Brexit means…?

Publication September 2016

That, as they say, is the question. Apparently, the Oxford English Dictionary is devising a definition of the term so we will need to wait and see exactly what “Brexit” means. Given the current level of uncertainty, quite a bit of waiting may be involved. This therefore begs the question about what insurers can do in the meantime - especially in relation to day-to-day arrangements and insurance transactions such as reinsurance. Where such reinsurance needs to be entered into now and will remain in force for many years (e.g. in relation to long term contracts), parties are understandably nervous and are looking at their options.

If we therefore take reinsurance as an example, UK authorised insurers and reinsurers currently benefit from a single passport to operate in the European Economic Area (EEA). If they lose this passport they would become “third country” (re)insurers under Solvency II.  Third country insurers would need to establish either a branch or subsidiary in the relevant EEA country and maintain capital (at least at the Solvency II Minimum Capital Requirement  level) in that country in order to sell products in the EEA. For pure reinsurers, a branch  is not required by Solvency II but may be under local law. Furthermore, in order for a Solvency II insurer to recognise reinsurance from a third country reinsurer, the reinsurance must be provided by a reinsurer in an equivalent jurisdiction or one with a credit rating of at least BBB (or whose obligations are guaranteed by an entity meeting such requirements or appropriately collateralised). If the UK does lose the single passport, it will presumably seek an assessment of equivalence under Solvency II. The criteria  for equivalence in relation to reinsurance are set out in Article 378 of the Solvency II Regulation (Commission Delegated Regulation (EU) 2015/35). Given that the UK is currently subject to the Solvency II regime, its current regime is, by definition, equivalent. It also seems likely that the UK would commit to maintain the substance and structure of the Solvency II regime (i.e. risk based insurance supervision with strong governance, mark-to-market valuation and public reporting). It should therefore, at least  in theory, pass an initial equivalence assessment. What seems less clear is how long the assessment process could take and whether the UK would be granted temporary equivalence in the meantime.

Even if equivalence is sought, it also seems inevitable that the UK would use Brexit to make changes to the detail of the Solvency II regime applied in the UK. Andrew Bailey, Chief Executive of the Financial Conduct Authority, has already indicated that there  are 'unintended consequences,' in the Solvency II Directive which still need to be ironed out. There are also compromises within the deal reached on the long-term guarantee package that the PRA might also like to amend. It seems more likely, at least initially, that these would involve some liberalisation within the regime rather than it becoming more stringent although over time, given the historic tendency in the UK to “gold plate”, the UK regime may become stricter in places. It is clearly difficult to be sure but it seems reasonable to assume that the UK will seek to retain equivalence under Solvency II.

That therefore turns the spotlight on those areas where the UK might tinker with the current structure and whether insurers can do anything to anticipate such changes. In practice, particularly for long-term reinsurance which is collateralised by reference to a best estimate of liabilities there are some areas where changes could affect existing agreements. These include possible changes to the definition of the best estimate liability, availability of the long-term guarantee adjustments, and the rules on collateral treatment. Solvency coverage ratios and related terms in reinsurance contracts could also potentially be an issue if the level of Solvency Capital Requirement (SCR) were to change. Without a crystal ball it is difficult to be sure but it seems unlikely the UK would seek to change the calibration of the SCR calculation although it may change some of the stresses within the standard formula .

So, what can insurers entering into long-term insurance arrangements today do to protect themselves from this future uncertainty. The loss of equivalence status by reinsurers would need to be dealt with by appropriate authorisation, a sufficient credit rating and/or provision of collateral. The relevant agreement may require the reinsurer to anticipate such changes prior to Brexit becoming effective. The potential  effect of changes to Solvency II concepts such as the best estimate is a little more difficult to predict. Many long-term reinsurance agreements already provide for changes in law and regulation. It is often a commercial point as to whether the agreement simply continues or is capable of recapture on cost neutral or other terms. However, some cedants and reinsurers have particular concerns around changes to elements of the Solvency II structure. In those cases it may  therefore be possible to be specific and anticipate the effect of changes to particular factors or to provide that the economic effect be determined by an expert. However, as it is still too early to anticipate all of the possible changes, it seems likely that parties will agree to cooperate in good faith, perhaps subject to stated objectives or principles, to try to preserve the economics of the deal and/or to allow recapture on agreed terms if the economic effect is more than a stated de minimis amount. Given the need for contractual certainty and clarity around risk transfer  drafting of such clauses would need to be considered carefully.

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