OREANDA-NEWS. A UK inquiry into Solvency 2 (S2) and the potential for post-Brexit changes is likely to look closely at capital requirements for annuities and at potential risks for reinsurers if future UK rules are not considered equivalent to S2, Fitch Ratings says.

The Treasury Select Committee, which announced the inquiry on Tuesday, would not be responsible for deciding the UK's post-Brexit solvency regime. But its aim is to assess the impact of S2 on the competitiveness of the UK insurance industry and on insurers' ability to meet customers' needs. We believe insurers are likely to highlight the impact on annuities because S2 capital requirements for these products are particularly onerous in the current market and because they have historically been a more important product for UK insurers than for those in most other European countries.

High capital charges have cut the returns annuities can offer, making them less attractive for customers, and have reduced choice as some insurers are retreating from the annuity market in favour of deploying capital elsewhere. Annuity business has also been significantly reduced by changes to UK pension rules.

The high capital charges are driven by the introduction of a risk margin for longevity risk, which increases significantly when interest rates fall. The vote to leave the EU and the Bank of England's subsequent expansion of its quantitative easing programme have exacerbated the impact by pushing gilt yields lower, which contributed to a decline in solvency ratios across the UK life insurance sector.

On an economic basis, however, UK annuity business is well shielded from interest-rate movements through the close duration matching of long-term insurance liabilities with similarly long-dated bonds. Low yields do not therefore weaken the capital position of annuity business under Fitch's Prism factor-based capital model, which is our primary tool for assessing insurers' capital. Any change to UK insurer solvency rules post-Brexit would therefore only affect ratings if it changed our assessment of the underlying capital position.

If the UK's supervisory regime were to change significantly after Brexit this would create uncertainty over whether it would be granted equivalence by European regulators. If the UK regime were not considered fully equivalent, this would likely reduce the attractiveness of the UK as a place to cede reinsurance to for EU-based insurers. This is because EU member states can impose additional requirements, such as a need to hold collateral, on reinsurers in non-equivalent countries.

For insurers, lack of equivalence would mean EU firms operating in the UK would have to comply with both sets of rules. This could put EU firms at a disadvantage if S2 requirements were significantly tougher than the new UK regime, but we think the impact would be limited, especially as few EU insurers have significant UK operations.

UK insurers operating in the EU generally already do so via subsidiaries in each separate market and these subsidiaries would have to continue complying with S2. A new UK solvency regime could require these subsidiaries to also comply with UK rules, but this would only make a significant difference if the UK rules increased capital requirements in some areas.