Solvency II reforms ‘could unlock £100bn in productive finance’

Announced in the Autumn Statement on November 17, the Treasury said it is unlocking tens of billions of pounds for investment from UK insurers in long-term productive assets. It said this will also help to drive a competitive insurance sector while retaining high standards of policyholder protection.

The final reforms were published in response to the Solvency II consultation, which ran from April to July 21, and have been strongly welcomed by the Association of British Insurers, which predicts that the reforms could unlock more than £100bn in long-term productive finance.

This comes after the trade body had previously been critical of proposed changes to fundamental spreads, warning that this would disincentivise investing in illiquid assets.

Meaningful reform of the rules creates the potential for the industry to invest over £100bn in the next 10 years in productive finance

Hannah Gurga, ABI

No reforms to fundamental spread

The government has this year targeted channelling institutional money from pension funds and insurers towards UK infrastructure as part of its “levelling-up” programme.

Local Government Pension Scheme funds were asked earlier this year to set out plans for investing up to 5 per cent of their assets in domestic initiatives.

The Treasury has ditched its original proposal to reform the fundamental spread. It had proposed this to better measure credit risk and increase confidence in a wider variety of assets being suitable for inclusion in matching adjustment portfolios. 

These spreads are used by insurers to calculate the risk-free curve for liabilities within a matching adjustment portfolio. Under the final reforms, the design and calibration of the fundamental spread will remain the same. 

The ABI warned in July that changes “would disincentivise investments in illiquids”, arguing that the reforms would introduce a direct link to spreads, which would lead to “material pro-cyclicality and balance sheet volatility”.

In response to the consultation, many respondents argued that the current methodology was prudently calibrated, allowing for around 2.5 times the historical average rate of defaults, and fully accounting for retained risks.

Keeping the fundamental spread at the current level will “lead to less volatile annuity prices and ultimately provide a more stable income for UK pensioners”, the ABI said.

Reductions to risk margin

In its final reforms, the Treasury also proposed reducing the risk margin by 65 per cent for life insurers and 30 per cent for non-life insurers. 

This comes after the Prudential Regulation Authority said that the risk margin was too large and sensitive to interest rates, a view shared by the ABI.

The Treasury’s final reforms stated that reducing the risk margin would free up substantial amounts of capital, removing a barrier to lower product prices and higher annuity yields, while reducing the volatility of life insurers’ balance sheets. 

At the same time, it said it would safeguard against the risk margin becoming too large and volatile during future periods of low interest rates, and retain a risk margin that ensures insurers hold sufficient assets to transfer their liabilities to another insurer if required.

The reforms also include proposals to broaden the asset and liability eligibility criteria for the matching adjustment. 

The ABI said this would allow the industry to invest in a wider array of assets, as well as enable relevant insurers to include morbidity liabilities in matching adjustment portfolios.

The trade body said policyholder protection is of the utmost importance for the industry, and it will work closely with the PRA on implementing the rules and the use of any supporting supervisory tools.

Reforms to support levelling up and net zero

ABI director general Hannah Gurga said these changes will allow the UK insurance and long-term savings sector to play an even greater role in supporting the levelling-up agenda and the transition to net zero, while encouraging a thriving and competitive industry.

She said: “Meaningful reform of the rules creates the potential for the industry to invest over £100bn in the next 10 years in productive finance, such as UK social infrastructure and green energy supply, while ensuring very high levels of protection for policyholders remain in place.”

ABI president and Royal London Group chief executive Barry O’Dwyer said the proposed reforms can help the sector to “maintain the highest standards of policyholder protection”, while also “contributing significant investment into UK assets and infrastructure” that will benefit customers, the environment and wider society. 

Other insurers also welcomed the proposals, saying these would make it easier for them to invest in productive capital and illiquid assets without compromising policyholder protection.

Phoenix Group intends to invest £40bn-£50bn in illiquid assets and sustainable investments over the next five years to support housebuilding, green energy and local communities across the country.

Andy Briggs, the group’s CEO, said that the proposed Solvency II reforms are a “very significant opportunity” to ensure more private sector capital can be directed by insurers into the real economy and better mobilise the UK’s £3.4tn of pension wealth. 

“These regulations are an important component of the changes needed to the wider UK investment landscape which will enable Phoenix to meet its ambition to invest more in the future,” he added.

Pension Insurance Corporation CEO Tracy Blackwell observed that the announcement provides the company with stability to support the government’s objective of investing in productive assets while ensuring that policyholder pensions are secured to the highest standards. 

“We now have the certainty we need to bring more pension risk off corporate balance sheets and invest in assets that generate economic growth and benefit communities across the country,” she said.