The UK Prudential Regulation Authority (PRA) has set out its priorities for insurance supervision this year in a 10 January 2023 Priorities Letter. In this newsletter, we summarize the broad themes that emerge from the Priority Letter and the earlier PRA Business Plan for 2022/23, together with our view on what may be behind the PRA’s sometimes indirect references.
The PRA has updated the business plan to flag a number of additional insurance market-wide risks, ranging from the impact of the predicted UK recession, increased inflation and risks arising from climate change, both to underwriting risk and asset values.
Credit and concentration risk (life insurance)
For the life insurance industry, the PRA specifically refers to the increased exposure to credit and concentration risk (especially for insurers using internal models) due to wider credit spreads, rating downgrades and increased levels of defaults. This points out that robust modeling will be required in prolonged adverse credit scenarios.
Claim inflation (general insurance)
For general insurers, the PRA notes increased levels of claims inflation. This is compounded by uncertainty about the severity and duration of this inflation, and also the potential delay before claims come through. In the PRA’s October 2022 letter on the subject, it identified a number of drivers (wages, parts, court settlements, medical as well as ‘social’ inflation), with the differences between different businesses and geographies. The profit warning and subsequent dividend cancellation by UK-listed general motor insurer Direct Line Insurance Group PLC in January 2023, attributed to adverse weather conditions in Q4, is a high-profile example of the issues facing the market.
The PRA notes that market and credit risks are now different from those that prevailed until recently. It expects firms to be certain of the continued validity of their models, and invites firms to look at the PRA’s model risk management principles for the banking sector, which has been a PRA focus since the collapse of Archegos Capital Management in 2021. This draft banking principles, contained in a consultation document released in July 2022, include proposals for assigning responsibility for risk management to a senior management function holder, improved reporting to the audit committee, and the identification and assessment of risks involved in the use of artificial intelligence (AI) in modeling.
Bulk purchase annuity transactions
For the life insurance industry, this presents a particular risk with the booming UK market for bulk purchase annuity (BPA) deals, where UK defined benefit pension schemes offload risk, typically to specialized divisions of life insurance groups. In 2023 the PRA will conduct a thematic review around its (thinly veiled) concern that successful bidders (ie., risk takers) on such transactions do not act in a disciplined manner. The prices offered by risk takers (and therefore the risk taker’s ongoing exposure over the life of the book) are likely to be scrutinized.
Liquidity risk/liability driven investment funds
The PRA also cites specific concerns about insurers’ liquidity risk frameworks, with express reference to the turmoil in UK financial markets in October 2022, and the way in which liability-driven investment (LDI) funds used by pension funds have struggled to obtain collateral for cover distribution. In general, the PRA will focus on insurers’ use of derivatives for risk management, and the scope for them to generate further liquidity risks.
The PRA subsequently published the results of its 2022 stress test of 54 firms in the general and life markets. While this confirms that the UK insurance sector is resilient to the PRA-specified scenarios, concerns remain about the ability of firms to sell assets following a market-wide stress where there may be few willing buyers.
We have already reported on the UK government’s proposals for material changes to Solvency II (changes referred to as Solvency UK) as part of wider reforms to the UK financial services regime, known as the Edinburgh reforms. See “The Edinburgh Reforms: Big Bang 2.0 or Thoughtful Change?” and ‘From Solvency II to Solvency UK: The UK Government Announces its Post-Brexit Solvency II Reforms’. Although HM Treasury led, these processes will of course require significant PRA engagement with the industry.
Temporary authorization regime and third country branches
The PRA aims to complete its assessment of UK branches of European Economic Area (EEA) insurers in 2023, with a view to whether such branches should obtain standalone UK authorization or phase out. The UK policy of ‘responsible openness’ in relation to the EEA extends to all third country branches where, as part of the Edinburgh reforms, it removes requirements for third country branches to calculate branch capital requirements and hold local assets to cover. they. Post-Brexit, EEA third-country branches operate in the United Kingdom under the extended grace period referred to as the Temporary Permission Regime (TPR). It remains important for TPR firms to follow the PRA’s requirements and timetables, given the regulatory willingness to enforce against breaches.
This is somewhat in contrast to the approach of the European Insurance and Occupational Pensions Authority (EIOPA), which in July 2022 strengthened efforts to limit the activities of branches of third countries in the EEA, both carriers and intermediaries.
Longevity and ‘funded’ reinsurance
The PRA also flags risks for UK policyholders in the life market arising from carriers’ reinsurance arrangements In particular it mentions (i) the increasing reliance of parts of the industry on longevity reinsurance (partly linked to the continued popularity of the BPA deals which discuss is) above), often ceding risk to US and Bermuda reinsurers with lower or different capital requirements. and (ii) the emergence of more complex ‘funded reinsurance’.
It will be interesting to see if and how these concerns form part of the PRA’s efforts to encourage an insurance-linked securities (ILS) market and guaranteed reinsurance in the general insurance sector. It may well be that the only way to bring such risks back onshore may be to create a UK regime for reinsurers broadly similar to what Bermuda offers.
The above concerns center around concentration risk, with the PRA noting that the use of specialized fully funded reinsurers can actually increase a carrier’s overall risk profile compared to a more conventional cession to a range of diversified reinsurers due to the trust on the integrity and suitability. from a discrete pot of collateral. As it says, ‘funded reinsurance also appears to be far removed from the traditional purpose of reinsurance, which is to access wider diversification of liabilities’. The PRA has particular concerns about the ability of a carrier to resume risk in the event of reinsurer default (recovery risk), noting that repossessed assets may not comply with Solvency II, terms governing the collateral are not standardized and sometimes opaque, and there is a danger of ‘wrong way risk’ (ie., where the same issues affecting the reinsurer also affect the collateral pot).
The PRA’s concern about general market conditions gives greater attention to its rules on operational risk and resilience. The PRA currently requires insurers to identify and map key business services and establish impact tolerances. Over the next three years, the PRA will expect insurers to demonstrate their ability to operate in a range of ‘severe but credible’ scenarios, including cyber attacks. This would naturally extend to arrangements where a firm relies on a third-party outsourced supplier.
Perhaps also linked to the concerns above, the PRA continues to make it a priority to improve ‘ease of exit’ – no doubt a euphemism for the long and complex processes that typically result from a business going into liquidation or failure. The largest and systemically important global (re)insurers have been required for some time now to develop and maintain ‘living wills’. Now the PRA is turning to smaller firms. Although all firms are already required under the PRA’s Fundamental Rule 8 to prepare for a decision to exit in an orderly manner, the PRA will consult in 2023 on whether this should be tightened to a requirement for all insurers to draw up exit plans.
This again links to ongoing initiatives at EU level, where the European Commission adopted a legislative proposal for an Insurance Recovery and Resolution Directive (IRRD) in September 2021, with possible adoption in 2023.
The content of the Priority Letter is perhaps not surprising given the macro challenges facing both the wider economy and insurers. What will be interesting to observe is how the PRA adjusts those priorities in real time to the further economic shocks and bumps we will undoubtedly experience in the coming year.