Page 1 INSURANCE BRIEFING PRA CONFIRMS APPROACH TO SUPERVISING INSURERS Documents published over the summer provide some insight into how the PRA is supervising insurers. In particular, firms should be aware of a new version of the PRA's "Approach to insurance supervision" (Approach Document) and of an update on the PRA's continuing transition from its current Handbook to a new, more concise Rulebook (PS5/14). 1. Key points Key points for insurers include the following: • A complex matrix of PRA rules, guidance, statements of policy and other information must be negotiated by firms in order to appreciate fully the standards the PRA expects them to meet. • In particular, experience over the last year demonstrates a need for insurers to have a detailed knowledge of the Approach Document, which underpins the PRA's approach to supervision and is relevant to all dealings with the regulator. • The PRA's apparent use of the Approach Document to impose new regulatory obligations on firms seems to sidestep its statutory obligation to consult on changes to its rules. • The transition of the PRA to its own Rulebook, including the replacement of high-level Principles by Fundamental Rules, marks the beginning of an inevitable divergence in PRA and FCA requirements. Given increasing reliance by both regulators on high-level statements of principle, insurers will have to make sure that they understand the strategic objectives of each of their regulators and how they intend to give effect to those objectives. We consider below some of the issues raised by the Approach Document and PS5/14 and, more generally, discuss the PRA's approach to rule-making and the issue of guidance. 2. PRA approach to insurance supervision On 19 June 2014, the PRA published PS5/14, which marks the continuing transition by the PRA from its existing Handbook (containing material largely inherited from the FSA) to a new Rulebook. The PRA also published a revised version of the Approach Document, which was last updated in April 2013. On the same date, the PRA published: • a Statement of Policy on the use of PRA powers to address serious failings in the culture of firms. The statement is designed to be read alongside the Approach Document (and its equivalent for banks); and • a Supervisory Statement (SS7/14) setting out PRA policy on, and expectations for the use of, skilled persons under sections 166 and 166A FSMA. 25 JULY 2014 London Table of Contents 1. Key points 1 2. PRA approach to insurance supervision 1 3. Approach Document 2 4. PRA Rulebook 3 5. PRA supervision of insurers 3 6. Fundamental Rules 4 7. How will insurers find the material they need? 5 8. Contacts 6 RELATED LINKS > Herbert Smith Freehills > Insurance homepage > Insurance insights > Herbert Smith Freehills insights Page 2 As is discussed further below, the PRA intends to supplement its new Rulebook (which will contain rules and directions) with Supervisory Statements to the extent that general guidance is needed to clarify PRA expectations of firms. Effectively, Supervisory Statements will replace guidance which currently sits within the Handbook. Statements of Policy (which are different from "Policy Statements") are not "guidance" as such, but are issued by the PRA to meet specific obligations under FSMA. As such, they remain outside the Handbook/Rulebook but nonetheless have a role to play within the broader regulatory framework. 3. Approach Document The Approach Document contains a number of changes from the April 2013 version, including: • amendments to reflect the PRA's new secondary objective to promote effective competition; • changes to reflect the introduction of Fundamental Rules in place of high-level Principles inherited from the FCA; and • details of how the PRA will use its powers to address issues with firms' culture (see the Statement of Policy referred to above). Unsurprisingly, the PRA places continued emphasis on its two primary objectives in supervising insurers, being to promote their safety and soundness and to contribute to securing an appropriate degree of protection for current or prospective policyholders. Following the introduction of a secondary competition objective into its remit, it also expects to consider changes to the prudential regime that might further its competition objective without undermining its two primary objectives. As such, the PRA's broader comments e.g. that it will be a forward-looking and judgement-based regulator contain little that is new. Other, more detailed, aspects of the Approach Document are, however, more surprising. For example, the April 2013 version contained a statement (which has been repeated in June 2014) that insurers issuing capital in the lead-up to Solvency II would need to meet Solvency II standards. This is despite there having been no change to Handbook rules or guidance to reflect such a requirement. It also seemed to ignore the fact that insurers will only be required, as a regulatory matter, to meet Solvency II standards from 1 January 2016 and that, even then, up to ten years' transitional relief will be available for capital instruments already in issue. Similarly, in the June 2014 version of the Approach Document, the PRA has inserted the following sentence into a discussion about the level of capital that insurers are expected to hold: "The PRA expects insurers to maintain a capital buffer above the Individual Capital Guidance." No Handbook authority is given in support of this statement. The PRA merely states that its approach is designed to maintain the confidence of an insurer's creditors and protection of its policyholders, including in stressed conditions. Both of the above statements of policy go significantly beyond the hard requirements of the rules applying to insurers under the Handbook and have seemingly been made without consultation. We question whether the PRA should be setting policy without going through a formal consultation process, given that the Approach Document has, in terms of day to day supervision at least if perhaps not in enforcement terms (although this point is untested at present), the same effect as rules. This concern is compounded by the significance of the Approach Document for interpretation of the Fundamental Rules (see below). Interestingly, the PRA does not (unlike the FCA) have a specific statutory power to issue general guidance, in which case consultation obligations attaching to the issue of guidance by the FCA are also not triggered. It is, however, required by section 2I FSMA to issue guidance about how it intends to advance its objectives in discharging its general functions, which is the purpose apparently served by the Approach Document. As there is no specific obligation for such guidance to be consulted on in advance of publication, the PRA might argue that it has met its statutory obligations. Taking this line should not, however, enable the PRA to override safeguards built into the regulatory framework to ensure that due process is followed in relation to the exercise of its rule-making powers. The PRA is also under a duty to consult on the extent to which its general policies and practices are consistent with its general duties under sections 2B to 2H FSMA (see section 2L). Finally, it is subject to a number of regulatory principles, including the principle that it should exercise its functions "as transparently as possible" (see section 3B FSMA). Perhaps the key point for insurers is that it has become increasingly clear over the first year of the PRA's life that firms must pay particular attention to the Approach Document, in addition to meeting their obligations under the Handbook/Rulebook. Use of the Approach Document to define PRA policy also adds a further layer to what is already a complex web of rules, guidance and other PRA material that insurers must navigate under the new "twin peaks" regime. Page 3 4. PRA Rulebook PS5/14 marks the latest stage in the PRA's transition from its current Handbook, which largely contains material inherited from the FSA, to a new Rulebook of its own creation. It serves as a reminder that, currently, both the PRA and FCA rulebooks reflect a crude split of the FSA's Handbook between the two regulators, with some rules and guidance being adopted by both. Clearly, the PRA is keen to put the FSA's past behind it and to come up with its own set of rules that reflect the statutory objectives it has been set. During the transition to the new Rulebook, the online website will contain both PRA Handbook material and PRA Rulebook material. This means that, to understand the full set of applicable requirements, PRA-authorised insurers will need to refer to both. In the absence of a clear structure for the Rulebook (which we expect to emerge), this is likely to cause firms difficulty as material is increasingly transferred across to the Rulebook. The PRA's intention is to have a "clear and concise" Rulebook appearing on a new website from 2015. In particular, changes to the online presentation of the Rulebook will be made to structure its provisions in a logical way and make them easy to navigate. However, as was outlined in a PRA consultation paper (CP8/13) published in October 2013, the Rulebook will contain rules and directions but no guidance. Instead, the PRA will produce a limited amount of guidance in the form of Supervisory Statements, which are intended to be "a homogenous set of material which is clear and understandable to firms". We hope that there will be a clear link from the Rulebook to relevant Supervisory Statements or it will be very difficult for firms to establish whether relevant guidance applies. As can be seen from the diagram below, a range of sources must be studied for a full picture of the PRA's approach to supervising insurers. Beyond this, EU legislation applying directly to insurers (e.g. Solvency II Level 2 delegated acts) will need to be understood as the relevant requirements will no longer be replicated in the PRA Rulebook or in other PRA material (see our previous briefing "Solvency II – a guide to the legal process and next steps"). 5. PRA supervision of insurers Approach to Insurance Supervision (June 2014) Individual Guidance Handbook of Rules and Guidance (pending transition to Rulebook) Rulebook, including Fundamental Rules (rules and directions) Other PRA material e.g. Statements of Policy PRA website (processes) Supervisory Statements (guidance) Threshold Conditions (statutory requirements for authorisation) Page 4 6. Fundamental Rules Replacing high-level Principles inherited from the FSA with the Fundamental Rules is the most significant change made by the PRA to date as part of its transition to the new Rulebook. The PRA argues that the Fundamental Rules are a clearer and more accurate expression of its expectations and underlying regulations than the Principles. The Fundamental Rules became effective on 19 June 2014, their date of publication. The PRA expects Boards and senior management to be familiar with them (as well as the more detailed requirements of the Rulebook) and to implement a culture of adherence "to the spirit and letter of these requirements". Firms are also encouraged to exercise judgement in their compliance with the high-level requirements, but are warned that the PRA will consider supervisory action if it considers a breach to have occurred or compliance to have been inadequate. Some of the PRA's original proposals have been amended to take account of feedback received through the consultation process (see table below), although the PRA does comment in PS5/14 that "even where there has been an amendment, the impact will not differ significantly from that of the draft rules". Proposed PRA Fundamental Rules (CP2/14) Final PRA Fundamental Rules (PS5/14) PRA/FCA Principles for Businesses [Note that table does not include Principles that only transferred to the FCA at Legal Cutover] FR1: A firm must act with integrity. FR1: A firm must conduct its business with integrity. 1. A firm must conduct its business with integrity. FR2: A firm must act with due skill, care and diligence. FR2: A firm must conduct its business with due skill, care and diligence. 2. A firm must conduct its business with due skill, care and diligence. FR3: A firm must act in a prudent manner. FR3: A firm must act in a prudent manner. FR4: A firm must at all times maintain adequate financial resources. FR4: A firm must at all times maintain adequate financial resources. 4. A firm must maintain adequate financial resources. FR5: A firm must have in place sound and effective risk strategies and risk management systems. FR5: A firm must have effective risk strategies and risk management systems. 3. A firm must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems. FR6: A firm must organise and control its affairs responsibly and effectively. FR6: A firm must organise and control its affairs responsibly and effectively. 3. A firm must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems. FR7: A firm must deal with its regulators in an open, cooperative and timely way and must appropriately disclose to the PRA anything relating to the firm of which the PRA would reasonably expect notice. FR7: A firm must deal with its regulators in an open and cooperative way and must disclose to the PRA appropriately anything relating to the firm of which the PRA would reasonably expect notice. 11. A firm must deal with its regulators in an open and cooperative way, and must disclose to the appropriate regulator appropriately anything relating to the firm of which that regulator would reasonably expect notice. FR8: A firm must prepare for resolution so, if the need arises, it can be resolved in an orderly manner with a minimum disruption of critical services. FR8: A firm must prepare for resolution so, if the need arises, it can be resolved in an orderly manner with a minimum disruption of critical services. FR9: A firm must not knowingly or recklessly give the PRA information that is false or misleading in a material particular. 8. A firm must manage conflicts of interest fairly, both between itself and its customers and between a customer and another client. Page 5 Responses to CP2/14 raised a number of specific concerns about variations in wording between the proposed text of the Fundamental Rules and those Principles which have been retained (for the time being at least) by the FCA. The final published Fundamental Rules accommodate some of these concerns. For example, a proposal to require notification under new FR7 to be "timely" has been dropped to avoid any suggestion that notification under the FCA equivalent (Principle 11) need not be timely. A new Fundamental Rule, FR8, requires all firms to prepare for resolution so "if the need arises, it can be resolved in an orderly manner with a minimum disruption of critical services". Where significant barriers to resolvability are identified, insurers "should propose and implement adequate changes to reduce these where possible". To place insurers under the same obligation as banks in this regard seems odd in the absence of a formal requirement for insurers to develop Recovery and Resolution Plans (RRP). Arguably, it is also inconsistent with the Approach Document, which indicates that insurers need only provide the PRA with information needed to assess their resolvability "on request". In practice, it seems that insurers have little option but to prepare the equivalent of an RRP, notwithstanding that the Approach Document makes it clear that the PRA has yet to take a decision on whether to introduce a specific requirement for them to do so. In the absence of any guidance in the Rulebook itself to explain the meaning of the Fundamental Rules, firms might have expected to look back at their introduction in CP2/14 for help. However, the PRA indicates in PS5/14 that firms should only look at the Approach Document and at PS5/14 itself for clarification. Indeed, PS5/14 states: "The [Approach Document] should be read alongside the Fundamental Rules as a detailed expression of the PRA's expectations", suggesting the two have equivalent status despite the fact that no consultation occurs in relation to the Approach Document. However, explanations given in CP2/14 as to the meaning of terms used in the Fundamental Rules are not always repeated in either the Approach Document or PS5/14. It is also not clear how this approach is consistent with PRA guidance on the interpretation of the Rulebook, which states: "Every provision in the PRA Rulebook must be interpreted in the light of its purpose." If the purpose of a provision of the PRA Rulebook can only be completely understood from comments made at the time of consultation, firms should be entitled to take those comments into account when a need to interpret the relevant provision arises. 7. How will insurers find the material they need? Whilst the PRA's efforts to reshape the material in the existing Handbook are welcome, the fact that the migration will occur in a number of stages creates difficulties for firms in understanding the regulations applying at any given time and navigating the appropriate guidance materials. The PRA has recognised the importance of functionality and search facilities to the final website (which is expected to be available in 2015), but has not offered any additional support during the migration phase. At present, the Rulebook appears on the PRA's website in PDF format only and is likely to become increasingly more difficult to navigate as additional sections are added. Once the Rulebook is fully in force, the PRA has promised that firms will be able to access rules which are specific, where applicable, to their firm type and which are separate from requirements set by the FCA. Rulebook content will also be "easy to engage and comply with". Improved accessibility of PRA material would be very welcome as the PRA website currently leaves much to be desired in this respect. Page 6 8. Contacts Geoffrey Maddock (partner) T +44 20 7466 2067 M +44 778 525 5016 Geoffrey.Maddock@hsf.com Barnaby Hinnigan (partner) T +44 20 7466 2816 M +44 780 920 0299 Barnaby.Hinnigan@hsf.com Alison Matthews (consultant) T +44 20 7466 2765 M +44 780 920 0879 Alison.Matthews@hsf.com If you would like to receive more copies of this briefing, or would like to receive Herbert Smith Freehills briefings from other practice areas, or would like to be taken off the distribution lists for such briefings, please email firstname.lastname@example.org. © Herbert Smith Freehills LLP 2014 The contents of this publication, current at the date of publication set out above, are for reference purposes only. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on the information provided herein.