With the first round of annual results and disclosure under Solvency II closing in, Bank of England's Executive Director of Insurance Supervision, David Rule, highlighted in a recent speech how Solvency II (Sii) has affected the insurance industry one year on since its inception. Here we present a short summary of his main points:
- The allowance of firm specific internal models to calculate solvency requirements is an example of how Sii meets the needs of the UK insurance sector. However, the diversity of companies within the UK insurance sector has made it problematic for all firms to fit into the standard formula of Sii, this has lead the Prudential Regulatory Authority (PRA) to approve 22 partial or full internal models with numerous more to come.
Sii’s Matching Adjustment (MA) allows an insurer who carries long-term sticky annuity liabilities to filter out movements in the market price of risk. The Financial Policy Committee concluded in their Financial Stability Report that MAs "are beneficial from a macroprudential perspective by reducing potential instability across financial system".
- The combination of MAs and internal models has motivated UK life insurers to invest in long-term illiquid assets, e.g., commercial property, equity release mortgages, and infrastructure financing. Currently around 25% of insurance annuities are backed up by such illiquid assets and this is predicated to reach 40% by 2020. This is seen as a positive trend that may have wider economic benefits. However, it requires supervision in order to confirm that firms have risk management capabilities to hold and monitor such assets, and to properly value them.
- Following the result from the first round of internal model evaluation and modification overview, Bank of England (BoE) see the trend that the overall changes proposed by firms reduce capital requirements, rather than increase them. For this reason, BoE has imposed a framework to monitor firms’ model estimates of capital in order to detect decreasing behaviour over time.
- For life insurers, the determination of capital resources rely heavily on MA. Here Sii has a clear criteria for assets that qualifies for the MA. They must match the maturity of the underlying liabilities and have fixed cashflows. In the aim of meeting these conditions, BoE has tried to interpret them such that firms can back annuities using a wide range of securities and still benefit from the MA.
- A problem that mainly affects UK life insurers, is the excessive sensitivity the design of the risk margin has to the current level of interest rates. The sensitivity arises because lower interest rates both reduces the discount rates applied to the future capital requirements and leads to higher future capital requirements. This sensitivity to interest rates is seen as a flaw of Sii and BoE believes that the risk margin is too high for UK annuity writers at the current level of interest rates.
- The European Commission has committed to review the design of the risk margin in its upcoming review of Sii, and BoE regard it a key priority.