Fundamental Takeaways

On 20 February 2023, PRA CEO Sam Woods delivered the Fundamental Spreads speech at the Association of British Insurers' annual conference dinner. Following a period of public disagreement between the PRA and both Government and industry, Woods struck a determinedly conciliatory note. He was at pains to emphasise that the PRA will follow the direction set by Government and that the new competitiveness objective will bring changes to the PRA's approach.

In what is the first of KPMG's 'Solvency UK — What will change?' series, we look at five key take-aways from Sam Woods' speech. In the weeks to come, we will be releasing a series of articles with KPMG professionals' assessment of where the industry and what firms should be considering.

1. Insurance policymakers will be busy…

As noted by Sam Woods, this is a pivotal moment for the UK reform of Solvency II, shifting from a somewhat theoretical discussion of 'Brexit dividends' to real life implementation. Insurers will have “a very good sense well before the end of 2023” of how the new regime will operate.

But before firms can start re-optimising their balance sheets and adapting investment plans, there is the small matter of:

• The UK Parliament agreeing to take forward the Government's proposals (PDF 250 KB) for reforming Solvency II. The Financial Services and Markets Bill (FSMB) is at the House of Lords Committee stage and is currently expected to receive Royal Assent this spring. It helps that there is broad political consensus on the reform, with Rachel Reeves, Shadow Chancellor of the Exchequer, stating the day after Sam Woods' speech that she is `very supportive' of the Government's plans.
• HM Treasury (HMT) setting out the principles-based framework for Solvency UK in secondary regulation.
• The PRA developing, consulting on, and finalising the detail of what will ultimately be in the PRA Rulebook. Sam Woods confirmed a two-stage process, with consultations in June and September, but would not be drawn on which changes would come at each stage.

This makes for some very busy policymakers across HMT and the PRA. The Government's and regulator's resources will be stretched, particularly given competing priorities. The compressed timeframe points to high-level Statutory Instruments, with the bulk of the framework contained in the PRA Rulebook. The consultations will be the first clear indication of whether Sam Woods' assurances of change translate into action.

2. Life insurers will be making their own minds up about how palatable the fundamental spread is…

The Solvency II debate has centred on the reform of two key elements for life insurers — the risk margin and matching adjustment (MA). In his remarks, Sam Woods looked to dispel insurer concerns that the PRA will reverse-engineer the outcome it had sought on the fundamental spread via the backdoor of its new safeguarding tools.

Insurers will be watching closely the PRA's next steps:

• On the charged question of the fundamental spread, annuity providers will be looking not only at the final rules, but also at how supervisors will apply their new tools. For example, what will be required as part of nominated senior managers' attestations that residual credit risk is not incorporated within the MA? How far will the PRA challenge these? What will the additional stress testing involve and will the PRA really publish individual results?
• Firms will also want to know if they will be in a position to deliver on the Government's promises to “unleash” insurers' capital into productive and green investment. Crucially, this includes the question of whether the extension of asset eligibility to include investments with “highly predictable” (not just “fixed”) cashflows will be drafted and applied in a workable way. HMT has already conceded most investments backing liabilities within the MA will continue to be fixed — will there be meaningful change?

Insurers that already avail themselves of the MA will be considering if it's time to revisit their MA portfolios and asset-matching strategies. Insurers newly within scope, such as income protection providers, will be weighing up whether the benefits are worth the hassle.

3. Traditional regulatory concerns are here to stay…

As you would expect from the PRA, policyholder protection will continue to be paramount, in line with its primary statutory objective.

In amongst Sam Woods' rhetoric of competitiveness and growth, he singled out continuing strong focus on the adequacy of valuations and internal rating for assets in matching adjustment portfolios. This won't be news to firms claiming the MA, but there is a prospect for an (even) deeper use of section 166 reviews.

Firms should be ready for close engagement with their supervisory teams, especially if looking to avail themselves of expanded eligibility criteria on either the asset or the liability side. For example, the PRA would expect strong governance over any new asset classes within the MA. Insurers should be prepared to demonstrate relevant expertise and robust risk management, including evidence on how the Board gained comfort with any decisions to change the MA portfolio composition.

Taking a step back, the unwinding of the PRA's position on the fundamental spread means these are not quite the “reforms as a package” it had in mind. Would the PRA really be comfortable with lower capital levels and more exotic investment portfolios?

4. General insurers in the wrong kind of spotlight…

While the focus has been on life-only issues, the anticipated streamlining of reporting and internal model processes will be of equal interest to general insurers. Sam Woods cited the proposed removal of an impressive 70% of internal model tests and standards, and significant streamlining of approvals. The PRA intends to rely on “sensible interpretation of a smaller number of principles-based requirements”.

If the internal model approval process (IMAP) is genuinely made more user-friendly, this could open the door for firms currently on the standard model or partial internal models to consider using them to reflect their risk profile more accurately. For insurers waiting for the second round of reporting reform, Sam Woods sounds a word of caution, stressing the benefits of regular reporting.

Solvency II reform notwithstanding, general insurers are under significant pressure from the PRA on financial resilience, the adequacy of pricing and reserving in the face of large natural catastrophe and cyber events, and closer scrutiny of reinsurance arrangements.¹

5. UK plc is open for business…

Looking to deliver on the objectives of the UK Solvency II review — and to evidence responsiveness to its new competitiveness objective — the PRA will look to bring in a new Mobilisation Regime. Sam Woods referenced the proposed increase in the threshold from which Solvency II applies, aimed at innovative insurtech firms to come to market.

The PRA also wants to remove capital requirements for branches of international insurers operating in the UK, making it easier to bring expertise and capacity to the London Market. This could create an interesting dynamic between UK and EU regulators, given that EIOPA is looking to reduce reliance on branches in third countries such as the UK.²

Final thoughts

It's all — or at least some — change for the PRA and Solvency II UK. But what should firms do to come out as one of the winners, not losers, of the reform? In the next article in KPMG's series of articles 'Solvency UK — What will change?', KPMG professionals offer their assessment of the operational preparations insures should consider.