Out-Law News 3 min. read
19 Feb 2016, 9:43 am
Insurance law expert Rabbani Choudhury of Pinsent Masons, the law firm behind Out-Law.com, said that firms would be paying attention to comments made by Andrew Bulley of the Prudential Regulation Authority (PRA) at an event hosted by life insurance trade body ILAG. In his speech, Bulley appeared to suggest that the PRA would take a robust approach to insurers' capital management strategies, Choudhury said.
"It was particularly interesting to hear his comments relating to how firms might be using or contemplating using the mechanics of the Solvency II architecture to circumvent holding higher levels of capital which were compatible with the tolerance levels of the PRA," he said.
"In relation to his comments about internal models, firms which may be considering model changes will not have been enamoured to hear that any amendments that they want to make to already approved models will result in their entire model application having to be reassessed. This does seem a bit excessive for a firm which may only be seeking to make minor, non-substantive changes to a model," he said.
The PRA has to date approved 19 applications by firms wishing to use their own 'internal models' in order to calculate their liabilities under the Solvency II regulatory regime, which came into force across the EU on 1 January 2016. Nine of these applications were made by the UK's major life insurers, meaning that the UK was "now in a position where the prudential capital ratios for firms that in aggregate represent over 80% of the UK life sector balance sheet are determined by approved internal models".
"That is a formidable achievement, one that sets the UK life sector apart from much of Europe and one of which I believe the industry can be proud' but ... it is also a development that carries profound strategic, supervisory, risk management and operational implications for firms and regulators alike," said Bulley, who is the PRA's director of life insurance.
"One of the risks of a prudential regime that permits firms to calculate their own capital requirements is that the system, over time, is gamed … [We] need to recognise that, left to its own devices, competitive pressure can exert a steady and determinedly downward pressure on capitalisation. We will accordingly monitor trends and developments in insurers' model capitalisations very closely indeed, looking to guard against any pronounced downward drift," he said.
The regulator expected to see a 'second wave' of internal model applications this year, as well as applications for amendments from firms with approved models, Bulley said. The new rules apply to more than 400 retail and wholesale UK insurance firms, many of which are currently using a 'standard' model to calculate their capital requirements.
Solvency II sets out broader risk management requirements for European insurers, including requirements for firms to hold enough capital to cover all their expected future insurance or reinsurance liabilities. Bulley said that the PRA's approach to insurance regulation had not changed under the new rules, and that the regulator would shortly confirm this by publishing its updated 'Approach to Insurance Supervision' for 2016.
"The thrust of the document is that we will continue to focus on strengthening the UK financial system through being a forward-looking and judgement based prudential regulator," he said.
As part of its forward-looking regulatory priorities, the PRA would also look at whether the new rules were providing life firms with an "additional incentive" to use reinsurance as a means of transferring longevity risks.
"Doing so may ease the requirement for holding a risk margin in respect of the reinsured liabilities," Bulley said.
"We recognise that the current design of the risk margin makes it acutely sensitive to interest rate conditions. However, we will be monitoring closely if firms become active in this market consistently and solely for reasons other than seeking genuine risk transfer," he said.
Insurance expert Rabbani Choudhury of Pinsent Masons said that Bulley's comments here were "quite inconsistent with how reinsurance contributes to the PRA's objective of securing protection for policyholders".
"Reinsurance has always been a traditional method of transferring the risk of loss, and if a by-product of that is capital requirements are lessened then that shouldn't be regarded as regulatory arbitrage," he said.