A review of the risk margin – Solvency II and beyond

Abstract

Abstract For life insurers in the United Kingdom (UK), the risk margin is one of the most controversial aspects of the Solvency II regime which came into force in 2016. The risk margin is the difference between the technical provisions and the best estimate liabilities. The technical provisions are intended to be market-consistent, and so are defined as the amount required to be paid to transfer the business to another undertaking. In practice, the technical provisions cannot be directly calculated, and so the risk margin must be determined using a proxy method; the method chosen for Solvency II is known as the cost-of-capital method. Following the implementation of Solvency II, the risk margin came under considerable criticism for being too large and too sensitive to interest rate movements. These criticisms are particularly valid for annuity business in the UK – such business is of great significance to the system for retirement provision. A further criticism is that mitigation of the impact of the risk margin has led to an increase in reinsurance of longevity risks, particularly to overseas reinsurers. This criticism has led to political interest, and the risk margin was a major element of the Treasury Committee inquiry into EU Insurance Regulation. The working party was set up in response to this criticism. Our brief is to consider both the overall purpose of the risk margin for life insurers and solutions to the current problems, having regard to the possibility of post-Brexit flexibility. We have concluded that a risk margin in some form is necessary, although its size depends on the level of security desired, and so is primarily a political question. We have reviewed possible alternatives to the current risk margin, both within the existing cost-of-capital methodology and considering a wide range of alternatives. We believe that requirements for the risk margin will depend on future circumstances, in particular relating to Brexit, and we have identified a number of possible changes to methodology which should be considered, depending on circumstances.