Brexit unlocks opportunities for solvency II reform

It took around a decade and a half to develop.

And by the time the European Union’s (EU) solvency II insurance regulation was finally implemented in January 2016, the momentous referendum that would terminate the UK’s membership to this trading bloc was only six months away.

Now, however, the insurance directive remains - for insurers at least - the most important legacy of the UK’s 47 years in the Brussels’ club.

Judging by the squeals of pain voiced frequently by insurers during the protracted shaping of solvency II, it may have been expected that the UK industry would leap at the chance to escape from the directive’s clutches.

However now that insurers have put the mechanisms in place to comply with the regime, they are reluctant to scrap it.

That is the key message to emerge from feedback to the Treasury’s recently concluded call for evidence about how to reform the UK’s system of prudential insurance regulation post-Brexit.

In its response to the exercise, Willis Towers Watson (WTW) called for any changes to avoid “unnecessarily” undermining the scope for equivalence between the new UK regime and solvency II.

Reforms should be conducted on a road map that would allow the impact on equivalence to be evaluated “at each step”, it said.

Kenny McIvor, a director in WTW’s insurance consulting and technology business, said: “The general approach would be to go through risk by risk - not ripping up the overall approach, but considering the benefits and negatives of how they should be adapted.”

Room for reform improvement

Meanwhile, the ABI said that while it wants to reform rather than scrap solvency II, there is considerable room for improvement.

John Dye, chair of the ABI, used his keynote speech at February’s ABI conference to push for “practical reform” that uses newly won Brexit freedoms to create a regulatory system tailored for the UK, not the aggregated needs of 28 markets.

The Allianz chief executive argued that such a review could deliver a “huge contribution” to the investment in the UK’s transition to net zero emissions, help the post-Covid economic recovery and create a reporting regime that attracts more businesses to the UK’s shores.

Julian Adams, director of public policy and regulation at M&G, told a break-out session at the ABI conference that Brexit provides the opportunity for the UK to develop a more fit for purpose set of regulations.

“The priority is to get that right rather than focus on equivalence per se. If you don’t do that, you are allowing yourselves to be dictated to by a European policy setting agenda that you are not in the centre of.”

Adams, who was previously executive director of insurance supervision at the Bank of England, said such an approach was not meant to be “aggressive”, but reflected the fact that the UK has left the EU and must take the opportunity this offers to get its regulatory regime right.

Hugh Francis, director of external reporting developments at Aviva, told the same ABI session attendees that “strong divergence” is not anticipated, however, because there is a lot of agreement between EU and UK insurers about how solvency II is working.

Gwyneth Nurse, director of financial services at the Treasury, said the government’s approach to the reform of solvency II will be both “ambitious and measured” because “we want to get these things right”.

When pressed on the scope for divergence resulting from Brexit, Nurse said that getting the right insurance regulation regime for the UK won’t “necessarily prejudice” the UK’s position on securing equivalence.

“We want to be best in class, we want to be the place where insurance firms want to locate,” she said.

Onerous processes

The chief competitiveness bugbear for general insurers around solvency II are the rules on solvency capital requirements (SCR).

In February 2021, the ABI and KPMG published a paper entitled ‘Report on economic impacts of potential changes to insurance regulatory framework in response to HM Treasury review of solvency II: Call for evidence’.

This said the “relatively high” 35% to 40% cost ratios for London market insurers are “partly driven” by what it described as the “onerous” internal model approval process.

These higher costs are “gradually” undermining Lloyd’s of London’s position vis-a-vis cheaper global markets, it explained.

Furthermore, one smaller insurer told KPMG that the estimated £2m cost of getting through the internal model process is a “significant deterrent” to firms taking this bespoke approach rather than adopting the solvency II standard formula, which may be less suited to the needs of their business.

The desire to deviate from the solvency II standard formula should not be treated as a concern, noted solicitors Fox Williams in its response to the Treasury review, which canvassed a number of insurers that it works with

It said: “The regulator must acknowledge that deviation usually reflects the precise nature of the business they supervise, rather than some renegade or otherwise risky approach to its management.

“Allowing firms to make greater use of management actions to address the parts of the standard model that are inappropriate for them would help.”

Barrier to entry

As well as being a “significant burden” on existing policyholders, the rules on SCR also form a barrier to new entrants, like fintech insurers, added WTW.

“Some small companies would like to do an internal model but are forced to use [a] standard model because internal models are too costly, so [they] are compelled to use a standard method that doesn’t work for them,” explained McIvor.

In the aforementioned report, KPMG proposed easing the very high requirements to go through the current internal model approval process in favour of a more pragmatic and “fit for purpose” review.

As well as reducing barriers to entry for new market entrants, easing the internal model rules would also shorten and simplify the process for existing insurers, it said.

Securing equivalence

Commentators suggest that an equivalence agreement for financial services is on the cards.

However, such a deal will easily get caught up in the increasingly fractious relationship between the EU and the UK, most recently exemplified by the British government’s unilateral decision to extend light touch rules for goods entering Northern Ireland from the rest of the UK.

It may be prudent for the insurance industry not to bank on securing long-term equivalence with the EU.