Series 3 Episode 10: Navigating Solvency II reform and the PRA’s insurance agenda

Transcript

Andrew Strange: Hello everyone, and welcome to the latest episode of the Risk & Regulation Rundown podcast. I'm your regular host, Andrew Strange, and today we're going to be talking about insurance prudential reform, following our episode last month where we talked about banking prudential reform. If you're interested in banking do go back and listen, but I promise today's insurance one is going to be equally interesting. We're joined by two expert guests, we have Anirvan Choudhury, who is a Senior Manager in my Regulatory Insights team, and Sarah Watson, a Senior Manager in our Insurance Regulatory team. We're going to be talking about Solvency II reform and what the PRA's business plan means for insurers more broadly. So, starting with the former, at the end of April, Treasury published a consultation on the Solvency II review, or the UK Solvency II, I think we're possibly calling it that, and the PRA also issued a discussion paper alongside this. Anirvan, do you want to just start by talking us through some of that?

Anirvan Choudhury: Yes sure, Andrew. So, just in terms of that, it's been quite a journey, so where are we at in that journey? So, October 2020 is when we first saw the consultation from HMT. Following that, in the summer of 2021 we had the quantitative impact study from the PRA, and now that that study has been completed we've got another round of consultation from HMT and a data collection exercise launched by the PRA.

Andrew: It's just the gift that keeps on giving.

Anirvan: Absolutely, and I think there'll be more to come so stay tuned. So, in terms of what's in there, so they initially started with ten areas that were under review, a lot of them were less controversial or non-controversial, so it's easy to get to consensus around those. There are two really major areas that are currently being debated, and that's the risk margin and then the matching adjustment, both quite technical and complex areas that potentially can have quite a big impact on capital positions for firms. So, these are really the two main areas right now where we are going to see further debate and probably further consultation.

Andrew: Okay. So, practically what does that actually mean? And, I guess, is there something about release of capital here and what's the impact of that going to be and what's that going to do to pricing?

Anirvan: Yes, absolutely, that's a great question, Andrew, so let's take that one by one. So, the risk margin, so risk margin has been a bone of contention ever since Solvency II came in in 2016. So, everybody agrees the risk margin has to be reformed but what is that reform going to look like? So, I think your question was spot on as to what will be the impact on firms? And we've got some indication from the regulators, as well as HMT, what it might look like. So, what they are saying right now is potentially a 60% reduction in the size of the risk margin for life insurers and about 30% for general insurers, which is something that I think, overall, industry as well as regulators would, well, at least industry would definitely welcome.

Andrew: Okay.

Anirvan: The other area, the matching adjustment. So, obviously the Lord giveth and the Lord taketh away, so risk margin is going to go down but there are proposed changes to the matching adjustment that would potentially increase the capital requirement for life insurers. The key area there is something called the fundamental spread, that is how you calculate what risk insurers retain on their balance sheet, and with the risk margin coming down the calibration and design of the fundamental spread might change and we might have an offsetting rise in capital. You've got, though, these two opposing forces, so finally what does it flesh out to? And it seems like there'll be a 10-15% reduction in capital release for the insurance sector, most of that is going to come from the life insurance sector.

Andrew: Okay, so it's not net-zero, there is some release from this.

Sarah Watson: And I think what you're seeing here, really, is a slight tug of war between the Treasury and the PRA. So, the Treasury is really thinking about how can they help the UK insurance sector be innovative, be competitive and drive some long-term investment in the UK. And the PRA, definitely, is very conscious and aware of that, but they're also trying to make sure that firms hold enough capital to protect safety and soundness and to make sure policyholders are protected.

Andrew: And it feels like a bit of the tug of war that actually the banking sector was talking about last month in terms of that international competitiveness versus that safety and soundness, definitely.

Anirvan: And just quickly on that point, you know, what Sarah just mentioned, when Solvency II reform first started in October 2020 the PRA came out and said that, broadly, the capital level held within the insurance sector is appropriate. There's definitely been a softening of that position and now they're publicly saying that potentially these reforms that we talked about, 10-15% capital release.

Andrew: Okay, interesting. So, what are the next steps on this then, Anirvan?

Anirvan: So really, Andrew, the next steps, following the publication in April 2022, now we have what is called the DCE, a data collection exercise, from the PRA, that's going to run from July to-, phased data collection exercise, July to September 2022. That's when the PRA's going to do another round of technical analysis on the data that comes out and then we're going to see the next round of proposals. What I'm not 100% sure of is between the data collection exercise and PRA's proposals if there's going to be another round of consultation from HMT, to sort of steer the direction of where these reforms should go. So, in terms of timeline, the question I often get is 'When will we see something that really is going to be implemented?' My best guess would be 2024, possibly 2025, because if you really think about it, next year, earliest, next year you'll get those set of reforms, that means 2023 and that would mean 2024 when it's implemented.

Andrew: Okay. I was getting excited and now you're saying it's a few years out, that's a shame. So, in solvency obviously is a big part of the PRA's wider business plan, which they published earlier this year, but what else did the plan cover there in terms of initiatives in the insurance sector and was there anything there more immediate than maybe some of the Solvency II reforms?

Sarah: Yes, definitely. So, there was quite a lot in the PRA business plan, and there were some cross-sector themes that affected both banks and insurance firms, so things like that would be operational resilience or responding to climate change risks. But there were also some insurance specific initiatives, and I'll kick off with those. Firstly, there is the 2022 insurance stress test, so that has now been launched, and that's to try and assess resilience for the insurance sector to a severe stress, the PRA has set distinct scenarios for both the life insurance firms and the general insurance firms. Secondly, there's going to be some continued focus on internal models, looking at both potential drift in internal models but also using the outputs from those models to compare across the peer group. Thirdly, in terms of supervision and where they'll be focusing, for life insurers I think it's still going to be credit risk and for general insurers it's going to be inflation and contract uncertainty risk. And then lastly, some initiatives around ease of entry and exit, and this takes forward some of the initially Treasury Solvency II review recommendations. So, for insurers on the ease of entry side, they're talking about simplifying the authorisations process and also looking at potentially reducing barriers for entry for new UK retail insurers and increasing the threshold at which Solvency II would start applying. On the exit side, I mean, just as a reminder, you may know this has been a bit of a gap for insurance in terms of there is no distinct resolution regime. The PRA is looking at this, so this will be coming through, we don't yet know timing, but I think we are starting to see this in what clients are saying to us which is they're getting a lot more focus from the supervision teams looking at wind-down planning. So, how are firms already preparing for recovery, for resolution, etc, and are those plans adequate?

Andrew: Okay, and that resolution exercise in the banking space over the years has been a monumental task for some organisations, so if the insurance sector gets their turn now then lucky them, that's going to be fun.

Sarah: Yes, well, some insurance firms have already started to do this. So, the largest ones, which used to be the G-SIIs, the globally systemic ones, they have done a lot on recovery and resolution planning, and under the new IAIG regime, the internationally active insurance groups, they had started to do this, but I think there's a lot more to come and it's going to be spreading out to some of the smaller firms as well.

Andrew: Sound like my asset management type clients as well, who, post the IFPR regime are now finding that kind of wind down and resolution piece is something they begin to focus on. Interesting, okay. I'll avoid talking about the FCA's authorisation approach which is slightly different from the PRA's, but it's good to hear that PRA wants to make it easier. So, I mean, you touched on some of the other priority issues in the PRA business plan there across the range of firms that it supervises, things like operational risk and resilience and climate change, diversity and inclusion, what are the implications around some of those things, specifically for insurers?

Sarah: Sure. Firstly on operational resilience. This is now being embedded in the supervisory approach, so I think insurers should expect some more challenging conversations coming through. Firstly, have they met the new policy requirements to identify their important business services and to set impact tolerances by the end of March 2022? But then also, have they had the right governance around those sort of discussions? Have they set the right level of those impact tolerances? And then looking forward, are they going to be able to deliver their important business services within those tolerances by the end of March 2025? And also, there's a lot more focus looking at firms' growing dependency on outsourcing, and in particular on the cloud service side of things. On climate change, as you know, this has been increasing in focus, you know, generally in the world but also in supervision and in the PRA's contact with firms. This year the PRA will be actively supervising on climate change, which means insurers should expect to be questioned on this throughout their supervisory cycle and interactions. So, how is climate change being incorporated throughout the business? Right from investment decisions, underwriting, reserving, but also the bigger picture, their strategy, the governance around it. That should all start to be discussed within the firm, but also with the PRA. The PRA has said there have been improvements in how firms are thinking about climate change risks, but the progress is not consistent across firms and I think in general there is still more to do, and in particular around data gaps and modelling. And then lastly, the largest insurers this year can expect to be asked to produce an extra report, which I'm sure they'll be pleased to hear about, which looks at how they have started to embed the management of climate change risks alongside their broader risk management frameworks, and they have to do that as part of the ORSA.

Andrew: Okay, interesting.

Anirvan: And just to pick up on one other key topic that is cross-sectoral, but definitely has significance for insurers as well, is diversity and inclusion. So, just in terms of where we are at, we are going to see another consultation paper from the regulators in the fall of 2022, and then possibly a final policy paper coming out in 2023. You know, listeners from the insurance sector will be aware that there have been some well-publicised cases about cultural issues affecting some pockets of insurance firms, and there is I think quite broad recognition that firms have more to do both on diversity as well as inclusion. I'll just leave you with this one thought that, you know, in insurance we always talk about diversification benefit when we think about how we model risks and our balance sheets. I mean, that now needs to work through the culture side of insurers as well. It's time to get diversification benefit on our staffing, how we staff.

Andrew: Yes, I think that's probably true, actually, of all financial services firms, and we've certainly done some podcasts on that D&I agenda in the past but you're right, it's not going away, and it's an inherent part of the 'S' part of ESG as well, isn't it.

Anirvan: Absolutely, yes.

Andrew: So, somebody earlier on briefly touched upon interest rates for inflation but, I mean, clearly there are some pretty challenging macro-economic trends out there at the moment. What does, is that featured in the supervision? Has that, sort of, filtered thought to the PRA's approach?

Anirvan: Absolutely. I mean, the macro-economic trends definitely are having an impact. So, let's pick up on inflation, for example. It was highlighted as one of the priorities for insurance supervision in 2022. The risk here is reserving risk. So, if we see 10%-plus inflation, claims inflation, which includes social inflation, could potentially be higher and there is definitely a concern from the regulators, and when we speak to regulators we hear this as well, is have firms really reserved for this sort of inflation for an extended period of time? And what do firms need to do, and this is where, you know, your risk management process, what do you put in your ORSA, comes into play. Have you done stress-testing around this to gain comfort that your reserves are going to be adequate if this sort of inflationary environment persists for a few months, or years? On the investment side as well, we are seeing a lot of asset volatility as well as quite sharp rises in interest rates. So, I think this is again an area where insurance firms need to think about are they following the prudent person principle under Solvency II. Is their risk management capability adequate to manage these sorts of fluctuations, whether it's on the interest rate side or geopolitical risk, and all those things, I think, come together in that area, and I would think that if insurers are trying to change their investment strategy at this point, exploring new asset classes, you know, crypto and those kind of things come up from time to time, I think that's where it is possibly reasonable to assume that you're going to get quite a bit of regulatory and supervisory scrutiny if you're changing your policy at this stage, especially going into unexplored and high-risk asset classes.

Sarah: And we are already hearing from clients that they are getting asked by the PRA, you know, what is the impact so far of inflation? How much further could it go? What will be the impacts on their balance sheet, on their investment decisions, etc. So, I think if you haven't yet been asked then you should be aware it's on the radar of the PRA.

Andrew: And the PRA also referenced in its business plan the work that it's doing to improve the way it's actually run itself as a regulator. And a key part of that I guess is, well, certainly from my experience it appears to be how they use data and analytics in terms of their own transformation and evolution. What are we seeing on that from an insurance perspective?

Anirvan: Yes, a couple of points on that, Andrew. So, first is data collection. Because the Solvency II review requires a lot of data collection, you know, I think we are in that, sort of, this phase where there are a lot of data requests going out to firms. But I think we need to separate that a little bit, because that is because of the modelling and complexities involved in coming up with the right reform for Solvency II. Longer-term, the Solvency II review is supposed to deliver a reduction in reporting requirements as well as more tailored reporting for UK-based insurance companies. So, that in turn, in theory, should reduce ad hoc data requests coming from the regulators going forward. Beyond that, I think there is always this issue about data accuracy. There are a lot of forms that firms need to submit under Solvency II and, you know, having that process in place so that the accuracy of the data is not compromised, because if there is incorrect information submitted it can have serious consequences. So, that is something that I would-, I always, you know, in my discussions with firms, I always flag that. Think of data quality as well as the governance and controls around data.

Andrew: Yes, I agree. I mean, and fewer data requests in some respect is good, but actually that puts a greater reliance on the data that the regulator does get, so certainly again if I think about my asset management clients, actually the data that goes in is really important and whether you're an outlier either in a positive way or a negative way, you need to be absolutely sure of where you sit because that's going to drive a lot of that engagement.

Anirvan: Yes, and one thing, I mean, this is not a topic for this discussion but how data is used, and especially on the underwriting side, I think we can do a separate podcast at some point about the issues around that, but let's park that for today.

Andrew: Well, sounds like I’m sold. We'll do that one later this year in that case, definitely. Well, I think there's an awful lot, clearly, going on here with the regulator and for firms to deal with. Given that we've talked about quite a lot in our discussion today, I'll just put you on the spot and ask what's the single biggest challenge that the current Prudential agenda presents for insurers? And Anirvan, I'm going to come to you first.

Anirvan: I know, Andrew, you love these questions. You know, on this one I'm really struggling to pick one, and I'll tell you why, because the things we talked about, D&I, OpRes, ESG, Solvency II review. They are all big topics, important topics, so I think the challenge really, for insurers, is to be able to manage this busy regulatory agenda. Because if you slip up on any one of these, you know, there can be-, from a regulatory point of view there will be consequences. So it is, I think, about prioritising, understanding the firm's own skills and capabilities. Where are they in terms of preparedness for OpRes or ESG and then trying to determine what is the most optimal allocation of the financial and non-financial resources to be able to deliver against this regulatory agenda.

Andrew: Okay, and Sarah, did you want to sit on the fence as well, or did you want to answer the question?

Sarah: Well, I do largely agree with Anirvan but I'll add one or two things. Firstly, I think the Solvency II review is going to have the biggest potential impact on insurance firms over the next year or two, but I recognise it's largely out of their hands as to where the review ends up so let's park that for now. The other area I think which will have a near-term impact is the increase in inflation and interest rates. There is going to be more short-term focus on how that's going to impact them, and perhaps some of the longer-term implications of it as well, but I think Anirvan's right. Everything is important. You can't just drop any one to focus on the other, and it's a really busy agenda for insurers.

Anirvan: Yes, and there are other things we didn't cover, right? I mean, there is IFRS 17, and those kind of, you know, large transformative topics that are also running in parallel with the regulatory items.

Andrew: Sitting on the fence and extending the fence as well. Well, Sarah and Anirvan, thank you both very much for joining us. I mean, I guess my reflections on this are that there is an awful lot going on. It's a bit obvious. I quite like the fact that, as a bit of a regulatory geek, that we've got the Solvency II review, sort of, ongoing in the background with some degree to influence it but longer term. Clearly, there's a load of regulatory stuff going on, plus you've got the macro-economic environment. You know, some of this stuff we're really passionate about as well, so the D&I agenda, for example. So, yes, a huge amount going on. It sounds like a really exciting time, actually, to be in the insurance space. To our listeners, I hope you are also finding this as interesting as we did, and I hope you've enjoyed our conversation today. Please do subscribe to future episodes, and rate and review the series, as it helps other listeners to find us. We'll be back next month with our next episode.