Insurance updater - Europe

This week we consider the impact of three Supervisory Statements published by the Prudential Regulation Authority (PRA):

• PRA’s approach to schemes of arrangement proposed by insurers under Part 26 of the Companies Act 2006.
• Capital extractions by run-off firms within the general insurance sector.
• Solvency II: calculation of technical provisions and the use of internal models for general insurers.

On April 25, 2014, the PRA published SS 3/14: The PRA approach to schemes of arrangement proposed by PRA-authorised insurers under Part 26 of the Companies Act 2006.

SS 3/14 provides feedback on the responses submitted to the September 2013 consultation on the PRA’s draft supervisory statement (CP 6/13) and clarifies the approach that the authority will take to any future schemes proposed by insurers. In addition, SS/14 explains the role that the PRA will play in assessing any scheme and provides insight into how the PRA will work with the Financial Conduct Authority (FCA) when considering its view on a scheme proposal.

What is a scheme of arrangement?

A scheme of arrangement is a statutory process (under Section 26 of the Companies Act 2006) whereby a company can enter into a mass compromise with its creditors. The scheme is binding on all creditors once the requisite formalities have been completed, including a vote in favour at a meeting of all creditors (or each meeting of separate classes of creditors) and the sanction of the Court. The vote must be approved by 50 per cent in number and 75 per cent in value of all creditors entitled to vote (or each class of creditors).

What are supervisory statements?

Supervisory statements are made by the PRA in order to provide guidance to firms and to clarify the expectations of the authority on a given topic.

What approach does the PRA take?

In CP 6/13, the PRA set out its draft statement on the use of schemes by ‘general insurance firms’. In CP 6/13 the PRA took the line that schemes of arrangement may be compatible with its statutory objectives, namely to ensure the safety and soundness of the financial system and the protection of policyholders.

For example, the PRA suggested that schemes might be appropriate where an insurer is no longer solvent. However, CP 6/13 stated that there were situations where a scheme is unlikely to meet the PRA’s objectives, namely where a solvent scheme is proposed. According to the draft statement this was because the use of a scheme by a solvent company would undermine the traditional shareholder/creditor hierarchy: enabling shareholders to extract capital from the business while policyholders were subject to a binding compromise in respect of potential claims.

Although SS 3/14 reiterates the position taken in CP 6/13 that a scheme of arrangement may be compatible with its objectives where an insurer is insolvent (as it can enable the insurer to maximize the assets available to distribute to its creditors), the PRA has amended its statement from the original proposal to state that solvent schemes “may not be” compatible with its objectives (CP 6/13 had stated that solvent schemes are “unlikely” to be compatible).

Rather than focusing on how schemes might enable shareholders to extract capital while binding policyholder, SS 3/14 states that solvent schemes may not be compatible as firms may wish to exit a portfolio for commercial reasons. In such circumstances, SS 3/14 states, a solvent scheme may compromise policyholders’ cover when the firm can continue to pay claims as they fall due.

What role does the PRA propose to play in a scheme?

The PRA is not given any role in relation to the procedures for a scheme of arrangement under Part 26 of the Companies Act 2006. Only the court has the power to determine whether or not a scheme should be sanctioned. The PRA nevertheless states in SS 3/14 that it will review all schemes in order to determine whether they pose a risk to its statutory objectives. After assessing each scheme, the PRA will consider whether it will inform the court of it views and if so, how those views will be communicated.

The PRA will expect any firms considering whether to undertake a scheme to inform the authority about its proposals with “sufficient time” for them to assess the impact on policyholders. SS 3/14 specifies that failure to provide adequate notice could be considered a breach of Principle 11 (relations with regulators).

In particular, SS 3/14 states that insurers proposing a scheme will need to provide the PRA with an explanation of:

• The nature of the business to be included in the scheme.
• The nature of the underlying policyholders (presumably to consider the sophistication of the policyholders).
• Why the firm believes that the scheme is compatible with the PRA’s objectives.
• What steps will be taken to ensure that policyholders will have an appropriate degree of continuity of cover (including in some circumstances what proposals the firm has for those policyholders who do not support the proposed scheme).

The PRA will consider each proposal on its facts. The PRA will take into account the particular business of the firm when considering the impact of the scheme on its statutory objectives.

Discussions with the FCA

In addition to discussing any proposals to undertake a scheme of arrangement with the PRA firms should also inform the FCA of their plans.

Feedback on CP 6/13

The PRA has provided feedback on some of the comments submitted in response to its draft statement. In particular, the PRA states that, although it is given no specified powers or role in relation to schemes of arrangement under Part 26 of the Companies Act 2006 it has a “regulatory interest’ in ensuring that firms act in a manner consistent with the authority’s statutory objectives when proposing a scheme.

The PRA refutes suggestions that the statement represents a hard and inflexible approach to schemes. In SS 3/14 the PRA says that this was not their intention. Rather, each proposal will be considered on its particular facts. The statement has been amended to clarify this.

The PRA has also responded to questions as to whether the statement applies to life and general insurers; the consultation referred only to general firms. The PRA has responded that the statement does indeed also apply to life business.

In response to questions raised about the impact of the statement on investment and innovation in the UK insurance market the PRA has responded that, since its new remit to consider its Secondary Objective on competition which came into effect in March 2014, the authority has confirmed that competition will be a relevant issue for consideration in each case.

For further information:  PRA publishes Supervisory Statement (SS 3/14) on schemes of arrangement

Also on April 25, the PRA published SS 4/14: Capital extractions by run-off firms within the general insurance sector. The aim of the supervisory statement is to set out the PRA’s expectations of firms’ compliance with the PRA Handbook provisions applicable to general insurance (GI) firms in run-off. Before approving an extraction of capital the PRA will wish to establish that the firm has reviewed the impact of the proposals on its capital, both immediately after the extraction but also over the longer term.

SS 4/14 highlights certain factors that the PRA will expect the senior management of a run-off firm to take into account when considering making a request to the PRA to extract capital from the firm during run-off. It also sets out the approach that the PRA will take when assessing such a request.

The PRA requires GI firms in run-off to read this supervisory statement alongside SS 3/14 published in relation to their approach to schemes of arrangement (see above).

The PRA will expect firms in run-off to hold sufficient regulatory capital to ensure that they can continue to meet their obligations to policyholders as they fall due. The PRA will also expect firms to be able to satisfy themselves and the authority that their capital will remain adequate after the proposed extraction of capital.

What is capital extraction and what are the regulator’s concerns?

Firms in run-off occasionally wish to extract capital from the business.  The PRA has concerns that such extractions have the potential to weaken the level of protection available to meet policyholders’ claims. As run-off firms often do not have the same access to sources of capital that a ‘live’ business might have the PRA is concerned that, should new risks emerge in the book or should there be a change in the frequency of claims, it can be hard for businesses in run-off to continue to maintain sufficient capital levels.  In addition, the PRA is concerned that inadequate policy records held by some businesses in run-off make it harder to accurately estimate potential future claims.

The PRA does, however, recognise in SS 4/14 that in certain circumstances requests to extract capital may be appropriate. This might be the case, for example, where there are significant levels of surplus regulatory capital and claims have developed favourably over a long period of time.

What expectations are there of run-off firms proposing to extract capital?

SS 4/14 states that the PRA will hold senior management in firms responsible for ensuring that firms maintain financial resources that are adequate at all times. Both the quality and quantity of those resources will be considered. In meeting this requirement firms must comply with the requirements set out in the PRA Handbook. Accordingly, firms will need to undertake an Individual Capital Assessment (ICA) and to consider the future capital needs – including under stressed conditions.

The PRA will expect senior management and boards to assess the level of capital required for the business on an ongoing basis, taking into account capital requirements in adverse conditions. Where a firm wishes to extract capital while in run-off, the PRA will expect senior management and the board to be satisfied that solvency levels after the proposed extraction will remain adequate for the duration of the run-off.

In SS 4/14 the PRA sets out steps that firms should take before proposing to extract capital. These are:

• The firm should undertake a review of its capital in order to assess its solvency position after the proposed extraction. This should include a review of the Minimum Capital Requirement (MCR) under the existing prudential requirements and an updated ICA. The assessment should take into account any restrictions on capital and the quality of the policy records available. The firm should also review how the capital position may change under Solvency II.
• In addition to assessing its current ICA, the firm will need to consider the expected future progress of the run-off, looking at least to the next 3-5 years. This assessment should be based on realistic assumptions on claims, reserve development and investment income and should reflect the experiences of the run-off to date. The firm should use this information to prepare a projection of its likely capital resources, MCR and ICA over this future period.
• Board approval should be sought for the proposal taking into account the review of the firm’s capital situation (including the results of the ICA). The Board should only approve the proposed extraction of capital where it is satisfied that the firm will be able to maintain adequate financial resources after the proposed extraction (i.e. it must be able to continue to meet both its MCR and ICA at all times over the 3-5 year period).

How the PRA will review proposals to extract capital?

Any request to make a capital extraction must be made by an approved person. The request must include a confirmation that the Board has considered all the factors raised in SS 4/14 and approves the proposal. In addition, firms should provide the PRA with copies of its latest ICA review and analysis submitted to the Board demonstrating the projected evolution of the MCR and ICA. The PRA may ask the firm to commission an independent review of its analysis to ensure that the data provided is robust. The PRA is more likely to ask that an independent review of underlying data and assumptions is undertaken where the proposed capital extraction is either: significant in size; would result in a projected coverage of a firm’s ICA of less than 200 per cent; or where the PRA has concerns about the data being used.

Having reviewed the data provided by the firm the PRA may issue Individual Capital Guidance (ICG). The ICG will specify the amount and quality of capital that the firm considers appropriate in order that the firm maintains adequate financial resources. Where the ICA will not be appropriate or does not adequately reflect uncertainties, the PRA may require the run-off firm to hold more capital.

For further information: SS 4/14: Capital extractions by run-off firms within the general insurance sector

The PRA has also published Supervisory Statement SS 5/14: Solvency II: calculation of technical provisions and the use of internal models for general insurers.

The aim of the Statement is to set out the PRA's expectations in relation to the firms’ preparations towards Solvency II compliance by ensuring that general insurers are setting an adequate level of technical provisions and hold sufficient capital.

The Statement covers:

• Technical provisions - Realistic assumption and adequate methods including the risk margin and events not in data (ENID).
• Internal models – Material risks (including ENID), consistency of with technical provisions, assumptions and techniques, data, risk mitigation, management actions, validation standards, external models and data, and data from third party models.

For further information: PRA publishes Supervisory Statement on Solvency II technical provisions and internal models for general insurers