The Prudential Regulation Authority (PRA) is proposing to extend its rules about pre-issuance notification (PIN) of capital (own funds) instruments. The proposed rules will apply to insurers and banks, but in this paper we focus on insurers. Feedback must be provided by 14th November.
We suggest in this paper that the PRA proposals are ill-considered and in some respects may be open to legal challenge.
- The original PIN regime
The PIN regime for insurers was originally adopted in 2011 following publication of a Consultation Paper (CP11/1) by the PRA's predecessor, the Financial Services Authority (FSA). It required pre-notification by firms of the issue of their own regulatory capital instruments.
CP11/1 also required firms to notify the FSA where capital was issued by members of their group who were not regulated by the FSA. The argument here was that the supervisor needed to obtain this information from its own regulated firms in order to exercise effective group supervision, since it had no power to apply to non FSA-regulated members of the group.
The original proposed PIN regime was heavily criticised during consultation. It underwent significant amendment before being adopted. Critics included the Association of British Insurers (ABI), which commented at the time:
"The ABI does not believe that the FSA has shown that its proposal for firms to pre-notify it of capital issues is necessary or delivers any significant regulatory benefits. We also believe that the FSA has not properly taken into account the significant potential costs to firms, not merely the compliance burden but in restricting their ability to manage their capital resources in response to changing market conditions and their business needs. Nor has the consultation paper provided any indication of what regulators wish to do with the information during the proposed pre- issuance notification period."
- The Solvency II Directive
Solvency II will replace responsibility for prudential insurance regulation that currently sits with individual member states with an EEA wide regime and what has been described as a single rulebook. Solvency II does not provide for pre-issuance notification of capital instruments to insurance supervisors. It does, however, require supervisory approval for, for instance, "ancillary" or off-balance sheet capital and capital items not covered by the list of capital items in the Solvency II Delegated Regulation.
Nonetheless, the PRA copied across the FSA's PIN regime into its rulebook for Solvency II firms (see the "Own Funds" section). This is due to come into force in January 2016 at the same time as the Solvency II regime.
- Further PIN proposals
In August 2015, the PRA published further proposals to align the insurance PIN regime with the equivalent regime for UK firms covered by the EU Capital Requirements Regulation (including banks). This involves extending the compliance obligations of insurance firms when making notifications.
The obligation to pre-notify will apply to further species of capital instrument (but not ordinary shares). In particular, firms are required to supply independent legal and in some cases accounting opinions in relation to their proposed capital instruments. So far as the group position is concerned, firms are expected to supply information about capital instruments issued by other members of the group not regulated by the PRA and explain how group capital adequacy may be affected by those instruments.
The requirement to provide information about other group members extends to "another member of its group which is not a firm". A group member will not be a firm if it is not authorised at all, either because it is not carrying on a regulated activity (this includes most holding companies and ancillary services undertakings) or if it is a foreign entity without a UK authorisation. A French insurance company, for instance, will not be a firm unless it has passported into the UK, in which case it will acquire a UK authorisation. Equally, a US insurance company in the group will not be a firm unless it has an authorised UK branch.
- Possible legal challenges
The PRA's proposals are open to legal challenge on a number of grounds.
The PRA seems to believe that it is proposing to do no more than fully carry forward its existing pre-Solvency II regime. It has not taken into account the changed legal context introduced by Solvency II. The proposals appear to undermine the maximum harmonisation principle established by Solvency II, by imposing an obligation on firms which cuts across the directive regime.
The Solvency II regime is described by the European Commission as:
"a modern, harmonised framework for the taking up of business and supervision of insurance and reinsurance undertakings in the Union. The Solvency II Directive provides for a maximum harmonising regime".
Paul Fisher of the PRA has added:
"We … recognise and respect that Solvency II is a maximum-harmonising directive with a key objective of promoting supervisory co-operation. The PRA is committed to upholding this valued objective and will implement the Directive as intended. We can’t and won’t gold plate."
To address this point, in our view, it should be made expressly clear in the rules that non-compliance with the PIN rules does not affect the ability of firms to include within the calculation of own funds and group own funds instruments which in fact meet the standards of the Solvency II Directive and the Delegated Regulation.
Limitation on the PRA's powers
The effect of the PRA's proposed rules will, in some cases, be to require the UK firm to supply information about the solo capitalisation of an insurance company in another EEA state or outside the EEA. Presumably, the PRA would intend to use this information to make its own assessment of whether the relevant rules are complied with. (If this is not the purpose then why is this information required?) It is arguable that this contravenes Section 137G(5)(b) of the Financial Services and Markets Act 2000 (FSMA) which provides:
"The PRA’s general rules may not … make provision, as respects an EEA firm, about any matter for which responsibility is … reserved to the firm’s home state regulator."
This will carry even more force when the home state regulator is also the group supervisor.
Inadequate time for preparation
The PRA proposes to bring its proposals into force in January 2016. Solvency II, however, provides for a gap of 9 months between adoption of the implementing rules and the date when they come into force (Article 309). This should be applied by analogy to any extension of the PIN regime, even if it is otherwise justified.
The PRA's proposals do not contain an adequate cost benefit analysis (CBA). The PRA says "the additional cost to firms of implementing the proposed requirements are expected to be modest". It also refers to its "belief" that costs will not be significant. However, Section 138L FSMA requires an estimate of costs of proposed rules to be provided. This involves much more than the unquantified guess-work apparently carried out by the PRA.
We believe that the correct comparison is not with the pre-Solvency II rules currently due to come into force. A better model is the PRA's rules adopted in March 2015. These did not require legal or accounting opinions.
It is inherently unlikely that proposals requiring the regular use of independent lawyers and accountants will be modest in cost. Professionals specialising in capital issues, which may run into billions, are expensive. In some cases they may need to be foreign qualified.
Moreover, the cost of compliance should be considered in conjunction with all the other rules coming into force on 1 January 2016. There is a limit to the extent to which insurers can give effect to regulatory change at any one point in time. They must have some time and space to run their businesses as well.
The PRA approach to CBAs is open to the same criticisms as has been applied to its sister financial regulator, the Financial Conduct Authority (FCA) and its predecessor, the FSA. The House of Commons Treasury Committee has commented:
"The cost-benefit analysis done at the moment has been variable in quality and effectiveness, to say the least. Something much better can and should be done. It can be one of the best ways of protecting the consumer from ever-rising fees."
Over time the FSA considerably improved its approach towards CBAs in response to criticism (see its "N2+2" report) but the same lessons have yet to be learned by the PRA.
On the benefit side of the CBA, the PRA has given no real analysis of the improvements, if any, arising since the PIN regime came into force. This is relevant to why that regime should be extended. The PRA merely says that the rules provide it with the opportunity to review and comment before the instrument is issued. That may be a benefit to the PRA, but the regulatory regime is not run for its benefit. A more pertinent question is whether the rules have avoided what might have been the next insurance failure. What additional benefit, if any, in the same class would arise from extending the regime?
- Policy issues
Apart from these legal points the policy basis for imposing some of these additional obligations is questionable.
The PRA has adopted a "belt and braces" approach to the information that firms must supply. It has not tried to understand the position from the viewpoint of the regulated insurer. So an accounting opinion and a legal opinion must be supplied by firm (1) (the UK insurer) in relation to fellow group member (2) as well as confirmation on compliance issues from the board of (1).
Firm (1) is required to supply comprehensive information "as soon as [emphasis supplied] it becomes aware" of (2)'s intentions. In most cases it will not be able to do so. It is one thing to know about a proposed capital issue in advance. It is another to have full access to the details in order to be able to instruct lawyers and accountants to give advice and to understand how the proposed issue by group member (2) contributes to group capital. Group member (2) may be required to treat the proposed issue and these related matters as confidential. Complex legal and accounting opinions and the related confirmations cannot be produced instantaneously.
So the rules proposed by the PRA will in many cases be requiring firms to do the impossible and will generate regulatory breaches on a routine basis.
The proposed rules require UK firms to provide information about the capital management of "another member of its group which is not a firm". No distinction is drawn between the following different categories of groups:
- groups of which the PRA is the group supervisor;
- those that are group supervised in another EEA member state; and
- those subject to group supervision outside the EEA by a supervisor recognised as "equivalent".
In the case of (2) and (3), the capitalisation of the group concerned is not the primary responsibility of the PRA. Secondly, in many cases it makes more sense to require parent undertakings rather than insurers to supply information about a group's capital. A mere insurer who is a member of a group will often not be aware of this information, have access to it and/or be in a position to compel its production.
Parent undertakings will sometimes be insurers in their own right, particularly in the case of mutuals. More often, they will not be authorised. Nonetheless, the PRA's rulemaking powers extend to unregulated parent undertakings under section 192J FSMA where they are insurance holding companies, financial holding companies or mixed financial holding companies, and whether they are ultimate holding companies or merely intermediate holding companies at the head of a sub-group. They must, however, to be subject to PRA rules, be incorporated in the UK or have a place of business in the UK.
Where the section 192J power is not available, and the PRA needs information about a capital issue, in many cases it can simply ask the supervisor in the jurisdiction concerned to supply that information. In other cases, of course, the entity may not be regulated at all, but that is surely not the problem of UK insurers in the group.
It is possible, of course, that the PRA may already have asked its fellow European Supervisors for information about the capitalisation of insurance groups. The response may sometimes have been less than what the PRA had hoped for.
What will happen to the rules?
It is not apparent, therefore, from the consultation paper that the PRA has asked itself a number of questions (particularly given the changes introduced by Solvency II). These include:
- what information it has the right to ask for under the regulatory regime;
- what should properly be the consequence of non-provision of that information in the required timescale or at all;
- who is best in a position to supply it with the information it requires; and
- how difficult and time consuming collecting information is likely to be for those concerned.
If the PRA's proposal turns into a rule change, thought will need to be given by it to these issues, informed, one hopes, by the outcome to the consultation. As stated above, responses are due by 14th November.