HM Treasury has published a consultation document entitled Financial sector resolution: broadening the regime. The paper sets out proposals for enhancing the mechanisms available for dealing with the failure of systemically important ‘non-banks’. In addition to the insurance sector, the consultation also covers investment firms and parent undertakings, central counterparties and non-central counterparties financial market infrastructures.

Reasons for broader regulation

Global reform of the financial sector has been ongoing since 2008. Although the issue of systemically important non-banks is being addressed internationally, the Treasury considers the threat of failure a significant risk and is committed to an accelerated timetable to address this issue. In its June 2012 white paper, the government considered the gaps in regulatory reform in relation to non-bank financial institutions. According to the government, the disorderly collapse of non-banks, including insurers, can pose a risk to financial stability and taxpayer support may be required to prevent the failure of such institutions.

Systemically important?

In times of market stress, traditional insurers are generally considered to have a stabilising effect. Consequently, plans for a systemic designation process in the insurance sector have been met with resistance from industry groups. Many have criticised the reasoning behind the proposals, suggesting that insurers could suffer unintended consequences. Whilst the government considers insurers to have the potential to be systemically important, it acknowledges that only some, or perhaps none at all, will actually be so.

The International Association of Insurance Supervisors (IAIS) is currently in the process of developing a methodology to identify global systemically important insurers. The government is in broad agreement with the IAIS’ view that insurers engaged in traditional insurance activities are unlikely to threaten financial stability. Those firms that deviate from traditional insurance business, however, are “more likely to amplify, or contribute to, systemic risk”. Non-traditional insurance activities, such as derivatives trading, financial guarantees, variable annuities and short-term funding business are considered to carry greater risks.

The government considers that the systemic potential of insurers is likely to increase with: the complexity of the business model, particularly where interconnected with banking models; dependencies and inter-linkages with other financial institutions; the size of the institution; and the size of market share in products required for the functioning of economic activity. The government’s consultation identifies some potential impacts in the event of an insurers’ failure. These include the direct impact on the capital and liquidity positions of insureds, the indirect impact on financial markets particularly where failure would affect the availability of funding for banks, and the impact on consumer confidence and policyholders who may find they are no longer adequately protected.

The proposals

The Government’s overarching objectives for responding to insurer failure are that:

  1. any insurer should be able to exit the market without disorderly impact; and
  2. an appropriate degree of policyholder protection should be achieved, including, where appropriate, through continuity of cover.

In order to achieve these objectives, the government believes it is appropriate to review the existing framework for dealing with insurer failure. Current UK insolvency proceedings for insurers do not differ significantly from other companies and so there is limited scope for ensuring policyholder protection. Under existing administration and liquidation regimes, compulsory obligations apply in respect of long-term business. An administrator of an insolvent insurer is required to carry out the insurer’s long-term business, but may choose to carry out those contracts that are not long-term. Similarly, a liquidator has a duty to continue to receive premiums and pay claims for long-term business. Both regimes require administrators and liquidators to fulfil their obligations with a view to either restoring the viability of the insurance contracts or transferring them to another insurer. With other creditors to consider, the protection of policyholders in the event of an insurer’s insolvency is a particular challenge. In light of this, the government is seeking views on how existing insolvency mechanisms can be strengthened to achieve effective protection for policyholders, and prevent an adverse impact on financial stability.

The Financial Services Compensation Scheme (FSCS) provides compensation to policyholders in the event that a Financial Services Authority (FSA) authorised insurer is unable, or is likely to be unable, to meet its contractual obligations. Having identified certain challenges in respect of continuity of cover and compensation payout, the FSA is currently consulting on potential solutions and considering what action to take. Specific issues addressed in the consultation include: the possibility of increasing FSCS protection from 90 per cent to 100 per cent of the contractual benefits for life insurance; and proposals to address the current risk that, in the event of failure, payments to policyholders may cease while the failed insurer’s systems are changed.

Next, the government considers whether the UK should introduce “a resolution regime for insurance firms that includes a set of stabilisation powers to permit the orderly resolution of any insurance firms that could be systemically significant if it fails”. Some countries, including Australia and the Netherlands, have already implemented resolution tools to cover the failure of insurance firms. Respondents are asked to consider whether a resolution regime is the most appropriate means of addressing the systemic risk posed by a failed insurer. In adopting such a regime, the government would assess the “likely systemic consequences of failure” and consider whether the public interest condition would justify exercising certain stabilisation tools.

Finally, the government proposes a “preventative supervisory tool” which would allow the FSA to direct the transfer of a failing insurer’s liabilities to another insurer under Part VII of the Financial Services and Markets Act. This tool could be used to transfer a portfolio prior to insolvency, therefore, ensuring continuity of cover. In some situations, the government believes, this would provide the best protection for policyholders.

What next?

The government invites responses to proposals set out in the consultation by 24 September 2012. The consultation indicates that in order to achieve their overriding objectives the government will, at a minimum, review the current insolvency framework. In terms of the other proposals, the government does not have a firm view and, therefore, seeks feedback on these issues.

The IAIS is in the process of finalised its methodology and is expected to announce the first list of global systemically important insurers in the first half of 2013. The list is expected to focus on those firms carrying out non-traditional insurance business.