Life insurance
Once-in-a-generation opportunities and challenges ahead
The life and pensions sector faces a series of once-in-a-generation opportunities and challenges. This is driven by a heady mix of higher interest rates and inflation alongside significant changes to the prudential regulatory regimes (Solvency UK and Solvency II) and conduct regulation in the UK. The higher interest rate environment is increasing consumers’ appetite for long-term guaranteed products such as annuities at a time when changes in regulation could reduce the capital required for this business. The pace of Defined Benefit pensions schemes transfers to insurers is also set to accelerate over the next few years. These trends can lead to opportunities for growth while providing customers with products that better meet their needs and result in better outcomes, provided insurers have the appropriate risk controls in place.
The new Solvency UK regime (SUK) will result in a reduction of the risk margin and give insurers more flexibility to invest in new asset categories. However, those benefits have strings attached. Under the proposals, insurers will need to attest annually to the sufficiency and quality of their Fundamental Spread and Matching Adjustment (MA)1. This means that, on the one hand, insurers might be allowed to invest in a wider range of assets but, on the other, will be made to prove they are not taking more benefit than they should by holding them. At the heart of this tension sits the fact that the UK Government intends the SUK reforms to result in more insurance investment in productive UK assets while the Prudential Regulation Authority (PRA) needs to ensure that any increased flexibility and risk taking are not done at the expense of policyholder protection.
The PRA is also proposing to increase risk management expectations over life insurers’ use of funded reinsurance. Proposals include the need for insurers to demonstrate they would remain solvent if they had to recapture the ceded risks in the event of the reinsurer's failure, and the need to assess the quality, liquidity and liability duration matching of reinsurance collateral as well as its MA eligibility. This is likely to result in an increased cost of capital for those seeking to fund long-term business with reinsurance capacity since the level of capital firms will have to retain in the UK in relation to funded reinsurance exposures is likely to rise.
Our view is that for insurers to navigate these waters successfully they will need to invest in the expertise and capabilities necessary to explore the benefits of investment flexibility, including asset origination, valuation and modelling.
Our view is that for insurers to navigate these waters successfully they will need to invest in the expertise and capabilities necessary to explore the benefits of investment flexibility, including asset origination, valuation and modelling. We believe the benefits will be gradual and modest at first but those entering this market early will gain the knowledge and understanding necessary to demonstrate a credible track-record to the PRA and make the most of the opportunity in the years ahead.
Insurers should engage as soon as possible with the attestation process, in particular those that have a range of assets other than corporate and government bonds in their MA portfolios. The building blocks of a successful attestation include assessing the current asset portfolio to identify higher risk categories of assets, creating the methodology for calculating the Fundamental Spread which will include identification of risks not currently in valuations or emerging risks, developing models to calculate the impact of new risks identified on the Fundamental Spread, and developing the necessary governance and controls that need to be put in place to allow the attestation process to run smoothly. In our view, the SUK proposals mark the beginning of a journey where firms and the PRA will learn through the process and fine tune the regime further. Insurers should use the next few years to test the benefits of investment flexibility and demonstrate proficiency to the PRA. This will put them in the best position to make good use of the regime as more eligible assets become available and the regime beds down.
The prudential regime does not have a monopoly on regulatory tensions. The implementation of the Consumer Duty (‘the Duty’) in the UK has been onerous, to say the least, and the Financial Conduct Authority’s (FCA) expectations around it are still evolving. It is widely recognised that the Duty will be a significant challenge for life firms in dealing with their portfolios of closed products. Many life insurers have grown over the years through mergers and acquisitions resulting in complex portfolios with many products managed under different legacy systems. Many of those products include features or fee structures that may not be considered fair value if they were sold today. Some of the contractual terms in closed products (e.g. fees and charges) will be considered vested rights. Firms will not be expected to amend charges where they fall under the vested rights category although they would be welcome to choose to do so if this resulted in improved outcomes for customers.
However, firms will need to assess carefully if certain products exploit customers’ lack of knowledge and if complex pricing structures make it more difficult for customers to switch or terminate a contract. Firms should also consider how their Duty work on customer understanding and support can help ensure closed products remain fair value to customers – looking at ‘value in the round’ in the words of the FCA. In our view, firms will need to consider if the value differential between open and closed products can be justified in the medium term. They might want to develop a path towards reducing gaps over time where justifying the differentials is likely to be challenging.
The Duty also raises difficult questions for firms when it comes to delivering good retirement outcomes and enabling customers to pursue their financial objectives. At retirement, decisions are notoriously difficult for customers, because of their complexity, and life insurers which do not have advice permissions are wary of being perceived as crossing the boundary from guidance to advice. This has resulted in a reluctance by firms to take a broader view of what they provide by way of guidance, thereby constraining their support for customers at retirement. The key question is for how long this reluctance will be a risk-free choice for life insurers. The FCA is aware of this dilemma and plans to review the advice/guidance boundary in 2024.2 Firms should assess the effectiveness of guidance and support services at retirement and develop an action plan to demonstrate they are delivering good retirement outcomes.
Firms should assess the effectiveness of guidance and support services at retirement and develop an action plan to demonstrate they are delivering good retirement outcomes.
Climate-related risks are another source of potential poor customer outcomes in the life insurance sector, especially for unit-linked pensions where policyholders bear all investment risks. Insurers need to consider actions to help customers understand and manage climate risk in their portfolios, for example the risk of stranded assets, while also being alert to potential greenwashing risks when offering unit-linked funds that include sustainability claims. In our view, insurers should consider applying the tools and expertise they deploy to manage their own climate-related risks to their customers’ exposures. Insurers could then provide customers with information and options about the level of risk they bear and ways to manage it. Life insurers might want to harness their work to comply with the ever-expanding climate disclosure requirements to ensure customers are well informed, understand the risks in their exposures and are offered a range of products that meet their appetite for sustainable investments.
Conclusion
A key feature of the regulatory landscape for life insurers is the inter-dependence of risks and opportunities. Leaving prudential reform to actuarial teams, Duty to compliance, and climate-related risks to sustainability teams will not result in the best outcome. Firms need to consider a multi-disciplinary approach to tackle these challenges to ensure they can make the most of the opportunities they present while managing and mitigating emerging risks. Firms should engage the Board early on in assessing the strategic impact of some of the key regulatory initiatives described above and setting up working groups that bring together expertise from different areas of the business to ensure opportunities and risks are identified and addressed promptly. In our view, those that can best put the different pieces of the jigsaw together and see the whole picture in the process will be the most successful in adapting to the new regulatory landscape.
In detail
Read more about Solvency UK and EU, implementing the Consumer Duty, advice guidance boundary review, climate- & environmental-related financial risk and disclosures, transition planning, operational resilience, artificial intelligence and data.
- PRA, Review of Solvency II: Reform of the Matching Adjustment, September 2023, available at https://edu.bankofengland.co.uk/-/media/boe/files/prudential-regulation/consultation-paper/2023/september/cp1923.pdf
- FCA, Advice Guidance Boundary Review – proposals for closing the advice gap, December 2023, available at https://www.fca.org.uk/publication/discussion/dp23-5.pdf