In a rapidly changing economic environment, Fitch Ratings predicts that the multi-year reviews of the Solvency II (S2) regimes of the European Union and the United Kingdom will continue as planned, with both review is expected to end in 2024.
These reviews, which started in 2020 and 2021, aim to adapt the insurance regulations to the current economic situation.
One of the most important changes in the economic landscape since the beginning of the reviews is the increase in market interest rates, reducing the sensitivity of insurers to some reforms related to duration, such as in the extrapolation of the interest rate and the risk margin. This change influenced the initial impact assessments.
Despite various challenges such as the COVID-19 pandemic, market volatility, and rising inflation, insurers have maintained strong regulatory capital positions, with solvency ratios of industry near an all-time high by the end of 2022.
This strength is attributed in part to the formula effect of higher long-term interest rates and improved fundamentals in the sector associated with these rates.
In the UK, the review of Solvency II, known as Solvency UK (SUK), aims to reduce the risk margin, which is part of the technical insurance provisions. The proposed changes seek to free up capital and encourage UK insurers to invest more in long-term assets, such as infrastructure, to grow the economy.
Although an initial proposal to change the calculation of the matching adjustment was rejected, the reform will expand the eligibility for matching adjustment assets.
Similarly, the EU Solvency II review proposed changes to the risk margin to ease the capital burden on long-term liabilities, potentially freeing up significant regulatory capital for investment.
These reforms mainly aim to encourage investment in long-term assets without harming the capital positions or ratings of insurers. With solvency ratios at record highs and low interest rate risk, most insurers have strong capital headroom.
For the UK, the reduced risk margin is expected to enable insurers to take more risk and possibly increase their allocation to unstable credit assets. However, a significant decline in credit quality or asset concentration risk can have a negative impact.
The EU’s change in the risk margin formula, a key quantitative item in the review, aims to reduce its size for long-term insurance business and lower sensitivity to interest rate movements. Changes in interest rates moderate the impact of these reforms.
While the EU also proposed the addition of the volatility adjuster, this change is expected to have a limited impact, as it generally improves the solvency ratios of insurers in the past.
Another notable proposal is to expand the eligibility criteria for long-term equity assets, potentially reducing the 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.
In addition, the proposed reform addresses the extrapolation of interest rates, ensuring that the provisions accurately reflect future obligations. The gradual implementation of this reform is expected to protect the capital positions of insurers.
Finally, the inclusion of recovery and resolution proposals strengthens the framework’s ability to protect policyholders and ensure financial stability in the event of insurer default.
With a nod to environmental considerations, European insurers must prepare mandatory transition plans towards achieving net-zero emissions by 2050.
Insurers investing in green projects will benefit from capital relief, marking an important 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, stability, and sustainability in the industry.
