As the U.K.'s transition period for exiting the EU comes to an end, the government has launched a review of Solvency II, a harmonized European Economic Area-wide insurance regulatory framework that came into force in 2016. Collectively, U.K. insurers' Solvency II ratios appear lower than their European counterparts'. This is because of their relatively higher risk margin, referring to the additional resources insurers must hold on their balance sheet in excess of the expected cost of claims, as well as the low discount rates that reflect a last liquid point at 50 years, versus 20 years in other EEA countries that therefore use less-observable data points to infer the discount curve and as a result benefit from higher discount rates beyond that time than in the U.K. Exposure to long-term liabilities and reporting of with profit funds' risks also contribute to U.K. insurers' seemingly lower Solvency II ratios (see a reference to U.K. insurers' Solvency II ratios at "U.K. Insurers: Steering Through A Chaotic World," published Nov. 18, 2020). We recognize that some of these aspects reflect features specific to the U.K. life insurance sector, suggesting that there could be room for adjustments to the regulatory regime.

Solvency II Equivalence: Not Required, But Highly Likely

We believe the Prudential Regulation Authority (PRA) and U.K.-based insurers will consider Solvency II equivalence as critical when modifying the regulatory framework. Nonetheless, if the review leads to material deviations from Solvency II and equivalence is not achieved, it could result in different capital requirements and additional expense and operational burdens for U.K. insurers' European operations. This might hinder their competitiveness in the EU.

In our view, the PRA has a strong track record of oversight and intervention, and the U.K.'s regulatory solvency framework is sophisticated. We consider that the PRA has sufficient resources to provide industry oversight. This contributes to our view that the U.K. insurance sector is in good shape to adapt to changes in the regulatory framework that capture the specificities of the U.K. insurance sector while sustaining competitive operations in Europe.

We do not anticipate developments in the U.K.'s solvency framework to significantly depart from the existing framework, to hinder prospective profitability, or to weaken the insurance sector's enterprise risk management and disclosure requirements. As such, the Solvency II review is unlikely to prompt changes either to our insurance industry country risk assessment (IICRA), in particular industry risk for the U.K. or to relevant aspects of governance at our rated U.K. insurers.

Pressure More Likely To Stem From Changes In Investment Portfolios Than From The Risk Margin

We recognize the sensitivity of the risk margin to interest rates, an aspect that alters the size and volatility of insurers' solvency ratios, especially for U.K. life players that can have material long-term longevity exposure. We note that the review could give way to an alternative method that leads to a lower risk margin, reduced volatility, and improved solvency ratios. But because the risk margin does not influence our view of an insurer's capital adequacy, any change is unlikely to directly affect our financial strength ratings on U.K.-based insurers.

Changes in risk margin that lower capital needs, however, could increase the competitiveness of U.K.'s insurance market. Such an approach would favor insurance or reinsurance longevity business in the U.K., since it is currently capital intensive due to the Solvency II risk margin.

Also, were a revision of the risk margin to usher capital relief into the industry, we would expect most of the excess capital to stay within the industry to support solvency levels. That said, if insurers allocated the excess capital for capital management actions, like additional dividends or growth, we cannot rule out an adverse impact on U.K. insurers' capital adequacy, as per our risk-based capital model.

Revising the matching adjustment (an upward adjustment of the risk-free interest rate for insurers with a close matching of long-term assets and liabilities) is also up for consideration. The impact of this feature is rather specific to the U.K., and we therefore believe there is room for a modified approach.

Under our analysis, we give partial consideration to the economic value of life insurance, through a maximum of 50% consideration for life value-in-force (VIF). Altering the approach to the matching adjustment might influence VIF. In addition, we would monitor the influence any change in the matching adjustment might have on the U.K. annuity market and an insurer's individual balance sheet. For instance, would deviations from the current framework incentivize or facilitate investment in riskier assets than currently allowed--such as equities or high-yield bonds or loans--we could witness additional asset risk-taking that may, in our opinion, constrain our insurers' financial risk profiles. In our risk-based capital model, for example, we apply higher risk charges to investments in real estate and private equity than we do to capital held in listed bonds.

Changes in an insurer's investment portfolios can also influence our liquidity analysis. We exclude non-marketable investments such as loans, private equity, and properties from our view of liquid assets. This means an increased exposure to these assets could worsen liquidity ratios. Nevertheless, U.K. insurers enjoy healthy liquidity positions on average, typically possessing more than enough liquidity to cover expenses and obligations for a 12-month period on a stressed basis.

We note that the Treasury also proposes to review the methods for calculating the solvency capital requirement, assessed through either the standard formula or an insurer's internal models. We believe the wide use of both approaches by insurers in the U.K. and overseas means material deviations from Solvency II are unlikely. Technical changes might therefore be very specific, and main changes would likely be operational, in our opinion.

Changes Will Take Time To Materialize

Given the PRA's track record of strong industry oversight, we do not anticipate the Treasury's review will materially change our current view on the U.K. insurance market or the creditworthiness of its players. The Treasury's call for evidence is the first stage of the review and insurers' responses will need to be carefully considered before any substantial measures are announced. Consequently, we believe an update won't be immediately implemented. We will closely monitor how the review evolves and how deviations from Solvency II could affect our financial strength ratings on U.K.-based insurers.

Related Research

• European Insurance In Transition: Plotting A Course In A Chaotic World, Dec. 3, 2020
• U.K. Insurers: Steering Through A Chaotic World, Nov. 18, 2020
• European Insurers: Capitalization Appears Resilient Under Solvency II, Somewhat Less Under Our Capital Model, May 28, 2020
• Solvency II 2020 Review Could Disrupt Insurers’ Solvency Ratios, Jan. 13, 2020
• Credit FAQ: The Use of Solvency II Reporting In Assessing Capital Adequacy For European Insurers, May 26, 2017
• S&P Global Ratings Responds To The Treasury Committee’s Solvency II Inquiry, Dec. 2, 2016
• The Impact of Solvency II Capital Adequacy On Our Rating Analysis For European Insurers, May 19, 2015