The UK’s Prudential Regulation Authority (PRA) set out its priorities for insurance supervision this year in a report dated January 10, 2023 Letter of priorities. In this newsletter, we summarize the main themes that emerged from the Priorities Letter and the previous ARP Business plan for 2022/23as well as our view on what might be hiding behind the sometimes indirect PRA references.
The PRA has updated the business plan to flag a number of additional risks across the insurance market, ranging from the impacts of the forecast UK recession, high inflation and risks arising from climate change, both to underwriting risk and to the value of assets.
Credit and concentration risk (life insurance)
For the life insurance industry, PRA refers specifically to increased exposure to credit and concentration risk (particularly for insurers using internal models) due to widening credit spreads, rating downgrades and increased level of defaults. He notes that robust modeling will be required in prolonged adverse credit scenarios.
Claims inflation (general insurance)
For general insurers, the PRA notes high levels of claims inflation. This is compounded by uncertainty about the severity and duration of this inflation, as well as the potential delay before claims occur. In PRAs October 2022 newsletteron the subject, he identified a number of factors (salaries, parts, legal settlements, medical and “social” inflation), noting variations between different companies and geographical areas. The profit warning and subsequent cancellation of dividends by UK general motor insurance group Direct Line Insurance Group PLC in January 2023, attributed to adverse weather conditions in the fourth quarter, is a highly publicized example of the problems facing the market. is confronted.
The PRA notes that market and credit risks are now different from those that prevailed until recently. He expects companies to ensure the continued validity of their models and invites companies to refer to the risk management principles of the PRA model for the banking sector, which are central to the concerns of the PRA since the collapse of Archegos Capital Management in 2021. These principle projects, contained in a consultation document published in July 2022include proposals for assigning responsibility for risk management to a senior management function holder, improved reporting to the audit committee, and identifying and assessing risks related to the use of intelligence artificial intelligence (AI) in modelling.
Group purchases of annuities
For the life insurance sector, he points to a specific risk with the booming UK block annuity (BPA) market, where UK defined benefit pension schemes offload risk, usually to specialist divisions life insurance groups. In 2023, the PRA will conduct a thematic review around its (thinly veiled) concern that successful bidders (that is to say., risk takers) on such transactions do not act in a disciplined manner. The pricing offered by the risk takers (and therefore the risk taker’s ongoing exposure over the lifetime of the book) will likely come under scrutiny.
Liquidity/Liability Risk Investment Funds
The PRA also flags specific concerns about insurers’ liquidity risk frameworks, with explicit reference to the turmoil in UK financial markets in October 2022, and the way liability driven investment (LDI) funds are being used. by pension funds struggled to find collateral to cover widening spreads. Typically, the PRA will focus on insurers’ use of derivatives for risk management, and the potential for this to generate other liquidity risks.
The PRA subsequently published the results of its 2022 stress test of 54 companies in the general and life market. While this confirms that the UK insurance industry is resilient to the scenarios specified by the PRA, concerns remain over the ability of companies to sell assets following a market-wide crisis where it may be few willing buyers.
Solvency United Kingdom
We have previously reported on the UK government’s proposals for substantial changes to Solvency II (so-called Solvency UK changes) as part of wider reforms to the UK financial services regime, known as the Edinburgh reforms. To see ‘The Edinburgh reforms: Big Bang 2.0 or thoughtful change?‘ and ‘From Solvency II to Solvency UK: the British government announces its post-Brexit Solvency II reforms‘. Although led by HM Treasury, these processes will of course require significant engagement by the PRA with industry.
Temporary authorization scheme and branches in third countries
The PRA intends to complete its assessment of UK branches of insurers in the European Economic Area (EEA) in 2023, with a view to determining whether such branches should obtain stand-alone UK authorization or go into liquidation. The UK’s EEA ‘responsible opening’ policy extends to all third country branches where, as part of the Edinburgh reforms, it removes the requirement for third country branches to calculate branch capital requirements and hold local assets to cover them. After Brexit, non-EEA country branches operate in the UK under the extended grace period known as the Temporary Permission Scheme (TPR). It remains important for TPR companies to adhere to PRA requirements and timelines, given the regulatory will to enforce violations.
This contrasts somewhat with the approach of the European Insurance and Occupational Pensions Authority (EIOPA), which in July 2022 increased efforts to restrict the activities of third country branches in the EEAboth carriers and intermediaries.
Longevity and “funded” reinsurance
ARP also flags risks for UK policyholders in the life insurance market resulting from carrier reinsurance agreements In particular, he mentions (i) the growing reliance of parts of the industry on longevity reinsurance (linked in part to the continued popularity of the BPA agreements discussed above), often the relocation of risks 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 feed into the PRA’s efforts to encourage an insurance-linked securities (ILS) market and collateralized reinsurance in the general insurance industry. It may well be that the only way to bring these risks ashore is to create a UK scheme for reinsurers that is broadly similar to what Bermuda offers.
The above concerns relate to concentration risk, with the PRA noting that the use of fully funded specialist reinsurers can actually increase an insurer’s overall risk profile compared to more conventional ceding to a range of diversified reinsurers. due to reliance on the integrity and adequacy of a discrete jar of collateral. As she puts it, “funded reinsurance also appears to be far removed from the traditional objective of reinsurance, which is to access greater diversification of liabilities”. The PRA is particularly concerned about a carrier’s ability to take over the risk in the event of reinsurer default (recovery risk), noting that the assets recovered may not be Solvency II compliant, the conditions governing the guarantee are not not standardized and sometimes opaque, and that there is a danger of “risk of misdirection” (that is to say., where the same problems affecting the reinsurer also have an impact on the guarantee pot).
The PRA’s concerns about general market conditions are prompting increased attention to its operational risk and resilience rules. The PRA currently expects insurers to identify and map key business services and set impact tolerances. Over the next three years, the PRA will expect insurers to demonstrate their ability to operate in a range of “serious but plausible” scenarios, including cyberattacks. This will, of course, extend to agreements where a company relies on an outsourced third-party provider.
Perhaps also related to the concerns above, the PRA continues to prioritize improving “ease of exit” – no doubt a euphemism for the lengthy and complex processes that typically result from a business in liquidation or bankruptcy. The world’s largest and most systemically important (re)insurers have for some time now been required to develop and maintain ‘living wills’. Now the PRA is turning to small businesses. Although all companies are already required under PRA Core Rule 8 to prepare for an exit resolution in an orderly manner, the PRA will consult in 2023 on whether this should be strengthened into a requirement for all insurers to produce exit plans.
This again ties in with ongoing initiatives at EU level, where in September 2021 the European Commission adopted a legislative proposal for an Insurance Recovery and Resolution Directive (IRRD)with a possible adoption in 2023.
The content of the priority letter is perhaps unsurprising given the macroeconomic challenges facing both the broader economy and insurers. What will be interesting to watch is how the PRA adapts these priorities in real time to new shocks and economic shocks that we will no doubt experience in the coming year.