Solvency II Reforms – what to do next

As we approach 2023 year-end, there is more clarity on what the future of Solvency II in the UK will look like. The PRA has confirmed the reforms to be implemented on 31 December 2023 in advance of their final decision on recent reform proposals.

These include:

• The removal of the Regular Supervisory Report including both the full triennial report and the material changes report.
• Removal of the requirement to submit templates: S.07.01, S.08.02, S.21.01, S.21.03, S.31.02 and NS.06.
• The removal of the FRR test when recalculating the TMTP unless firms were required to limit the TMTP due to the FRR test in the recalculation before 31 December 2023. In this case, the removal of the FRR test will be subject to assessment by the firm’s supervisor.
• Approval of the Statutory Instrument to implement the changes to the calculation of the risk margin. Reducing the cost of capital from 6% to 4% and an amendment to the risk margin formula with an introduction of the risk tapering factor for life insurers and reinsurers.
• Clarification of calculating the risk margin in respect of Periodical Payment Orders (PPOs).

What are the next steps?

• Firms that were required to limit the TMTP in their last calculation due to the FRR test should contact their supervisors to request the removal of the FRR test.
• Where firms are unable to project capital requirements on PPO obligations only in applying the risk tapering factor, they should liaise with their supervisor to propose potential simplifications to their risk margin calculation.

Whilst the changes above are imminent, implementing the new reforms will be staggered over 2024. We have summarised below, the key decisions and activities firms should be engaging in over the next 12 months.

What management should consider

The MA reforms will be implemented in June 2024, giving firms time to prepare and take advantage ahead of year end 2024. The remaining reforms such as internal models, TMTPs, and reporting templates will be implemented on 31 December 2024. Therefore, managing your time effectively over the next 12 months is crucial in the successful implementation of the Solvency II reforms.

Management should engage in the following key areas to best prepare for the implementation of Solvency UK:

1. Roadmap to implementation. The reforms are expected to be phased in from 31 December to 2023 and over 2024. With the changes staggered over the next 12 months firms should be planning their roadmap to implementation. Outlining what all the changes are and what impact they will have on the firm will highlight the opportunities the reforms bring to your firm. This will also allow you to factor in time critical decisions and execute action points that management should be aware of and acting on now. With the next consultation closing in January 2024, and policy statements anticipated in 2024, this will be an ongoing assessment throughout 2024. Our ‘road to reforms' journey map shows there are four key areas of dependency management should work through first, but experience shows this is dependent on company objectives. This has proven to be a vital pulse check for firms regulating their readiness for the reforms and highlighting key areas that require further work.
2. Strategy alignment – Identifying the key areas of reform that align with the business strategy such as opportunities to widen the investment pool under the MA or applying for permission to adopt an IM will allow you to position the firm in good stead of conforming to the new regime with maximum benefits. Further work will be required to analyse the benefits against the cost of these to the firm which will require forward planning. We offer a holistic approach to help firms strategically place themselves at the forefront of capitalising on the opportunities presented by the regulatory reforms.
3. Allocation of resources - The next 6 months will be reporting heavy, with firms preparing for their annual statutory and regulatory reporting requirements. Identifying periods of ease and seeking support where relevant will help position your firm strategically to adopt Solvency UK. Steps 1 and 2 above will allow you to identify the appropriate teams to execute strategic decisions and allocate responsibility effectively. We have collaborated with firms to bridge the gaps that have been identified in the ‘road to reforms’ journey map exercise. Early engagement and onboarding of experts will be vital to ensure your firm is ready to adopt Solvency UK.  

Further reading

Matching Adjustment

• The latest consultation paper published in September 2023 provided further details on the reforms to the Matching Adjustment. This consultation paper proposed reforms on Asset Eligibility and Liability Eligibility with additional requirements introduced around attestation on the level of the matching adjustments and risk retained in the matching adjustment process.
• The PRA has allowed for assets with highly predictable cashflows within Matching Adjustment portfolios up to a maximum of 10% of the MA benefit. A roadmap of how these assets will be identified across the industry needs to be implemented, with preliminary assessments of whether the potential benefits of including these assets are outweighed by the costs of including them.
• The BBB cliff will be removed, allowing for investment freedom without severely penalising the MA benefit. To facilitate these reforms the PRA will require internal credit assessments to be comparable to those arising from an external credit agency. Firms should map the process of how the internal credit rating process will be set up including timelines for identifying key dependencies and engaging stakeholders such as the MA and IM teams. This will allow firms to be well positioned to capitalise on the benefits in time for implementation in June 2024.
• The introduction of the annual attestation from the Senior management Function Holder, most likely the CFO still requires further clarification. The attestation will need to confirm the MA process considers all the risks that the company has retained. Firms will need to formulate the attestation process by identifying the logistics and the technical information required to support the attestation process and the key milestones. The first set of attestations on the matching adjustment will be expected for the year end 2024.

Risk Margin

• The reduction in the cost of capital will allow for a substantial release of capital that was previously held to support the risk margin. The expectation is that this will support the growth of the UK economy through increased investments. However, in the absence of clear rules on how to deploy the release of capital, firms will most likely choose to distribute some of the capital released in the form of dividends. To avoid volatility in the balance sheet firms should prepare allocation plans and consider the effect of these on their balance sheet, capital requirements and any reputational impact from various stakeholders.
• Insurers with significant longevity exposures may use this opportunity to reduce their longevity reinsurance arrangements previously used to manage the capital required for the risk margin. Firms wishing to pursue this should ensure only the layer relating to the risk margin is removed without it impacting their ability to meet their obligations to policyholders.

Internal Model

• The PRA has proposed to streamline the application and ongoing maintenance process for using an Internal or Partial Internal Model (IM), with a greater onus placed on firms to demonstrate ongoing compliance. The PRA will be able to exercise more flexibility in permitting firms to use the IM, providing firms with an opportunity to move away from the Standard Formula (SF) to a more tailored model.
• For firms contemplating the adoption of an IM the following need to be considered:
  • Early engagement in the design and mapping around the provisions of documentation that will become expectations rather than requirements – as they are currently- are crucial. This will allow firms to identify the relevant stakeholders and engage with them at predetermined decision points giving firms a greater success in being granted permission without capital add-ons.
  • Models which are not fully compliant with the PRA’s expectations could be granted permission to use IMs with Residual Model Limitations. These models would be subject to capital add-ons which are yet to be defined. It is therefore critical that firms approach this by engaging in a programme in 2024 of internal model validation to identify any limitations and set a timeline over which these will be reduced where a potential capital add-on will be acceptable.
  • Engage in the ORSA process to assess the risk profile against the SF. Key risk areas which result in the reduction of the Solvency Capital Requirement (SCR) will need to be identified and a timeline of how these will be modelled should be initiated and managed.
  • Where there is uncertainty surrounding the final form of capital add-ons, there may still be benefits of introducing an IM with limitations. Milestone planning and early communication with the PRA on the expectations of capital add-ons will be key in preparing for the use of an IM.