The UK’s Prudential Regulation Authority (PRA) has been developing its Early Warning Indicators (EWIs) for Solvency II internal model firms for more than a year.  From September 2013, it will expect these firms to:

  • Calculate their EWIs;
  • Be aware of the performance of their internal models against their EWIs; and 
  • Be prepared to discuss the “reasons for any significant … change[s;] the causes of those changes[; and] any [failure to meet] the [EWI] thresholds” with their supervisors.  

It may therefore have come as a surprise to read that Andrew Bailey (the CEO of the PRA and a deputy governor of the Bank of England) is impliedly concerned about their possible illegality: “We believe we can implement these Early Warning Indicators in the UK within the [Solvency II] framework, but in any event we would pursue this approach and accept the risk of EU challenge”.

Does Bailey need to be concerned about possible illegality (if he is)? If so, is the only risk, the risk of EU challenge? Long story short: yes and no.

The PRA’s reasons for developing and effectively imposing EWI obligations on internal model firms have varied over time, but two reasonably consistent themes have emerged:

  • The PRA is concerned that a small number of firms will use their internal models to pare their regulatory capital requirements and/or the quality of their internal model outputs will fall over time, and those firms will end up holding less capital than Solvency II would otherwise have required; and
  • It would be helpful, from a financial stability perspective, if the PRA had a simple, easily comparable, set of indicators that it can use to track insurance sector capital movements over time.

To meet these needs, and reduce the risk that supervisors will be overwhelmed by internal model data, the PRA will require firms to calculate and monitor EWIs. Then, if a firm’s EWI breaches a minimum threshold, it will be expected to report that fact to the PRA and, when it does, it can expect a capital add-on* for its trouble. The underlying assumption seems to be that if the EWI threshold is breached, there must be something wrong with the firm’s model, it must be generating an artificially low Solvency Capital Requirement (SCR), and the only way to correct that is via a capital add-on of some kind. If that’s a fair summary, illegality is a risk both in the here and now, and in a Solvency II world.

Here and now: The PRA is a public body. It was created, and it’s governed, by statute. It’s been given powers – but they can only be exercised if certain tests are met, and then only in accordance with UK public law. For example, the PRA has:

  • Information gathering powers that can be used to require individual firms to generate and report information;
  • Rulemaking powers that can be used to require groups of firms to carry out calculations and report the results; and
  • Variation of Permission powers that can be used to require individual firms to restrict the amount of new business they write; and/or to require them to hold more capital.

But these powers are either not available, or the pre-conditions for exercising them have not been met…which may suggest the PRA is not entitled to effectively require internal model firms to meet its EWI expectations in the here and now.

In a Solvency II world: Solvency II is largely maximum harmonising. The UK is therefore required to implement it exactly – it cannot require any more than the maximum, and it cannot require any less. Solvency II also “occupies the field”. It will require each internal model firm to use a “feedback loop” to maintain the quality of its model, and the calibration of the model’s output. It will also carefully and deliberately restrict the circumstances in which the PRA (and other regulators) can impose a capital add-on.

There are good reasons to suppose that the EWIs and the PRA’s minimum EWI thresholds will gradually and materially raise firms’ effective capital requirements over time, and to such an extent that the PRA will eventually require firms to hold more capital the SCR and Solvency II would otherwise have required. There is also a risk that, if the PRA wants to impose capital add-ons as quickly and frequently as its rhetoric seems to suggest, it will eventually be forced to do so in circumstances which fall outside permitted by Solvency II…which seems to suggest that the PRA’s proposals will be illegal in a Solvency II world as well.

If there’s anything in this, could the PRA get its ducks in a row? Yes and no.

In the here and now: If the PRA consulted on its proposals, took the responses into account, and made a reasonable set of rules, it could require internal model firms to calculate and monitor their EWIs. It could also require firms to report their EWI results if they fell below certain thresholds. But the PRA hasn’t consulted – it hasn’t formally set out its proposals and reasons; there’s been no express invitation to respond to the proposals; and it hasn’t published a cost benefit analysis or impact far.No doubt, it could do these things…and it should. If it did, it may be able lawfully to require firms to do what it’s effectively requiring them to do already, providing its requirements are reasonable. It’s not yet apparent that they are.

Getting the ducks in a row for Solvency II will be rather more difficult. It seems unlikely that the tri-partite authorities would allow the EWIs to be incorporated into Omnibus II. Without that, it will be harder to incorporate them into the Solvency II regime – but it may not be impossible. The Commission and/or EIOPA may be able to incorporate them into the level 2 Technical Standards or level 3 Guidelines, provided they can find a way of doing that which is consistent with the framework directive. Not easy – but perhaps not impossible either. Without that, Bailey’s right: there may be a risk of European Commission infraction proceedings. Perhaps there’s also a risk that a UK firm or a UK industry body will take legal action of its own.

Wouldn’t the better course be an open consultation which enables the PRA to use the EWIs lawfully – if they can be justified – at least in the interregnum?

Shouldn’t the EWIs be abandoned when Solvency II begins to apply to firms, unless they form part of an integrated Solvency II regime, rather than creating another “local difficulty” for UK authorised firms?

Isn’t there at least a risk that the PRA is avoiding each of these things because the EWIs will be difficult to justify following a cost benefit analysis, when the cost of accumulating and retaining additional capital to meet the EWI thresholds has been fully taken into account?

(Re)insurers – if the PRA was really on your side, wouldn’t it consult you on these issues now?

My previous blogs on these issues are herehere and here.

(* Capital add-on – a material increase in the amount of regulatory capital the firm is expected to hold. When Solvency II is in force, the fact of a capital add-on, and it’s about will have to be publicly reported.)