Solvency II reforms: into the finishing straight?

For many in the insurance industry, the path to reform of UK and EU Solvency II rules has been long and winding. In the EU, preparation for the formal review kicked off in February 2019 with the Commission making clear it wouldn’t be seeking to make major structural reforms, stating that “the fundamental principles of the Directive should not be questioned”¹. In the UK, the starting gun was delayed by Brexit, with the (then) Chancellor, Rishi Sunak, only announcing a review in June 2020². However, since then the UK Government’s reforming ambition has grown, leading ministers to claim that reshaping the EU-inherited regime to suit the structural features of the UK market could “unleash £100 billion into all parts of the UK” over the next decade.³
 

Final consultations on UK reforms

Despite well-publicised differences between the UK Government and the Prudential Regulation Authority (PRA) in relation to changes to the Fundamental Spread⁴, UK reforms to Solvency II look set to provide a significant degree of capital relief for insurers. Other promised benefits include reducing red tape and simplifying the overall regime.

The UK will finalise its reform package in three tranches:

• Tranche one: HM Treasury will legislate to reduce the Risk Margin.  Draft regulations published⁵ in June proposed to cut the risk margin for long-term life insurance by approximately 65%, and for non-life insurance by approximately 30%; and final legislation is expected by the end of the year.
• Tranche two: the PRA will publish final rules on the Matching Adjustment (MA). In September, the PRA published a consultation paper setting out draft plans to “enable broader and quicker investment by insurers in their MA portfolios”⁶, as well as an attestation process for the amount of MA benefit being claimed. The PRA expects to publish final policy and rules on the MA during Q2 next year, with the changes coming into force on 30 June 2024.
• Tranche three: all other Solvency II reforms on which the PRA has consulted will take effect on 31 December 2024. These include the draft proposals consulted on in June, which the PRA predicts “will allow a meaningful reduction to the existing administrative and reporting requirements for the UK insurance sector”⁷.
   

A longer lead out for EU reforms

By contrast, EU reforms to Solvency II looks set to be more protracted, split between changes to the Solvency II Directive (the Level 1 legislation) followed by reform of the Level 2 regulation (the Delegated Act) that sits beneath the Directive – which will only be timetabled once reform of the Directive is complete. The process is somewhat further complicated by differences in opinion between the European Commission, the European Council and the European Parliament as to whether reforms to key parts of the Solvency II framework – such as to the Risk Margin – should be part of the Level 1 or Level 2 reviews.

Currently, the Commission, Council and Parliament are engaging in a process of trilogues – a mix of technical and political negotiations to agree the final text of reforms to the Solvency II Directive. On current planning, the aim is to reach final agreement by the end of 2023. But with significant differences between the three parties in a number of areas – including, for example, on the addition of requirements for insurance companies to develop climate transition plans – there is a risk that negotiations could run on into the first quarter of 2024. Ultimately, the revisions to the Solvency II Directive are expected to enter into application in mid-2025.
 

Growing risk of divergence

Through the parallel reform processes, the risk of increasing regulatory divergence between the UK and EU is clear. Once finalised, implementing and operationalising two different sets of reforms will create additional challenges for insurers operating cross-border. However, such firms will also need to be alive to future risks. For example, in the broader context of the EU’s Strategic Autonomy agenda, there is a risk that the degree of divergence could generate fears of regulatory arbitrage among EU policymakers – which could in turn lead to calls for economic substance requirements for EU insurers to be strengthened. So far, the topic appears only to have emerged at a technical level; but it will be one to monitor under the next European Parliament and new political leadership of the European Commission.