Solvency II one year in
Speech given by
David Rule, Executive Director of Insurance Supervision
Association of British Insurers, London
21 February 2017
1
All speeches are available online at www.bankofengland.co.uk/speeches
We are approaching the first round of annual results and disclosures under Solvency II. Today, I want to
recap how Solvency II was designed to work for the UK insurance industry; to look back on our approach to
implementation and experience of operating the Solvency II framework in the first year of its life; and to pick
out a few areas where we now know that Solvency II needs improvement, in particular the impact the current
design of the risk margin is having on UK annuity writers'
Solvency Capital Requirements (SCRs) and
associated use of so-called Transitional Measures on Technical Provisions, which firms will be disclosing
over the next few months. My focus will be life insurance, although I will touch on general insurance too
along the way.
First, some history. Prior to Solvency II, the UK regulatory regime for insurance had been designed by the
Financial Services Authority in the early 2000s. One of its primary aims was to address the lessons from the
company's problems
near failure of Equitable Life in 2000. That crystallised when it emerged it had
insufficient funds to meet guaranteed rates on annuities. It lost a House of Lords court case brought by
policyholders with these guarantees, leaving it with a liability of £1.5 billion and forcing its closure to new
business. In his Report to Parliament in 20041, Lord Penrose described how Equitable had increased the
share of returns to 'with profit' policyholders paid as This had "the intended
discretionary terminal bonuses.
effect" of reducing
future benefits required to be reserved for and recognised as liabilities in the statutory
accounts and regulatory returns, which only captured contractual liabilities. In this way, Equitable
over-allocated to policyholders from the late 1980s onwards, weakening its underlying - although not its
reported - solvency position. The regulatory solvency position was also bolstered by consistent adoption of
the weakest valuation basis for reserves and by use of valuation practices "of dubious actuarial merit".
Following Equitable, the FSA supplemented the existing regulatory reporting with 'realistic' reporting, defined
present value of expected contractual and 'fair' discretionary bonus payments plus
as the a realistic capital
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margin. That realistic capital margin was based on stress testing, taking account of all key risks for
example, in the case of life insurers, market, credit, longevity and lapse risks.
The Equitable case, along with several failures in the London Market in the preceding 20 years, showed why
robust prudential regulation is necessary. Firm failure or even near-failure can bring significant costs for
policyholders, particularly when it disrupts the provision of core insurance services. It also showed the
importance of effective, forward-looking supervision. Although the board and managers bear first
responsibility for the safety and soundness of their firms, we cannot rely entirely on firms' own judgements
about risk, reserves and capital adequacy. As Lord Penrose concluded, "the practices of the Society's
management could not have been sustained over a material part of the 1990s had there been in place an
appropriate regulatory structure adapted to the requirements of a changing industry that happened to
extreme form in the case of Equitable Life".
manifest themselves in an
1
Report of the Equitable Life Enquiry, March 2004.
Solvency II has many key elements in common with the ICAS regime that followed Equitable Life and was
subsequently developed by the FSA and PRA. This was no coincidence of course: the UK government, UK
regulators and UK firms were heavily involved in the negotiation of Solvency II. Both regimes require firms to
value assets at market prices; both require valuation of liabilities on a 'realistic' basis; both include the
possibility for firms to determine capital requirements using their own group-wide stochastic modelling and
scenario testing; and both set the same years' target calibration for the level of capital an insurer
'1 in 200
should hold.
As an aside, this is very different to banking regulation, which is largely based on the accounting balance
sheet, allows a more limited scope for internal modelling of capital requirements2, includes a much greater
scope for supervisory capital add-ons under Pillar 2, does not allow for diversification between risk types,
includes leverage and liquidity requirements and has seen a very significant increase in capital requirements
and buffers since the financial crisis.
Allowing firms to use internal models to calculate their solvency requirements is an example of how
- from Lloyd's
Solvency II meets the needs of the UK insurance sector. UK insurers are many and varied
and the wholesale London market, to motor and household insurers, to large life companies with significant
annuity books, to specialist providers and mutuals. The Solvency II standard formula works well for many of
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these firms. But no standard formula however well designed can work for all of them. That is why the
PRA has now approved 22 partial or full internal models and several more are in the pipeline.
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The UK is unusual within the EU in having insurance companies with large annuity books and insurers are
increasingly purchasing the legacy annuity obligations of defined benefit pension schemes that corporate
sponsors have closed to new members.
Solvency II seeks to balance the need for companies and regulators to take account of all the underlying
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economic risks of annuity obligations for example, changes in market prices of assets and long-term
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interest rates used to discount liabilities with the need to avoid excessive volatility in capital positions,
which would create the potential for procyclical investment behaviour by firms as market prices
'buy and hold' investments
move. Where insurers have long-term, backing long-term, sticky annuity
liabilities, the so-called Matching Adjustment allows them to filter out movements in the market price of
risk. Although application of the Matching Adjustment is subject to a number of asset and liability eligibility
- the 'liquidity
criteria, it has much in common with a similar feature of the previous UK ICAS framework
premium'.
Within the EU, the main users are UK life companies. Indeed the only countries with firms
currently using the Matching Adjustment are Spain (15 companies) and the UK (23 from the UK).3
2
Under Solvency II, the scope of internal models is comprehensive and firm-wide. A typical insurance group internal model might take 1
day to run 500,000 scenarios with key processes requiring multiple model runs. A diversified insurance group internal model may use
around 150 risk drivers, separated into over 10 different risk categories (e.g. credit, market, mortality, lapse, operational). By contrast,
under Basel standards and the EU Capital Requirements Regulation, bank internal models are separate and limited to particular risks
eg credit and market, with capital requirements from them added up at the firm level.
3
Long Term Guarantee Report, EIOPA, December 2016.
Financial Stability Report
In its in November 2016, the Financial Policy Committee concluded that the
matching adjustment "is beneficial from a macroprudential perspective by reducing
potential instability across
the financial system".4
This combination of internal models and the matching adjustment has created strong incentives for UK life
firms to invest in long-term illiquid assets, such as commercial property, equity release mortgages and
infrastructure financing. Based on supervisory information from firms, currently around 25% of annuities are
backed by such illiquid assets but firms have plans for that proportion to increase to 40% by 2020. This
trend is welcome and may have wider economic benefits. As supervisors, we will be checking that firms
have the risk management capabilities to hold and monitor such assets, and value them properly. Especially
where firms are using internal ratings for these illiquid assets, we are also currently consulting on a
supervisory approach intended to ensure that any Matching Adjustment benefit being taken is appropriate.5
I now want to make a few points on the PRA's implementation of Solvency
II, which I believe has been
robust but proportionate, in line with our statutory objectives. The first thing to say is that Solvency II is
'maximum harmonising' EU regulation. The PRA cannot set capital requirements that
largely a so-called
exceed the requirements of Solvency II. Unlike banking regulation, Solvency II does not allow supervisors
routinely to set additional capital requirements or buffers akin to those applied under Pillar 2 for banks to
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reflect our judgement about risks specific to a firm for example, based on stress testing.6
Partly because we cannot simply require firms to top up capital if we think a model is too aggressive, we take
an intrusive approach to model approval. We have to be sure that the models are up to scratch before we
can allow firms to use them to determine their capital requirements. And Solvency II sets tests and
standards that we must enforce. As models can be highly complex, this is necessarily an intensive process.
As you would expect, we are reviewing our approach in the light of experience, including seeing if we can
streamline in some areas without compromising standards. We do already seek to focus on the most
important risk drivers, including assumptions made about diversification across risks. This includes
assessing the expert judgements firms have applied against our own estimates in key areas such as (in the
case of life insurers) credit, longevity and interest rate risk. But these are not rigid standards. If firms can
provide credible evidence that a different number is appropriate for them, we will accept it. And our
estimates are usually in the pack of firms' estimates. We are not enforcing a higher standard of prudence
than required by Solvency II.
For the same reasons, we take a robust approach to approving major changes to firms' internal models. We
have now completed the first round of such modifications and my observation is that firms proposed
4
Financial Stability Report , Bank of England, December 2016, chapter on 'Risks to financial stability from insurers' investment
behaviour'.
5
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Solvency II: Matching adjustment illiquid unrated assets and equity release mortgages CP48/16, Prudential Regulation Authority,
December 2016.
6
Solvency II does include provision for supervisors to set temporary capital add-ons reflecting management and governance failings.
considerably more changes that reduced rather than increased capital requirements. We do put a lot of
weight on accountability of senior executives (re-enforced through our new Senior Insurance Managers
Regime), risk and actuarial functions and good governance within firms. But without strong supervisory
oversight of models, firms might relax assumptions, follow their competitors in adopting more aggressive
approaches and interpret new data in a favourable light. Model complexity gives ample opportunities to do
this. The reality is that firms have strong incentives to reduce capital requirements in order to report higher
coverage ratios, increase return on regulatory capital and ultimately pay higher dividends. That is why we
have put in place a framework to monitor the possibility that firms' model estimates of capital will drift lower
over time.
I am aware that our model change process can sometimes leave a firm in the anomalous position of needing
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to change a model for example, following a sudden change in circumstances such as a loss event or
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acquisition but without having approval for the change. Firms can help in this by giving us timely and well
presented information. Where we can change things in the PRA to speed the process, then we will do so.
For example, our recent consultation on market turning events highlighted the importance of timely decision
making in those types of circumstances.7
Capital requirements are only one side of the equation. Even more important is how firms determine their
capital resources. Reviewing the adequacy of reserving is a core element of our supervisory approach,
particularly for general insurers. In the case of life insurers with significant annuity books, a key determinant
of reserves is their use of the Matching Adjustment. Solvency II sets clear criteria for assets that can qualify
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for the Matching Adjustment. They must match the maturity of the underlying liabilities so, for example,
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long-dated annuity liabilities require similarly long maturity assets and they must have fixed cashflows.8
These requirements are set by the Directive; they are not a feature of the PRA's implementation. Indeed we
have sought to interpret them in a purposive and proportionate way so that firms can back annuities with a
wide range of assets, including illiquid assets, and still benefit from the Matching Adjustment. For example,
we have allowed firms to restructure portfolios of illiquid assets, such as commercial real estate mortgages,
infrastructure finance or equity release mortgages, using internal securitisations in order to create senior
tranches that meet the Solvency II requirements. We have also allowed pairing and grouping of assets to
meet the eligibility criteria - for example, combining a floating rate note with an interest swap, or a foreign
currency-denominated bond with a cross currency swap. Restructuring of this kind has added complexity,
operational risk and some costs for firms. But we think it is leading to a better market outcome than if we
had interpreted Solvency II very narrowly and limited the Matching Adjustment to, for example, long-dated,
fixed rate sterling bonds, such as gilts. That could have led to higher annuity rates for UK policyholders
whereas, in fact, there is no clear evidence that the introduction of Solvency II has affected UK annuity rates
7
'Dealing with a market turning event in the general insurance sector' - CP32/16, Prudential Regulation Authority.
8
DIRECTIVE 2009/138/EC (Solvency II), Article 77b (1): Insurance and reinsurance undertakings may apply a matching adjustment
[...]where the following conditions are met: (a) the insurance or reinsurance undertaking has assigned a portfolio of assets,
consisting of
bonds and other assets with similar cash-flow characteristics, to cover the best estimate of the portfolio of insurance or reinsurance
obligations [...] (h) the cash flows of the assigned portfolio of assets are fixed [...]
(see the Appendix). The overwhelming driver of sterling annuity rates over recent years has been the level
of risk-free interest rates.
I am well aware that some still see the Matching Adjustment as complex and too restrictive. As I have said
earlier, we have sought to interpret the requirements as flexibly as we are able within the current legal
requirements. We remain open to suggestions that fit within the current legal structure.
Indeed, it would be surprising if a new regulatory framework as complex as Solvency II had no shortcomings.
In our experience there have been fewer challenges for general insurers in implementing Solvency II, largely
because the net impact of the changes in the balance sheet and capital has been smaller. However, for life
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insurers with long-dated liabilities such as annuities and especially in the current low interest rate
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environment a significant limitation is the design of the risk margin, which is currently too sensitive to the
level of risk-free rates. As the Financial Policy Committee stated in its December 2016 Financial Stability
Report, addressing this excess sensitivity would have macroprudential benefits. The European Commission
has committed to review the design of the risk margin in its forthcoming review of Solvency II and we regard
it as a key priority. The PRA has looked at whether it would be possible to fix the problems locally through
our own supervisory implementation but concluded that changes to the existing legislation would be more
effective and desirable.
The risk margin is calculated by multiplying a fixed cost of capital (6%) by the net present value of future
capital requirements. It is intended to provide the financial resources necessary to cover the return on the
capital a hypothetical acquirer would need to run off the insurance liabilities. In estimating future capital
requirements for the purpose of calculating the risk margin, Solvency II requires insurers to assume that an
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acquirer would be able to hedge the market risks but not the insurance risks such as longevity on the
book. The interest rate sensitivity arises because lower interest rates both reduce the discount rate applied
to the future capital requirements and lead to higher future capital requirements. UK life firms with
long-dated annuity liabilities are more affected than most other EU insurers. This is primarily a UK issue.
With the fall in sterling interest rates between January and September 2016, the overall risk margin of major
UK life firms rose from around £30bn to nearly £44bn.9 We estimate that a 100 basis point reduction in
interest rates increases the aggregate risk margin for these firms by around 27% and a 100 basis points
increase in rates lowers it by around 20%. Bank analysis has found that that margin at which insurance
liabilities have transferred between firms in the past is not nearly so strongly correlated with interest rates.
Financial Stability Report
As the December 2016 describes, one consequence of this interest rate sensitivity
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is to introduce potential procyclicality into Solvency II to some extent counteracting the effectiveness of the
Matching Adjustment in removing procyclicality. It could incentivise insurers to de-risk as interest rates fall
9
Across the whole UK insurance sector, the aggregate risk margin was around £51bn at end-September 2016.
(and re-risk as rates rise) in order to maintain a stable SCR. We saw some evidence of this behaviour in
2016, primarily through a sharp increase in reinsurance of longevity risk on new annuity business.
before the introduction of Solvency II, insurers' capital positions have been shielded
For business written
from this volatility in the risk margin by Transitional Measures on Technical Provisions (TMTPs). The effect
of these transitionals is to cushion the immediate impact of new requirements for technical provisions
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introduced by Solvency II notably the risk margin. Following the large fall in sterling market interest rates in
the first half of 2016, the PRA allowed many life firms to recalculate TMTPs upwards as at June 2016, to
some degree offsetting the increase in the risk margin.
Given its flawed design, we believe that the risk margin is too high for UK annuity writers at current low levels
of interest rates. As a consequence, TMTPs are higher than they would need to be to serve their purpose
with a better designed, more stable risk margin. Analysts and investors should take this into account when
considering the scale of use of TMTPs by UK life firms at end-2016. As a broad guide to the scale of this
inflation of the risk margin and of TMTPs, the current aggregate level of risk margin for UK life firms of
around 50% of SCR (with firms in a range around this average) can be compared to the size of the risk
margin at the time of the EIOPA impact study used to calibrate its design (when market interest rates were
higher) of around 35% of SCR. The purpose of Solvency II was not to raise capital levels on the stock of
existing business across the industry. Therefore, the PRA has complete confidence in TMTPs as a legitimate
means of achieving a glide path to the new Solvency II requirements and we give firms the full benefit of
TMTPs when considering their capital positions. We encourage firms to provide full disclosure of the risk
margin and drivers of TMTPs in their first Solvency and Financial Condition Reports in May.
To conclude, Solvency II was too long in the making and expensive to implement for both regulators and
industry. But that is the past. Broadly, it is now working well, with only a few notable exceptions such as the
excessive sensitivity of the risk margin to interest rates. Some of the most important parts of Solvency II
were drawn from the UK ICAS regime that was born out of UK experience, including the near collapse of
Equitable Life. As a result, key elements of it, such as the Matching Adjustment, were designed with the
needs of the UK industry in mind. The PRA's implementation of Solvency II has been robust but
proportionate, consistent with our statutory objectives.
Appendix: Drivers of changes in UK annuity rates10
Chart 1: Annuity rates, risk-free rates and Chart 2: Relationship between annuity rates and
corporate bond spreads since 2007 risk-free rates
Percentage points Per cent Annuity rate (Per cent)
Risk-free rate (rhs)
6 8
Annuity rate (rhs) 8
Corporate bond spread (lhs)
Pre-SII (2007-15)
7
5
Since SII (2016)
6
7
4
5
3 4
6
3
2
2
5
1
1
0 0
4
0 1 2 3 4 5 6
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Risk-free rate (Per cent)
Sources: Bank of America Merrill Lynch, Bloomberg, Sources: Bloomberg, sharingpensions.co.uk and Bank
sharingpensions.co.uk and Bank calculations. calculations.
Table 1: Estimated relationship between annuity rates, risk-free rates and corporate bond spreads(a)
AnnriryRard = α ∙ RirkFrdd + α ∙ Rprdad + α
Coefficients p values(b) R2
α α α α α α
Pre-SII: 2007-15
0.753217 0.069835 0.035934 3.51E-50 0.007549 3.74E-58 0.890489
SII: 2016 0.630423 0.080868 0.03866 0.001673 0.785268 5.98E-07 0.786387
All: 2007-16
0.740991 0.068925 0.036442 9.18E-63 0.006131 5.02E-75 0.917595
Sources: Bank of America Merrill Lynch, Bloomberg, sharingpensions.co.uk and Bank calculations.
(a) Estimated using ordinary least-squares.
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(b) p values below 0.05 are generally interpreted as being statistically significant meaning all estimated coefficients in this table apart
from the  of 0.785268 obtained using just 2016 data.
10
Using standard annuity rates for a 65 year old on average across males and females (sharingpensions.co.uk); 20-year sterling
risk-free market interest rates (Bloomberg), to roughly match conditional life expectancy at age 65; and sterling-denominated
option-adjusted corporate bond spreads (BoA-ML).
Chart 3: Estimated contributions to annuity Chart 4: Component of annuity rates not
rates, using the relationship in Table 1 over explained by risk-free rates using the
2007-16 relationship in Table 1 over 2007-16
Residual Corporate bond spread
Residual
Risk-free rate Constant
Per cent
Per cent
Annuity rate (actual)
1.0
8
Corporate bond spread
7
0.8
Component not explained by
risk-free rate, excluding constant
6
0.6
5
0.4
4
0.2
3
0.0
2
-0.2
1
-0.4
0
-0.6
-1
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Sources: Bank of America Merrill Lynch, Bloomberg, Sources: Bank of America Merrill Lynch, Bloomberg,
sharingpensions.co.uk and Bank calculations. sharingpensions.co.uk and Bank calculations.