Last week, the Bank of England and FSA published a paper describing the approach the Prudential Regulation Authority (PRA) will take to supervising insurance and reinsurance companies. The paper is not strictly a consultation paper, but it is intended to facilitate public debate. It was presented and discussed at a conference for CEOs and senior managers.
This briefing focuses on the PRA's proposed approach to insurance. In doing so, it refers to some of the issues that were raised in the government's recent White Paper on regulatory reform (discussed in our 17 June e-bulletin). We also highlight briefly aspects of this week's paper on the Financial Conduct Authority (FCA).
- Prudential standards for insurers will be driven by Solvency II, leaving the PRA with limited discretion in relation to rule-making
- The PRA will take a judgement-based approach to supervision that recognises that insurers and banks are different. However, it seems from comments made by Hector Sants that, relative to their size and complexity, baseline supervision of insurers is likely to be more intense than that of an equivalent bank, given the PRA's obligation to look after policyholders' forward-looking expectation
- Further work will be done on the meaning of "policyholder protection" for the purposes of the PRA's statutory insurance objective; with-profits business raises particular issues
- The PRA will recognise that mutuals bring diversity to the financial marketplace; its supervisory approach to mutuals will be proportionate and will take account of limitations on their ability to raise capital
- The FCA will ensure that its judgements are reasonable and proportionate – success in this regard will depend on it gaining a deeper understanding of commercial and behavioural drivers and of consumer behaviour, needs and experiences, enabling it to identify potential causes of consumer detriment
The PRA will be responsible for supervising all insurance and reinsurance companies. Based on the FSA's current data, this means that more than half of the over 2,000 firms to be supervised by the PRA will be insurers. Of those, just under a fifth will be life companies and about a tenth are London Market companies (it seems that Lloyd's managing agents are included in this total even though they do not themselves underwrite risk).
The PRA will become group supervisor under Solvency II for a number of large UK-based insurance groups.
The government announced in its recent White Paper that the PRA would, in its role as insurance regulator, be given the objective of "[contributing] to the securing of an appropriate degree of protection" for policyholders.
An objective in these terms sits neatly with the commitment that the Solvency II Framework Directive makes to policyholder protection but will nonetheless raise difficult questions of interpretation. At last week's PRA conference the need for further work in this area was acknowledged and it was noted that:
- A conscious decision has been taken to base the PRA's "policyholder protection" objective on an objective test of "appropriateness", rather than one that is dependent on the opinions of policyholders. "Baggage" associated with concepts such as "policyholders' reasonable expectations" should be avoided.
- The PRA's competence is limited to matters relating to the interests of policyholders that could have an effect on the financial position of the firm and it should not stray into other areas that properly fall to the FCA (e.g., customer dealings), notwithstanding that they are also concerned with policyholder protection.
- The PRA/FCA divide is a particular concern in relation to with-profits business and this is an area that will be returned to at a later date.
Connected to the PRA's role in protecting policyholders, the recent White Paper established that the PRA would be given sole responsibility for securing "an appropriate degree of protection for the reasonable expectations of policyholders as to the distribution of surplus under with-profits policies". Additional commentary on this aspect of the draft Bill indicated that the PRA's role would extend beyond the (clearly prudential) realistic reserving requirements applicable to with-profits business or successor requirements under Solvency II into areas covered by COBS 20 (treating with-profits policyholders fairly). It did not indicate where the line between the FCA and the PRA might be drawn, including how much of COBS 20 is likely to remain with the FCA under the new structure.
As further thought is given to this issue, it will be important to bear in mind that the same split is likely to determine where the home/host divide in regulatory responsibility rests under Solvency II and, it follows, which aspects of the with-profits regime can be applied to incoming EEA insurers. Conversely, the split is likely to determine how much of what is currently in COBS 20 should be treated as applicable to the EEA with-profits operations of UK companies.
For example, to use the test referred to in last week's paper, the entirety of COBS 20 may be seen as relating to "the interests of policyholders which could have an effect on the financial position of the firm". If so, COBS 20 should properly be regarded as part of prudential regulation which is a matter for the home state under Solvency II and the UK would have no power to apply the same requirements to the UK with-profits business of incoming EEA insurers. We very much doubt that this is the outcome that either the PRA or the FCA would wish to achieve.
Risk Assessment Framework
The PRA's approach to risk assessment will be proportionate. The risk assessment framework for insurers will operate in a different way to banks, reflecting the PRA's additional insurance objective, the different risks to which insurers are exposed and the different ways in which insurers fail. The framework will capture three key elements:
- Potential impact on policyholders and the financial system of a firm coming under stress or failing – for example, would the failure of a firm disrupt the income flow to policyholders and might it (directly or indirectly) disrupt the provision of financial services to the economy as a whole?
- How the macroeconomic and business risk context in which an insurer operates may affect the viability of a firm's business model e.g., its vulnerability to changes in mortality
- Mitigating factors, including risk management and governance (operational mitigation), an insurer's financial strength, including its solvency position (financial mitigation) and resolvability (structural mitigation) that may reduce the potential risk a firm poses to policyholders and to the stability of the financial system
PRA focus on resolvability is important for insurers as we do not believe that it is something they currently think about in great detail. The PRA expects to consider whether and how Recovery and Resolution Plans (i.e., so-called "living wills") might be introduced for insurers, which is unlikely to be welcomed (or regarded as necessary) by the industry.
PRA supervision of insurers will be consistent with the UK's international obligations, including Solvency II.
The PRA's supervisory approach will involve making forward-looking judgements, with early supervisory interventions taken, aimed at ensuring that its objectives are met. Across all insurers, the PRA will seek to ensure that there is a "reasonably high probability" that policyholder claims can be met as they fall due, which it believes will require different levels of supervisory activity across different firms. This test does not seem to be particularly demanding although in practice most insurers will be subject to the specific requirements of Solvency II or, if or to the extent that implementation of Solvency II is delayed beyond establishment of the PRA (as now seems increasingly possible), the ICAS regime. Both include an obligation to maintain capital reflecting a 99.5% confidence level over one year.
Critically, Hector Sants indicated in his speech that, to deliver on judgement-based supervision, the PRA must be staffed by the right individuals "with the optimal experience and technical ability". Currently, there is a well-publicised shortage of highly qualified specialist staff, including actuaries, in the insurance industry. This shortage is in no small part down to the need for substantial amounts of resource to help with firms' Solvency II preparations.
What will PRA supervision involve at a practical level?
Insurers, no matter their size, will be subject to a baseline level of supervision. This will involve:
- Ensuring compliance with prudential standards for capital, liquidity, asset valuation, provisioning and reserving
- At least annual review of the risks to the PRA's objectives from the firm or its sector
- Assessment of firm's planned recovery actions and how it might exit the market in a way consistent with its objectives Firms posing a greater risk to stability will be supervised more intensively.
The PRA will assess a firm's:
- Business risk - the extent to which firms' business models are sustainable and vulnerable to specific events
- Financial strength - the adequacy of its solvency position on a forward-looking basis, including in times of stress
- Risk management, governance and culture
- Resolvability and resolution - whether there are arrangements in place which would allow PRA-regulated firms to exit while minimising the impact on policyholders
Supervisory assessment: supporting tools
The paper discusses the importance of the roles of auditors and actuaries (consulting actuaries, rather than office-holders, such as actuarial function-holders or with-profits actuaries) in supporting prudential supervision, although quite how the PRA intends to "draw" on external actuaries is unclear. In the absence of a formal statutory role for such actuaries, in particular, it is difficult to see quite how this can be achieved, consistent with the obligations of professionals to their clients.
Supervisory judgements will also be informed by quantitative and qualitative reporting by firms. For firms subject to Solvency II, there will be some quarterly reporting in addition to fuller annual reporting. The PRA will put in place quality assurance mechanisms to ensure that firms submit high quality data. The importance of good quality data is, of course, already an area of particular concern to firms in the lead up to implementation of Solvency II.
International insurers operating in the UK
The PRA's supervisory approach will be based on the principle that all insurers operating in the UK should be subject to equivalent prudential requirements. In practice, this is expected to mean the following:
- UK subsidiaries of overseas insurers will, as now, be subject to the same prudential requirements as UK insurers which are ultimately owned by UK companies.
- With regard to UK branches of EEA insurers, the PRA's supervisory powers are extremely limited as responsibility for prudential supervision rests with the home State regulator.
- Consistent with Solvency II, the PRA's prudential powers will be broader, but still limited, with regard to UK branches of non-EEA insurers. The PRA may want such firms to ring-fence capital.
It is anticipated that the PRA will carry out regular assessments of the scale of activities undertaken by EEA insurers through UK branches so that it is aware of the potential impact of those branches on its statutory objectives. It will also aim to establish that those risks are being actively managed. This is despite the fact that the home state regulator has sole responsibility for prudential supervision of those EEA insurers. Where it considers that the prudential risk from a UK branch of an EEA insurer is too great, or where it is unable to assess the risk satisfactorily, the PRA will "make that understood publicly so that it is clear that policyholders are protected by the home state regime". If this really means what it appears to, it is astonishing.
First, even if it is really the PRA's role to concern itself with such matters at all, an announcement in these terms can only suggest that the PRA has no confidence in the home state regulator's ability to safeguard the position of policyholders and so has no place under the Solvency II regime. Indeed, the UK is likely to make itself extremely unpopular within Europe if it seeks to undermine other EEA supervisors in this way, which may be to the ultimate detriment of the UK insurance industry.
Second, consideration does not appear to have been given to the likely impact on UK policyholders of such an announcement, in particular, if they are not able to switch insurers with ease.
A new Proactive Intervention Framework
The FSA's ARROW approach will be set aside. The PRA will establish a new risk assessment framework with five stages (ranging from Stage 1 - low risk to Stage 5 - resolution/winding up order) called the "Proactive Intervention Framework" (PIF). Firms will be made aware of where they sit within the framework.
Where a firm is placed within the framework depends on the assessment of the firm's current and future viability. As firms move through each stage of PIF, the intensity of supervision and intrusiveness of supervisory actions will increase. Contingency planning will also be stepped up. Last week's discussion confirmed that the PRA's approach would be consistent with Solvency II's "ladder of intervention", while enabling the exercise of judgement-based supervision. It will be interesting to see how this balance is achieved.
Hector Sants commented at last week's conference that the FSA operates on the basis of a presumption that diversity in the financial marketplace is a good thing. This philosophy could be expected to be carried over into the PRA.
The PRA will establish a single department to supervise all retail mutual insurers and friendly societies. This should enable supervisors to regulate mutuals consistently and develop relationships with relevant bodies. Sectoral analysis will be undertaken so that issues and risks that are specific to mutuals' business models are identified e.g., the PRA's approach will take account of mutual insurers' ability (perhaps this should have said "inability" or "limited ability") to raise capital. The paper notes that the Equitable Life case underlined the importance of ensuring that a firm's business model does not run ahead of its capital-raising potential and highlighted the importance of understanding a firm's scope to raise further capital.
In the absence of more explicit support for mutuals in the draft Bill, this may be the most that mutuals could have hoped for from the PRA. The draft Bill provides that, where a rule proposed by the PRA will apply both to mutual societies and other authorised persons, it must publish a statement saying whether the rule will affect mutuals significantly differently from other authorised persons. If so, details of the difference must be given.
Whether this proposal demonstrates a real commitment to diversity in the UK financial services sector in terms suggested by George Osborne in his 15 June Mansion House speech (albeit that his comments were made in the context of inviting bidders for Northern Rock) is arguable. It does not provide the protection of a "have regards" requirement enshrined in the legislation as part of the statutory objectives of the new regulatory authorities and seems to differ little, if at all, from a cost-benefit analysis.
Greater support for mutuals would have been particularly welcome given the FSA's failure to date to recognise essential differences between mutuals and proprietary firms in the context of the Project Chrysalis debate and CP11/05.
The FCA notes that it is not its role to promote particular ownership structures. However, it does recognise that diversity of business models can contribute to its objective of promoting efficiency and choice.
The PRA indicates that all supervisory interventions will be clearly and directly linked to reducing risk to policyholders and, where appropriate, the stability of the system i.e. to the PRA's objectives. We question whether the PRA will be able to meet this high standard in practice.
A range of statutory powers will be available to the PRA. Firms may take some comfort in the statement that "Successful application of the PRA's approach should mean that enforcement actions will be relatively rare". Whether this statement turns out to be true is in part dependent, of course, on the PRA; the paper certainly does not rule out the possibility of prosecutions or fines.
PRA policies will set out the high-level framework and expectations against which a firm is to be judged; prudential rules will set the minimum standards with which firms must abide. The aim is to support judgement-based supervision by ensuring that supervisory judgements are made within a clear and coherent framework.
- The PRA will seek to ensure that its policies and rules are straightforward, clear in intent, robust and that they support timely interventions.
- Firms will be expected to comply with the spirit as well as the letter of the PRA's rules – policy documents will explain the underlying purpose of the PRA's policies and rules and, wherever possible, clear statements of purpose will be included.
- The PRA will seek to ensure that broader international regulatory standards support its judgement-based approach by playing a proactive and constructive role in their development.
The PRA anticipates that its approach to transposition of directives, including Solvency II, will be to maximise use of copy-out. It will also aim to ensure that supplementary policy required for UK-specific issues delivers the same degree of policyholder protection as envisaged in the Directive itself. It is not clear how this approach will be reflected in the final PRA rulebook. Large parts of the current UK regime (e.g., in relation to with-profits and aspects of the approved persons regime) are not covered at all by Solvency II and therefore appear to deliver a higher degree of policyholder protection than is envisaged under the Directive. Their retention may be difficulty to justify, given that it is unlikely to be possible to describe these issues as "UK specific".
Coordination between the PRA and the FCA
The need for greater clarity on how the PRA and FCA will coordinate their processes and activities is paramount, given the importance of effective coordination for all dual-regulated firms. For insurance, Hector Sants noted at the PRA conference that imposing an obligation on the PRA to deliver policyholder protection increases the risk of regulatory underlap or overlap as compared with banking. Particular attention will be paid in this context to with-profits business and more detailed thoughts are promised in due course.
The FCA also notes in its paper earlier this week that effective coordination is key to the success of the new regulatory architecture. It describes a number of arrangements for coordination of regulatory processes that affect dual-regulated firms, including insurers, with a view to achieving this.
One area that remains less than transparent is how the PRA and the FCA will cooperate in the context of approvals of individuals holding significant influence functions (SIFs). The White Paper suggests that the PRA will have the final say on the approval of, for example, the CEO – we assume, however, that such approval would not be forthcoming in the face of opposition from the FCA based on concerns about, for example, a lack of understanding of conduct of business requirements (see further on SIFs below).
Authorisation of firms and approval of individuals
Authorisation of insurers
The PRA's approach to authorising insurers and approving individuals will, as far as possible and subject to the requirements of Solvency II, mirror its approach to banks.
Prospective insurers must apply to the PRA for authorisation. Authorisation will only be granted if both the PRA, as prudential regulator, and the FCA, as the conduct regulator, are satisfied it is appropriate to do so.
- There will be a single administrative process with a single application form and timetable for decisions. The PRA will lead on the authorisation process, but it must obtain the consent of the FCA before granting permission.
- The PRA will assess the prudential soundness of a firm on a "whole firm" basis and ensure that the statutory threshold conditions are satisfied, both in current and future states of the world. The PRA will also assess the impact on policyholders and the system should an insurer need to be wound up in the event of failure.
Approval of individuals
Around 5,000 individuals are likely to be carrying on SIFs covering prudential functions in the 2,000 firms to be regulated by the PRA. The authorities promise to design a simple and transparent process for SIF approvals that will minimise the administrative burden for individuals and firms.
- The PRA, working in close coordination with the FCA, will lead on the approval of individuals to roles which have a bearing on the safety and soundness of the firm. The FCA will be responsible for conduct-focused roles.
- PRA's assessment of approved persons will cover competence as well as probity and integrity.
- A list of the functions which will be approved by each authority will be published in due course.
- Hector Sants has indicated that he envisages interviews for approved persons will be similar to those currently held for approval of SIFs and will be undertaken by a panel formed from both the PRA and the FCA.
FCA – Approach to regulation
The FCA paper, which was published on 27 June 2011, provides further detail on its proposed regulatory approach. The deadline for responses is 1 September 2011. Key messages are:
- Prevention – The FCA will be ready to intervene early to tackle potential and emerging risks before they materialise and in order to prevent large-scale detriment. It will build on the FSA's new and intrusive approach to product development. As Hector Sants acknowledged in his speech at the FCA conference, the underlying premise here is that the FCA will be able to identify that consumer detriment is going to occur
- Causes and symptoms – Given the limitations of the FSA's traditional focus on conduct at the point of sale, the FCA will aim to shift the balance towards tackling the root cause of problems
- Engaging with retail consumers – The FCA will be committed to a better understanding of consumer behaviour, needs and experiences
- Differentiated approach – The FCA will use a differentiated approach to the particular risks in the sectors, firms and products that it regulates. On the one hand, the emphasis will be more on thematic work; on the other there will continue to be intensive, institution-specific supervision for those institutions that individually can cause significant consumer or market detriment
- Credible deterrence – The FCA's more interventionist stance and lower tolerance for consumer detriment is likely to mean that it will bring more enforcement cases than the FSA and use more enforcement resource
- Transparency and accountability – The FCA's culture will be based on a presumption of transparency. It will be accountable to government and parliament through more mechanisms than currently exist for the FSA
Regulated firms, including insurers, have a great deal of information to absorb following publication of HM Treasury's White Paper and the PRA and FCA approach papers. Clearly, there is more to come, including a paper on coordination arrangements between the PRA and FCA and further detail from the PRA on how it proposes to meet its insurance objective, including in relation to with-profits business.
Draft legislation giving effect to the regulatory reforms (which was published as part of the White Paper) will now undergo 12 weeks of pre-legislative parliamentary scrutiny. The consultation period closes on 8 September 2011 and it is envisaged that the Bill will be introduced into Parliament before the end of the year.