The European run-off market has been increasing year on year since 2009 and this trend looks likely to continue after the Solvency II Directive (the Directive) comes into force. The Directive’s new capital requirements, which will come into effect on 1 January 2016, are forcing insurers and reinsurers to reassess their approach to non-core business and books of business in run-off. Many insurers are looking to exit from legacy business which will no longer be capital efficient post-Solvency II. This newsletter considers the treatment of run-off business under the Solvency II regime and how insurers can tackle issues that may arise.
What is run-off under the Directive?
There is no standard industry-wide definition of what constitutes run-off, although it is generally accepted to be lines of business which are no longer written. Even then, it can be difficult to agree at what point a business should be classified as being in run-off: some consider that run-off starts from the date of expiry of the relevant policy, whereas others would only consider a business to be in run-off a certain period after that.
The Directive itself does not use or define the term “run-off”, but does contain transitional measures aimed at firms within its scope which exclusively administer their existing portfolio in order to terminate their activity. The Directive applies to almost all insurers and reinsurers except those that satisfy the conditions set out in Chapter 1, Section 2 of the Directive, which broadly relate to the size of the firm. Therefore, unless exempt, firms in run-off are subject to Solvency II.
Firms in run-off
The transitional measures, set out in Article 308b of the Directive, state that where a firm ceases to conduct new insurance or reinsurance contracts and exclusively administers its portfolio in order to terminate its activity, it will not be subject to the majority of the provisions in the Directive if (i) it has satisfied the supervisory authority that it will terminate its activity before 1 January 2019; or (ii) it is subject to reorganisation measures and an administrator has been appointed.
In the case of (i) above, if the supervisory authority is not satisfied with the progress that has been made towards terminating the firm’s activity, the firm may be fully subject to the Directive from 1 January 2019 (or from an earlier date specified by the supervisory authority). In the case of (ii) above, the firm will be fully subject to the Directive from 1 January 2021 (or from an earlier date specified by the supervisory authority) if the supervisory authority is not satisfied with the progress that has been made towards terminating the firm’s activity.
In order for the transitional measures to apply, the following conditions must be met:
- the firm must not be part of a group unless all members in the group have ceased to conduct new (re)insurance business;
- the firm must notify its supervisory authority of its intention to apply the transitional measures; and
- the firm must provide its supervisory authority with regular reports of the progress made in terminating its activity.
The PRA has proposed in its consultation paper Transposition of Solvency II: Part 3 – CP 16/14 that firms in run-off which consider that they qualify under the transitional measures must inform the PRA sufficiently before 1 January 2016 in order to allow the PRA to determine whether it agrees with the firm’s assessment.
Firms in breach of the minimum capital requirement
Solvency II increases the regulatory capital requirements for businesses in run-off. Under the Directive, supervisory authorities must withdraw a firm’s authorisation if it fails to comply with the minimum capital requirement (the MCR) and the supervisory authority considers that the finance scheme submitted is manifestly inadequate or the firm fails to comply with the approved scheme within three months from failing to meet its MCR (Article 144(1) of the Directive).
Last year, the Treasury consulted on how this withdrawal obligation should be exercised. The problem of firms in financial difficulties has often been addressed by running off their portfolios over a period of time. Where run-off is appropriate, it can be advantageous to policyholders by (i) allowing claims to arise before finalising payments, therefore potentially achieving a more equitable distribution of assets to policyholders; and (ii) avoiding the disadvantages inherent in liquidating the business. The Treasury stated that, given that policyholder protection is the overarching objective of Solvency II, the government considers that Article 144 would require an undertaking to be closed to new business, but it might be allowed, in appropriate circumstances, to continue to manage existing insurance contracts, subject to on-going supervision by the PRA. Where an undertaking is in run-off, the PRA would have the power to impose individual requirements on it under section 55M of the Financial Services and Markets Act 2000 (FSMA). Where the PRA determined that run-off was no longer in the interests of policyholders, it would have to bring run-off to an end.
The PRA has said that it will take the same approach to firms which are failing to meet their MCR, whether they are still being run by their directors or whether an administrator or liquidator has been appointed. The PRA expects those firms to act in a way which avoids significant systemic disruption, while protecting vital economic functions, and which ensures that policyholders are appropriately protected.
The PRA has identified three main issues with which it is concerned:
- that policyholders can maintain their insurance cover or obtain alternative insurance cover on reasonable terms where this is critical to them or their business;
- that payments to policyholders which are essential for their living necessities should continue without disruption; and
- that the method for distributing assets amongst creditors (and shareholders) is fair to both current and future claimants, given the increased risk that the firm will not have sufficient assets to pay all creditors in full.
Where a firm is not able to comply with the MCR, the PRA will require it to bring its business to a close rapidly and in the best interests of policyholders. The PRA, however, acknowledges that this process may take some time and there will be certain circumstances where a run-off strategy is in the best interests of policyholders.
In practice, it may be that firms continue activities necessary to carry out existing contracts of insurance but not write new business. Where a firm continues carrying out contracts of insurance as principal under FSMA, the firm would continue to be authorised and retain a Part 4A permission for these limited purposes, and therefore remain subject to PRA supervision.
The PRA will also exercise its powers under FSMA to impose restrictions on a firm failing to meet its MCR from disposing of its assets. Firms will, however, be permitted to pay the necessary costs of administering its business and to pay policyholder claims as appropriate. Any other transactions are likely to require the PRA’s approval.
The Solvency II regime does not, however, directly address the different nature of the risks that need to be addressed for an insurance portfolio in run-off as compared with a business that is still active.
As firms look more carefully at their core business and the increased regulatory, compliance and capital requirements under Solvency II, consideration must be given to underperforming non-core activities. Under Solvency II, a standalone run-off portfolio could incur a significantly higher capital charge than under the current regime. Indeed, the regulatory burden of the Solvency II regime and capital management are considered to be the key drivers of run-off restructuring in the short to medium term. The impact of Solvency II on a run-off portfolio also depends on whether the book of business in question is standalone or whether it forms part of the activities of an insurer or insurance group.
Those firms with non-core run-off portfolios are actively considering and engaging in a range of alternative measures, including consolidation of underperforming lines of business, reinsurance restructuring and exit options. The latter include share sales, reinsurance and insurance business transfers under Part VII of FSMA. The PRA has stated that solvent schemes of arrangement may not be compatible with the PRA’s policyholder protection objective; therefore such schemes should be considered with caution.
It is expected that this activity will continue in the lead up to, and following implementation of, Solvency II, as firms are better placed to determine the capital impact of their run-off business.