News analysis - Regulation: The more things change

Clarity is beginning to emerge for insurers about what it will mean to be regulated by the Prudential Regulation Authority. On Monday 20 June, the Financial Services Authority published a paper setting out its approach to the prudential supervision of UK authorised insurers, giving for the first time a clear sense of what life under the PRA will look like.

Given that Hector Sants, current chief executive of the FSA, will also be running the PRA, it will come as no surprise to find many of the FSA's recent regulatory themes appearing in this paper. For example, supervision under the PRA will be "forward-looking" and "judgement-based".

Differences delineated
The paper is keen to stress that the PRA recognises there are key differences between the risks posed by insurers and those posed by banks — indeed, it might be thought that the paper and accompanying speeches risk protesting too much on that point.

But the message is a welcome one for insurers, and reflects a significant shift in tone from the position a year ago. In particular, both the Lloyd's market and friendly societies will welcome the fact each will have their own dedicated supervisory groups within the PRA.

However, the paper emphasises that insurance companies do, from time to time, become insolvent or come close to it. It expressly refers to the need to learn lessons from Equitable Life, HIH, Independent Insurance and AIG — as well as the London market exposures in the 1970s and 1980s arising from asbestos and catastrophe claims.

With that perspective, it is unsurprising the paper focuses on issues such as reserving, governance and risk management. It particularly targets with-profits policies although, in doing so, the paper also highlights the potential for underlaps and overlaps between the PRA and the Financial Conduct Authority. Interestingly, Mr Sants suggests that, in his view, the risk of either conflicting regulatory actions, or an issue falling through the gap, is greater in insurance than in banking.

Some of the comment following the publication of last week's paper expressed concerns that the PRA's approach to the prudential regulation of insurance closely resembles that set out last month by Mr Sants in relation to the prudential regulation of banks. This is not hugely surprising, nor should it be unduly concerning. Indeed, it would be bizarre if, at this macro level, there was not some commonality of approach.

It is worth remembering that the risk-based approach of Solvency II draws on the current European capital adequacy model for banks, itself derived from Basel II. Similarly, approaches to corporate governance and risk management will have much in common whether applied to a bank, an insurance company or any other large organisation. So it makes sense for the PRA to apply the same high-level risk assessment framework to both banks and insurers.

The underlying principle behind the PRA's approach will be twofold: securing "an appropriate degree of protection" for policyholders and ensuring financial stability. Crucial to this will be exactly what the PRA regards as an "appropriate degree" of protection, or, as it also describes it, a "reasonably high probability that policyholder claims and obligations can be met as they fall due". This will not, though, be a zero-failure regime — although whether politicians and the general public appreciate that is debatable.

Managing failure
The PRA will apply some of the lessons learnt from recent banking failures to insurers. Consequently, insurers can expect to see a greater focus on stress- testing, including reverse stress-testing, and challenges to their internal models.

The PRA will aim to identify failing insurers at an early stage and try to manage their orderly winding down. It will also consider whether and how 'recovery and resolution plans' — so-called 'living wills' — might be introduced for insurers.

Each insurer will be placed within the PRA's 'proactive intervention framework' ranked from one (low risk) to five (insolvent). While firms will know which category they have been given, these rankings will not be made public.

There should be no surprise that the advent of the PRA will not herald any relaxation of the regulatory environment in which UK insurers operate. Indeed, despite the fact that insurers generally came through the financial crisis in good shape, the PRA believes that, relative to their size and complexity, an insurance company will require more intense supervision that an equivalent bank.

Curtailed powers
The paper is also clear about the limits of the PRA's powers in the case of insurers authorised in other EEA member states passporting into the UK. While the PRA will lobby in Europe where it identifies issues, it cannot ultimately control the approach taken by the regulators in other member states.

As the collapse of a number of Icelandic banks made clear, that is a weakness in the European passporting model. Only time will tell whether the new European regulatory architecture that is now in place is able to deal with the problem. If it isn't, that may create the risk of regulatory arbitrage for insurers between member states.

In addition, since Solvency II is largely a 'maximum harmonisation' regime, there may be a limit to the extent to which the PRA will be able to impose its judgements-led approach on UK insurers.

If insurers think that they can wait until the Financial Services Bill becomes law, they will be in for a shock: the approach to supervision will change during the course of 2012, ahead of formal implementation. Insurers should speak now if they want to influence the outcome.

Mathew Rutter is a partner in the financial services team at Beachcroft