather, I would say the MA is too important for users not to understand.

Enhanced stress testing – and the public disclosure of individual results at least for those life insurers where these issues are likely to be most material – should play an important role in promoting greater transparency and market discipline.

That said, we recognise publication of individual firm results will be a big shift from our current approach, in which insurers make private submission of their individual stress test results to the PRA and we publish an aggregate summary. Of course, this is a shift we made some years ago for banks, so we are aware of the issues involved and equally aware of the differences.

Given this shift, we are keen to engage with a range of stakeholders as we develop our plans. In particular, we want to understand the information potential users of stress test results might find most useful. We also want to ensure any disclosures can be properly understood given their potential sensitivity. To do this it is important we engage more broadly with a range of users of insurers’ financial information such as analysts and pension trustees. We set up a stress testing engagement group earlier this year to start to explore these issues further. Discussions so far have highlighted both the potential value and impact of individual disclosures, as well as the need for education around the MA and helping the market to understand how the MA works.

We will say more about our evolving work on stress testing as our plans develop. For now, you can expect us to take things in a number of stages as we prepare for our next insurance stress tests.

First, for life insurers, we will continue our external engagement in the autumn on both disclosure and design of the next exercise. We will then aim to publish more details about our approach to the next exercise in the first half of 2024 and invite further technical input on the mechanics of the exercise, including on disclosure. Our expectation is the first of the new stress tests will be launched in Q1 2025 with the publication in Q4 that year.

For this next exercise, given the amount of reform under way for both us and firms over the next year or so, we expect individual disclosure of results for the largest life insurers will be one of the more material changes from our last stress test in 2022. Beyond that point, we will consider how the framework might evolve in future.

Secondly, for general insurers, our approach to disclosure for our next stress test will remain, as before, on an aggregate basis – further details will be set out over the next month.

How prudential requirements for insurers affect the economy

Looking further ahead still, let me come back to how we take into account our new secondary objective for growth and competitiveness when we make policy. We are keen to deepen the framework we use to assess the role insurers play in contributing to the real economy and the effect of regulation.

We expect to focus first on the life insurance sector, and we will consider the two important roles that sector plays within the economy: the supply of risk transfer and the supply of finance. We are considering what the evidence shows about the potential macroeconomic benefits of how insurers support the wider economy, such as enabling consumption smoothing and lowering the cost of finance.

We will also look at the evidence on the potential macroeconomic costs of insurer distress or failure. (For example, these costs could include: first, claims and benefits not being met in full, or higher levies for insurers under the Financial Services Compensation Scheme, and, secondly, disruption to the supply of finance, through procyclical investment behaviour, and undermining confidence in financial servicesfootnote[5].)

The theoretical sweet spot for regulation is the point at which our regime maximises the net benefits, taking into account our primary objectives of safety and soundness and policyholder protection, as well as our secondary objectives.

We have a lot to do yet to refine this framework, estimate the costs and benefits, and consider where more research could usefully be done to better understand the impact of financial requirements for insurers on the economyfootnote[6]. But it is an important area of focus for us, and we are aiming to publish some initial research next year. And, of course, we will monitor the effects of the reforms introduced by Solvency UK, which might give us some useful evidence in due course on how these changes in regulatory regime have affected these factors.

Alignment with international standards

Finally, and briefly, my remarks today have covered our domestic agenda. At the same time, there has also been good progress at the international level through the International Association of Insurance Supervisors (IAIS). Currently insurance regimes differ significantly across countries. In future the International Capital Standards (ICS) will provide a minimum set of capital standards for internationally active insurance groups. Our secondary competitiveness and growth objective requires us to align with relevant international standards. As a global financial centre, this is a key contributor to the UK’s international competitiveness because it helps foster trust and confidence in the UK regime, making it easier for UK firms to operate in overseas markets and vice versa.

As well as having a key role in this work at the IAIS, we have also made sure our domestic reforms are directionally consistent with these new international standards. This should avoid the need for any parallel regimes in future. Subject to confirmation through a final round of data collection this year, we expect our Solvency UK regime will be an “outcomes equivalent” implementation of the ICS. In other words, UK insurers – and stakeholders assessing their financial position – should be able to be confident the UK regime will deliver a level of resilience at least in line with these minimum international standards.

Summary

I hope it’s clear we are well on the way to implement Solvency UK in 2024 and to take our supervision of insurers forward beyond that in line with our objectives. What should you take from what I have said today?

My key message is that since the direction of reforms was announced last November, we have moved rapidly to produce our detailed proposals and to plan carefully for implementation. We will have consulted very soon on our comprehensive package of policy reforms needed to help deliver the outcomes of the Solvency II Review in line with the government’s announcements and planned legislation. Firms should then have all the information they need to understand our proposals and to start to plan for implementation, including adapting their investment strategies where appropriate. And in parallel, we are also taking the necessary steps to plan for implementation and to embed these new approaches in our supervision including through our enhanced stress testing.

And while these reforms remain our key priority for the coming months, we are also looking beyond 2024 to consider how our regime might operate in future. We are thinking carefully about how we can maximise our contribution to delivering our secondary objectives over the long-term, and working closely with international insurance supervisors to make sure our regime aligns.

So this is an exciting and very busy time to be in the sector. In closing, I want to express my gratitude to all my colleagues at the PRA who have been working incredibly hard to produce all the detailed policy material we are consulting on this year. I am also grateful for all the external input we have received in response to our consultations so far, which I’m sure will continue over the next few months. We look forward to finalising the reforms over the next few months and to 2024 being a year of successful implementation.

Thank you.

I would like to thank Jemima Ayton, Stefan Claus , Phil Evans, Olga Filipenko, Charlotte Gerken, David Humphry, Adam Jorna, Shoib Khan, Anu Ralhan, Abdullah Shah for their assistance in preparing these remarks.

  1. Conference on the role of financial regulation in international competitiveness and economic growth

  2. Consultation Response - Review of Solvency II 

  3. CP12/23 – Review of Solvency II: Adapting to the UK insurance market 

  4. Source: Solvency II QRT data

  5. The Government has consulted on introducing an Insurer Resolution Regime, to provide the UK authorities with new powers and tools to effectively manage the failure of a systemic insurer or multiple insurers. Government's response to the consultation on introducing an Insurer Resolution Regime 

  6. The Bank’s annual research conference will consider insurance within the theme of the prudential regulatory framework Annual BEAR research conference: The Prudential Framework