How proposed Solvency II reforms for insurers affect de-risking options for defined benefit pension schemes

In November 2022, HM Treasury (HMT) published its response to the Solvency II consultation, setting out its final package for reforming the prudential regulation of the UK insurance sector.

The following month, the Chancellor of the Exchequer positioned these proposals alongside a wider set of so-called Edinburgh Reforms, which set out around 30 proposed changes to the UK financial services regime over the next few years. These are intended to build on the Financial Services and Markets Bill and boost growth in the financial services sector post-Brexit.

This article sets out, for the benefit of those involved with defined benefit pension schemes: how the regime will change, how this differs from the proposals released previously and how this could affect the schemes' de-risking options. We also consider whether the reforms will – as claimed – unlock "tens of billions of pounds" for investment in the UK.

Background and overview of changes

The European Union's Solvency II capital rules were introduced in the UK in 2016 and replaced with an onshored equivalent regime following Brexit.

In April 2022, HMT issued its consultation on the reform of this regime. This formed part of a wider Future Regulatory Framework Review to determine how the overall framework for financial services regulation will be adapted to the UK’s position outside the EU. At the same time, the Prudential Regulatory Authority (PRA), the prudential regulator of insurers in the UK, issued a discussion paper setting out its views on some key aspects of the potential reform package, the risk margin and matching adjustment.

Solvency II reform: key points

HMT's response, issued on 17 November 2022, confirmed that:

The risk margin will be reduced. This is an additional amount of capital which insurers hold so they can cover the potential costs of transferring their obligations to a third party if they fail. The response quantifies the reduction as being 65% for life insurers "under recent economic circumstances" (although this estimate may not reflect more recent rises in interest rates).
Matching adjustment (MA) requirements will change. The MA allows insurers to allocate a particular pool of assets to cover certain liabilities (such as buy-in policies), where the assets match the cash flow characteristics of that liability throughout the lifecycle of those obligations. The response confirms that insurers will be given greater investment flexibility as more assets become eligible for MA portfolios. These will include assets with "highly predictable" (rather than "fixed") cashflows. The capital treatment for assets with ratings below investment grade (BBB) will also become less onerous.
The existing design and calibration of the fundamental spread will remain. This is a component of the MA, intended to better reflect its sensitivity to credit risk. The response confirms that the Government has decided not to take forward the PRA's proposals to reform the fundamental spread. However, the PRA will be granted new powers to increase the fundamental spread, with the aim of protecting policyholders.
Reporting and administrative requirements will be reformed "to reduce EU-derived burdens".

The reforms will be made under the Financial Services and Markets Bill, which will repeal certain legislation incorporating the Solvency II Directive into UK law, and changes to the PRA Rulebook. The Government noted, in the Policy Statement released by HMT in December 2022, that it expects to make "significant progress" with these reforms by the end of 2023. Please see our Financial Services Regulation 2023 - New Year briefing for further detail on other measures to reform the UK's regulatory framework for financial services set out in the Bill.

How could the reforms affect de-risking options?

The reforms are intended to balance three objectives:

enabling the UK insurance sector to be innovative and internationally competitive;
protecting policyholders; and
supporting insurers in investing in long-term productive assets.

In a de-risking context, pension scheme trustees are likely to be most interested in how they will affect pricing, market capacity and safeguards for policyholders.

Pricing and market capacity

The reforms will remove some of the costs associated with bulk annuity businesses, by limiting the need for insurers to structure assets to make them eligible for MA portfolios. Broader eligibility criteria may also allow insurers to identify new investment opportunities to help them write more business. The Government claims that by publishing these reforms it "is unlocking tens of billions of pounds for investment from UK insurers in long-term productive assets".

A lower risk margin could result in some improvements in pricing. It could also reduce insurers' reliance on the longevity capacity in the reinsurance market and give them more flexibility as to how they write new business in respect of deferred members.

Other constraints, such as the capacity of insurer pricing teams and other human resources, are unlikely to be affected by the reforms. Trustees should prepare ahead to ensure they are well placed both to take advantage of opportunities to transact if pricing and market capacity improve, and to attract insurer attention in a busy market.

Policyholder protection

The Government's original proposals predicted that UK life insurers would be allowed to release as much as 10%, or even 15%, of their capital. Earlier this year we noted that in these circumstances, trustees would also need to consider how such a reduction in the capital held by insurers could affect the protection available to the scheme and, ultimately, their members both when they transact and in the future.

Although HMT has confirmed that the risk margin will be reduced, it has not repeated these initial estimates on how the overall level of insurers' capital requirements could be lowered. HMT has emphasised that policyholders "will remain protected by the Solvency Capital Requirement, requiring insurers to hold enough capital to withstand a 1-in-200-year shock, and the PRA’s existing supervisory powers". The reforms will also make further tools available to the PRA to safeguard policyholders, such as the ability to increase the fundamental spread and require insurers to participate in regular stress testing to assess their resilience.

Do the reforms represent a "Brexit dividend"?

The Government was urged to pursue these reforms by the report of the Taskforce on Innovation, Growth and Regulatory Reform (TIGRR), which advised on how to take advantage of the UK's new regulatory freedoms outside the EU. The TIGGR report argued that Solvency II went further than was required to achieve its objectives and that significant sums could be released for investment if the regime were to be modified. Whilst the reforms could be said to represent a "Brexit dividend" in that respect (since it seems likely that at least some capital will be released), the Government has not put a figure on this - and as the TIGGR report acknowledged, other measures would need to be pursued to encourage investment of that capital in the UK, rather than elsewhere.

More information

For further information about these reforms and how they could affect your end-game strategy please contact our Pensions de-risking team or your usual Travers Smith contact.

Please see our previous article for further background on the earlier proposals for reform, how the risk margin and the MA affect the de-risking market and steps trustees can take to manage credit risk on de-risking transactions.

Spotlight on better regulation

This article is part of a series on regulatory reform and better regulation across a range of different sectors, entitled 'Spotlight on Better Regulation'.

You can also use our 'Regulatory reform' portal to check for the latest updates on changes to regulation across all areas on which we advise.

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