Fundamental Spreads − speech by Sam Woods

Speech

It’s a real pleasure for me to be with you all here at the ABI dinner this evening. Now I ought to warn you that I visited Cuba a few years ago and drew inspiration from Fidel Castro in my approach to speeches. So you can judge whether it’s been a pleasure for you to spend the evening with me when I’ve finished my speech in approximately three hours’ time.

Anyway I’m sure you’ll enjoy another long lecture from me, especially as, just when you thought it was safe to start going to industry dinners again, I’m going to devote my remarks entirely to our favourite topic.

Now I can tell from the anguished expressions I see in front of me that you think I’m going to give a long speech about Solvency II. Clearly you have not been keeping up, and I will do no such thing. I am going to give a long speech about Solvency UK. You probably thought we couldn’t possibly add yet another acronym to the regulatory lexicon, but the authorities have come up with a new cracker: SUK!

In fact confusion about the names of things is not limited to dinners at the ABI. As some of the CEOs here know, I was recently talking to a beloved elderly relative who asked me to remind her what I do for a living. Very proudly I told her that I work for the Prudential Regulation Authority. “Oh how absolutely wonderful”, she replied, “I had no idea that you worked for an insurance company!”

My serious point here is that, if Parliament agrees to progress the Solvency UK package^{footnote [1]} the government puts to it, we will then be moving from the debating phase of regulatory reform into the implementation phase.

Let me give you some assurance on one point as we prepare, subject to Parliament’s views, to make that shift. There has been a well-aired and very public disagreement between us and the annuity sector about the approach we should take to capitalisation of that line of business in the future, and in particular about what construct to adopt for the fundamental spread.

The government has been clear that it does not intend to make major changes to the fundamental spread, and intends to leave it very largely as it is while going ahead with a large cut to the risk margin and the rest of the reforms. Now while that is not the position we sought^{footnote [2]}, we have accepted that that is the government’s final view on this issue. So if Parliament supports that position then we need to move on from the debate and into implementation.

The PRA’s approach

As we do this, I detect some unease within the industry about how the PRA will use the additional tools the government intends to equip us with – senior manager attestations on the appropriateness of the levels of matching adjustment benefit being taken, scope for voluntary top-ups of the fundamental spread, and publication of individual firm results in stress testing.

Specifically, there is a concern that we will use those tools to try and reverse-engineer the effect we had been looking to achieve through fundamental spread reform. Let me say very clearly and simply that we will not do this. If Parliament agrees to calibrate the fundamental spread in a certain way, and with arguments for and against that having been set out fully in the public domain, then it would be wrong for us to reverse that through the back door. And as a practical matter, even if that was not the case I do not believe that the tools in question could actually be used to deliver the same effect as reforming the fundamental spread itself.

Now “of course risk goes up when rules are relaxed, and all of us in financial services and beyond should identify and manage those risks all the time.” Those are not my words – they are a very recent comment from one of the most senior figures in the UK insurance industry. But I do agree with them, except for the “all the time” element because we do need to keep some time for sleeping and for listening to long regulatory speeches, which can of course be done concurrently. The government has also made it very clear that it expects us to maintain a strong focus on policyholder protection. So you should expect us to implement the new tools robustly, but they are not a means of achieving fundamental spread reform via another route. You should also expect us to continue to focus hard on the adequacy of valuations and ratings for assets in matching adjustment portfolios, given the very heavy reliance the regime has on them.

Now the fundamental spread is a bit like that other truly fundamental spread: Marmite^{footnote [3]}. Some love it, some hate it, some – including the entirety of the general insurance sector in this room – are perfectly indifferent and somewhat sick of hearing about it. So let me put it on the record that I love Marmite and that it’s definitely my favourite fundamental spread. I did try the other fundamental spread on a piece of sourdough once but it really didn’t taste good at all.

But in the context of Solvency II reform I sometimes feel that we have an enormous jar of Marmite which is crowding out of view the numerous other things we are serving for breakfast, all of which should be tempting even for the jaded palates of members of the ABI. Let me see if I can move the Marmite jar aside briefly and whet your appetite for the rest of the menu.

Competitiveness and growth

In brief, the entirety of the rest of the Solvency UK package is about competitiveness and growth – and in the back and forth over the risk margin and fundamental spread this basic point has got somewhat lost. Here is a very brief run-down:

• First, we are making use of our exit from the EU to remove reporting requirements that we don’t think we need for the UK market. We have already cut reporting up to 40% for small and medium-sized firms^{footnote [4]}, significantly increasing the proportionality of the regime. We have also removed some reporting requirements for all firms on things like variation analysis^{footnote [5]} which had been overly complex to complete. We plan to follow these cuts with more reductions to be consulted on later this year. Having said that, we should of course remember that there are benefits to regular reporting such as enabling the PRA to focus our supervisory activities where they are needed and avoiding excessive ad hoc requests. These consultations should help us get to a reporting package that is right for the UK.
• Second, we plan to implement a significant streamlining of the rules for internal model approvals. It is vital that the model approval process is very robust, given it leads directly to the setting of capital requirements. But the mandated process we have inherited from the EU is much too bureaucratic – we intend to do away with around 70% of the nearly 200 internal model tests and standards, alongside other changes. I want to emphasize that this is not meant to be a lowering of standards. Most of the deleted requirements are in fact sensible things to do and some of them can be effective ways to demonstrate compliance with the remaining standards. We just don’t think that we need to have them all as specific requirements; instead we intend to rely on approved functions to interpret sensibly a smaller number of principles-based requirements. If necessary we can clarify expectations via supervisory statements, but our starting point is that as a single national supervisor, we need fewer prescriptive requirements than the EU needs to ensure consistency across 27 supervisors.
• Third, we plan to widen the range of assets that are eligible for the Matching Adjustment – including to allow assets with prepayment options and construction phases. In addition, we are working with industry to find the best way to implement the government’s decision to widen the eligibility requirements to include assets with highly predictable cash flows, and to understand the consequential impacts of removing the MA cap on sub-investment grade assets.
• Fourth, for smaller or newer players we propose to raise the threshold at which firms are required to enter the Solvency UK regime. We plan to triple the threshold for gross written premiums to £15m and double the threshold for technical provisions to £50m. We also plan to introduce a mobilisation regime for insurers, which will lower barriers to entry for new firms by giving them a little extra time to build out their businesses.
• Fifth, we propose to make a series of other changes to ease the flow of business in ways that we do not expect to increase risks. Given that a branch cannot fail independently of the overseas insurer, we plan to remove capital requirements for branches of international insurers operating in the UK, reducing barriers to entry and enhancing competition and the international competitiveness of the UK market. We also propose to allow greater flexibility in the calculation of group capital requirements; this has the potential to lower merger and acquisition costs, increasing the UK’s competitiveness whilst maintaining capital adequacy.
• In addition to all this, we have taken steps in parallel to the Solvency II Review to simplify and clarify expectations around the UK ISPV regime, which should make it easier for firms to participate in this market and allow new ways of raising capital – we shall continue to engage with market participants to see what other steps may be necessary to improve access even further.

Next steps

We would like to implement these reforms as swiftly as possible, but we can’t take inspiration from Fidel Castro and simply impose new rules by fiat. Of course one of his rules was that there should be no private sector activity at all, so I can see why he didn’t consult on that.

What we are doing instead is to work closely with the Treasury to ensure that we can consult on a set of rules that is consistent with the legislation and that we publish those consultations as soon as possible. In order to improve those consultations we are engaging with industry experts through a set of Subject Expert Groups on some of the more “Marmitey” areas of reform. Of course those groups cannot carry out any of the functions or responsibilities of the PRA, but they will help inform the detailed proposals for consultation and ensure that major technical issues are addressed early on in the policy process.

Inevitably the changes are more complex in some areas than in others. So rather than a ‘big bang’ implementation of the full reform package on a single date, we are looking hard at what we can do to ensure we deliver some reforms as quickly as possible, while also giving time for adequate consultation on others.

Discussions with colleagues in the Treasury about precise timings are ongoing, but at this point our broad expectation is that we will publish a first consultation on some of the topics above in June, followed by a second consultation, on those areas that will benefit from more time for industry engagement to make sure we can get the details right, in September. We are also mindful that for some changes, firms will need advance notice to prepare, but we expect that these consultations will give firms a good sense of how the detailed regime will operate. In particular, it means that firms will have a very good sense well before the end of 2023 of how we expect the new regime to operate, so that they can begin to adapt their investment plans as soon as they wish.

If Parliament passes the Financial Service and Markets Bill currently before it, then we will be taking forward all of these actions under a new secondary objective to facilitate competitiveness and growth. We very much support the proposal in the Bill and look forward to the significant shift it will require of us – while maintaining safety and soundness and policyholder protection as our primary objectives.

Now I know that when some of you hear that, you fear that there will be no change at all and that only a new primary objective would serve. Honestly, you are wrong about that – but actions will speak much louder than words so I will let you form your view in light of what we do rather than what we say.

Alternatively, I could now repeat the equally long speech I gave at the Lord Mayor’s dinner in October^{footnote [6]}, which set out how we will embrace and deliver our new competitiveness and growth objective. I have this option because Hannah you haven’t yet learnt the Lord Mayor’s trick of imposing a strict time limit on how long I am allowed to speak for at dinners. Actually the Lord Mayor’s limit seems to get shorter every year, and I think the idea is that by the time I give my last speech in the Mansion House all I will do is stand up and propose the toast.

This evening though, the sky is the limit and I’m only just getting going so I hope you are sitting comfortably.

Ah now I see that Hannah is trying to convey a message to me. What’s that Hannah? The audience wants more? Ah, no… I see – I didn’t read the small print! Apparently I’ve breached the Speaking Requirement set for me by the ABI and need to finish now. But to finish I’d like to suggest that we borrow another leaf from the Lord Mayor’s book and have a toast. So could you all please now be upstanding and join me in a toast to policyholders, competitiveness and growth.

I am grateful to Emily Buckland and other colleagues for their assistance in preparing this speech.