In a rapidly changing economic environment, Fitch Ratings predicts that the multi-year reviews of the Solvency II (S2) regimes in the European Union and the United Kingdom will continue as planned, with both reviews expected to conclude in 2024.
These reviews, initiated in 2020 and 2021, aim to adapt insurance regulations to current economic conditions.
One of the most significant shifts in the economic landscape since the inception of the reviews has been the rise in market interest rates, reducing insurers’ sensitivity to certain duration-related reforms, such as interest rate extrapolation and the risk margin. This change has influenced initial impact assessments.
Despite various challenges such as the COVID-19 pandemic, market volatility, and rising inflation, insurers have maintained resilient regulatory capital positions, with industry solvency ratios near all-time highs by the end of 2022.
This resilience is attributed in part to the formulaic effect of higher long-term interest rates and improved sector fundamentals associated with these rates.
In the UK, the Solvency II review, known as Solvency UK (SUK), aims to reduce the risk margin, which is part of technical insurance provisions. Proposed changes intend to free up capital and incentivise UK insurers to invest more in long-term assets, such as infrastructure, to boost the economy.
Although an initial proposal to alter the calculation of the matching adjustment was rejected, the reform will broaden eligibility for matching adjustment assets.
Similarly, the EU Solvency II review proposes changes to the risk margin to ease the capital burden on long-duration liabilities, potentially releasing significant regulatory capital for investment.
These reforms primarily aim to encourage investments in long-duration assets without jeopardising insurers’ capital positions or ratings. With solvency ratios at record highs and lower interest rate risk, most insurers have strong capital headroom.
For the UK, the reduction in the risk margin is expected to enable insurers to take on more risk and potentially increase their allocation to illiquid credit assets. However, significant decreases in credit quality or asset concentration risk could have a negative impact.
The EU’s revision of the risk margin formula, a key quantitative item in the review, aims to reduce its size for long-duration insurance business and lower sensitivity to interest rate movements. Changes in interest rates have mitigated the impact of these reforms.
While the EU also proposed increasing the volatility adjuster, this change is expected to have limited impact, as it has generally improved insurers’ solvency ratios in the past.
Another notable proposal is to widen eligibility criteria for long-term equity assets, potentially reducing capital requirements for equity risk for insurers using the standard formula. However, this is not expected to lead to a significant increase in risky asset allocation.
Additionally, the proposed reform addresses the extrapolation of interest rates, ensuring that provisions accurately reflect future obligations. The gradual implementation of this reform is expected to safeguard insurers’ capital positions.
Finally, the inclusion of recovery and resolution proposals reinforces the framework’s ability to protect policyholders and ensure financial stability in the event of insurer default.
In a nod to environmental considerations, European insurers will be required to prepare mandatory transition plans toward reaching net-zero emissions by 2050.
Insurers investing in green projects will benefit from capital relief, marking a significant step towards sustainable finance in the insurance sector.
The ongoing Solvency II reviews are expected to shape the future of insurance regulation in the EU and UK, promoting stability, resilience, and sustainability in the industry.
