In this article, we consider the implications of the UK's new insurer regulatory framework – Solvency UK – for the bulk annuity market.
Since 2016, insurance companies operating within the European Union have been subject to the requirements of Solvency II, a regulatory framework intended to protect policyholders by ensuring adequate levels of capitalisation and disclosure.
Since the UK's departure from the EU, the Prudential Regulation Authority (PRA), part of the Bank of England, has been considering and consulting on potential reforms to the Solvency II framework, with the aim of refining it to better suit the UK market. These reforms – which create Solvency UK - are now starting to come into effect, with full implementation planned for 31 December 2024. In this article, Shelly Beard and Tom Collier share a summary of the changes as well as their thoughts on how these may impact the bulk annuity market.
Changes to the Risk Margin
The overall capital that an insurer is obliged to hold when it accepts risk through an insurance contract under Solvency II is made up of several elements. One of these is the Risk Margin (RM) which is a margin required to be held for any unhedged risks. For certain risks the RM has can be a substantial requirement. For example, it is particularly large for longevity risk associated with younger lives and this has led most bulk annuity providers to pass on much of their longevity risk to a reinsurer.
Under the Solvency UK legislation, adjustments to the RM formula reduce the resulting capital requirement because of a decrease in the assumed cost of capital from 6% to 4%. This modification was implemented on 31 December 2023, and so insurers incorporated the change into their end 2023 balance sheets. Given its relatively recent implementation, how it will affect new business pricing remains to be seen, but we expect it should be helpful for pricing overall and will also allow insurers to write more business.
At a theoretical level, we would expect that the changes would reduce the appeal (and in some cases necessity) of reinsuring certain risks, but in practice most of the insurers are continuing to pass on longevity risk, as they regard the current reinsurance pricing as compelling (which mirrors our experience on recent longevity swap projects).
Reforming the Matching Adjustment
The Matching Adjustment (MA) was another key area of focus in the PRA's review of Solvency II. Under Solvency II, insurers can take credit for a proportion of expected future investment returns on eligible assets (after allowing for credit risk) when pricing bulk annuities, through the application of the MA. This enables a higher discount rate to be used, improving pricing that can be offered. This allowance may be applied if the liabilities and assets are very closely matched, and the bar for an asset to be MA-eligible is very high, for example the cashflows needing to be fixed. Eligible assets are held in the insurers' MA portfolios, the details of which are maintained with the PRA.
The PRA consulted on a set of reforms that came into effect on 30 June 2024. The reforms improve MA flexibility, including by widening the types of assets eligible for inclusion in MA portfolios, and streamlining the process by which firms can apply to the PRA to include certain assets in their MA portfolios. Up to 10% of the assets in the MA portfolio can now have "highly predictable" rather than fixed cashflows – this will allow the inclusion of assets such as 'construction phase' real estate/infrastructure assets, or environmental/social impact bonds. There is also a focus on preserving appropriate levels of risk management, with insurers required to submit data to the PRA on the details of their MA portfolios, and greater emphasis on insurers taking more responsibility for the levels of risks and benefits introduced through their MA holdings.
Sourcing appropriate MA-eligible assets has typically been a challenge for bulk annuity providers given the long-term nature of pension liabilities. Hopefully we will see that a greater range of MA-eligible investment opportunities will mean bulk annuity providers are able to offer more competitive pricing, as well as more capacity, as MA-eligible assets become less of a scarce resource.
Other asset side changes that have been introduced include allowing insurers to include returns on sub-investment grade (below BBB) assets (with suitably increased capital requirements) and requiring senior personnel within the insurer to provide regular attestations that the additional investment return they are allowing for through the MA can be earned with a high degree of confidence.
Finally, one thing the changes do not do is make it materially easier for insurers to accept illiquid assets from pension schemes – which will disappoint some trustees who were hoping the PRA would assist in solving this issue.
Other changes
There are a variety of other alterations that the PRA has been consulting on, which are expected to be introduced on 31 December 2024, bringing Solvency UK into full effect.
These changes include several intended to improve the efficiency and efficacy of existing Solvency II processes, for example, supporting greater flexibility in capital modelling within insurance groups and streamlining the process by which insurers can implement or adjust internal capital models. Reporting requirements are also expected to be streamlined, with the PRA aiming to reduce the amount of work required by insurers while still receiving sufficient monitoring data.
More detailed 'notched' asset credit ratings have also been introduced into the calculation of asset returns, allowing for a more detailed assessment of credit risk.
One point of interest for the bulk annuity market is the various changes that have been proposed to ease the transition into the Solvency UK regime for new market entrants. A new 'mobilisation' regime will be introduced. This is an optional 12-month stage intended to allow new entrants to operate within the market (with limitations) whilst finalising any remaining actions needed to meet full regulatory requirements (e.g. finishing development of systems and controls, securing further capital etc).
This mobilisation period may not be used by all new entrants, but with several new entrants either recently authorised by the PRA or expecting authorisation soon, this slight easement of the barriers to entry could be a welcome addition for those looking to compete in this dynamic market in the coming years.
Overall
As you'd expect Solvency UK is a refinement, rather than a rewrite, of the existing regime. Overall, it is likely to be helpful in ensuring the bulk annuity market remains competitive and an attractive option for pension schemes looking to their endgame.
Whenever changes are made to the insurance regime, the key questions we get asked are (1) will bulk annuity pricing get cheaper; and (2) do I need to worry about member security? In relation to (1), on a like-for-like basis Solvency UK should facilitate slightly cheaper premiums, but this must be considered in the context of an incredibly busy market, and historically low credit spreads, working in the opposite direction. In relation to (2), the PRA continues its focus on policyholder protection and the changes are slightly positive.
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