On 19 April 2012, Julian Adams, Financial Services Authority (FSA) Director of Insurance Supervision, Prudential Business Unit, gave a speech considering the Prudential Regulation Authority’s (PRA) approach to insurance supervision in the context of the Solvency II Directive.
Adams begins his speech by confirming that the PRA is expected to assume its statutory responsibilities in spring 2013, and that in order to make the change more manageable, the FSA was recently reorganised to reflect the future split in responsibilities between the PRA and the Financial Conduct Authority (FCA).
Adams then discusses the principal benefits of the new arrangements. According to Adams, the clear combination of macro and micro-prudential responsibilities within the Bank of England will allow supervisors to understand and manage the nature and extent of cross-sectoral risk transfer, and the potential effects this may have on the overall system. Supervising insurers and banks together ensures consistency of treatment between the two sectors, meaning that transactions will be treated in the same way if they are the same in substance, irrespective of their legal form. The PRA’s objectives will also result in a clearer focus from supervisors, concentrating on matters which go to the heart of the financial viability of firms, and their ability to meet commitments made to policyholders.
Adams explains that the approach of the PRA is an evolution of that taken by the FSA in relation to insurance supervision in recent years, and goes on to list some of its main features. Firstly, he stresses that the PRA is not intending to implement a zero failure regime. Rather, the PRA will look to minimise the probability of firm failure and bring about a situation where the impact of such failure, both on policyholders and the financial system as a whole, is minimised. The PRA will also replace the FSA’s current Advanced Risk Responsive Operating FrameWork (ARROW) with a new framework which brings together all strands of regulatory activity in a single supervisory strategy. The first stage of the new framework will be an assessment of the vulnerability of a firm’s business model, followed by consideration of a reasonable resolution approach, which could be adopted in the event of firm failure. For insurers there are a number of long-standing and well-understood resolution mechanisms (including solvent run-off and schemes of arrangement) and Adams states that the FSA is comfortable with how these operate in practice. However, in the future the PRA may need to develop new (and possibly mandated) resolution approaches for insurers. The PRA will also undertake a detailed analysis of a firm’s financial strength and consider the quality of a firm’s risk management and governance arrangements.
With the move to “internal twin peaks” within the FSA, Adams states that the first and most immediate change insurers will notice is that there will be separate supervision arrangements for prudential and conduct issues. From a prudential point of view, supervisors will start to implement various aspects of the new regime in addition to working with insurers in preparation for Solvency II.
Solvency II brings with it significant requirements for supervisors to exercise judgement when dealing with the firms they supervise. This is especially true in relation to internal model approval, but also applies more generally across the full spectrum of the regime. The Directive enshrines a principle of proportionality which cuts across all aspects of a supervisor’s work with firms. Adams explains that the principle does not provide scope to waive or otherwise disapply aspects of the regime for one group of firms or another. Instead, proportionality comes into play in the amount of work firms will have to do to demonstrate that a requirement has been met, and in the amount of supervisory time devoted to the review of firms’ evidence. To illustrate, Adams discusses the self-assessment template used for internal model applications. Whilst the template includes 300 or so requirements Adams reassures firms that the FSA does not expect 300 separate pieces of evidence and that its supervisors and actuaries will not carry out an in-depth review of the evidence which supports each and every requirement. Instead, the review work will be targeted at those issues which are of the greatest and most fundamental materiality to a firm’s overall solvency position. The approach will be judgement-driven and it is inevitable that differences of opinion will arise. Adams suggests that firms will see this in their relationship with the PRA more generally, and that the PRA will be more challenging than firms have been previously accustomed to.
Adams believes that the need to be robust is especially important in the case of model approval, as models represent an approximate view of the world and are only ever as good as the data and assumptions that underpin them. This applies at both the level of individual types of risk and the way in which different parts of the model interact with each other. As a result, over the coming weeks and months Adams informs firms that they can expect a much higher degree of feedback than has been the case to date, with the FSA now being in a position to draw meaningful conclusions, not only at firm level, but across peer groups. If the FSA is of the view that a firm will not reach the required standard by a date which makes model approval viable before implementation, Adams warns that it will cease to work with the firm, who will need to exit the process.
The need for a framework for intervention is another aspect which is recognised both by Solvency II and the PRA’s design. Last summer, the FSA set out its intention to create a proactive intervention framework for the PRA, which will be an extension of the “ladder of intervention” under Solvency II. This will set out a series of trigger points at which regulatory action will be presumed and dictate the actions expected of firms’ management and PRA supervisors. These actions will become more intensive as the firm’s position deteriorates and will start to involve greater degrees of contingency planning. Adams contends that the use of skilled persons’ reports is also likely to increase under the PRA.
Adams suggests that the PRA’s stated approach will be dependent upon its ability to collect and analyse high quality data, and the new data and reporting system for Solvency II will help in this regard. As well as informing the PRA’s work, the Solvency II data requirements, and in particular the new disclosure regime, should have the effect of significantly enhancing the degree of market discipline to which firms are subject, through publication of reports which are compiled on a consistent basis across Europe.
In the final part of his speech, Adams concentrates on what is currently happening with Solvency II. The FSA is now moving toward the submission stage of the internal model approval process and, as previously noted, firms could be forced to withdraw if they have not made sufficient progress. With this in mind, Adams believes it useful to highlight some of the points that the FSA has noted in its review work to date. Firstly, Adams states that some firms are falling behind with their own implementation plans and that this is beginning to cast doubt on their ability to achieve their submission slots. More specifically, the FSA has observed that: validation workstreams seem to be significantly behind other workstreams within firms; a perception exists amongst some firms that expert judgement is a “magic bullet” which can be used to explain away any aspects of a model which are not properly documented or justified; supporting documentation is often weak or underdeveloped; and much of the work the FSA is seeing on model change policies is weak.
Whilst Adams mainly concentrates on internal model work throughout his speech, as we move into 2013 attention is turning to those firms who are intending to use the standard formula, and he concludes by stating that the principles expressed above are every bit as applicable to this work as they are to internal model approval.
For further information: The new approach to insurance regulation and the implementation of Solvency II