Insurer Resolution Regime will be time- and resource-intensive for firms in scope

07/02/2023

HM Treasury is proposing to introduce an Insurer Resolution Regime (IRR). The regime will provide the Bank of England (BoE) with tools to manage the failure of insurance companies. The aim of the proposed regime, which will draw on aspects of the well-established bank regime, is to allow UK authorities to act quickly to stabilise a failing insurer and to minimise risks to policyholders, financial stability, the wider financial sector and the taxpayer.

The Prudential Regulation Authority (PRA) already has rules which are aimed at preventing insurer failure, and plans to develop these further. This includes capital requirements and obligations on insurers to prepare for orderly resolution. Generally, there has been an assumption that insurers in difficulty close to new business and go into runoff, potentially pending a sale of the business.

The PRA does not operate a "zero failure" regime, however, and the IRR is intended to give the authorities the tools to facilitate alternative outcomes if the PRA's normal approach proves to be insufficient.

In January, the PRA also announced that one of its goals for supervision in 2023 is to facilitate a review of how insurers deal with reinsurance risks, looking at the management of reinsurance in a resolution scenario, recapture plans and concentration risk. This objective and the development of the IRR are interrelated. It also seems likely that the volatility in asset markets and the liability-driven investing (LDI) crisis will inform the PRA's thinking when progressing these developments.

Scope

In theory, the powers granted to the BoE under IRR could be applied to any UK authorised (re)-insurer, including UK branches of third-country firms. In practice, it is likely that the statutory test for resolution action and the requirements for pre-resolution planning (see below) will only be met by, and applied to, a few insurers. Given the nature of the tests, insurers providing investment products, particularly annuities, are likely to be a focus of the IRR.

When will resolution apply?

Four resolution conditions (RCs) will need to be met before an insurer can be placed into resolution. The first condition (RC1) is that the PRA assesses that an insurer is failing or likely to fail. This is the initial trigger for resolution. Failing or being likely to fail will be defined to include:

  • the insurer is failing or likely to fail to satisfy the threshold conditions for PRA authorisation;
  • the insurer's assets are less than its liabilities, or the insurer is unable to pay its debts as they fall due, or either of these circumstances is likely to arise in the near future; and/or
  • extraordinary public financial support is required.

This assessment will obviously require the exercise of judgement by the PRA.

If the PRA considers that a relevant insurer is failing or likely to fail, the resolution process will only begin if the BoE considers that the other RCs are satisfied. In summary, these are that it is not reasonably likely that action can be taken (other than stabilisation) which will result in RC1 ceasing to be met (RC2), the exercise of stabilisation powers is necessary having regard to the public interest (RC3), and that one or more of the statutory resolution objectives would not be met to the same extent if stabilisation powers were not deployed (RC4).

The concept of runoff will be particularly relevant when determining whether the RCs are met. The government considers that if a firm could afford to runoff safely (with appropriate amounts of capital), the RCs would not be met.

What happens when the resolution conditions are satisfied?

There are four main stabilisation options available to the BoE. The first is a transfer to a private sector purchaser. The BoE will be able to transfer the shares or the business of the failing insurer to a willing purchaser. This could be a full or partial transfer and will (or could) override any veto rights of third parties such as shareholders, policyholders, or other creditors. Unwilling shareholders could be forced to sell. Any transfer will not require the involvement of the courts (so the usual protections for transfers of insurance business in Part VII of the Financial Services and Markets Act 2000 will not apply). As part of its pre-resolution planning the BoE will identify potential buyers in advance of resolution.

The second option is to transfer the shares or business of the failing insurer to a bridge institution as a temporary measure. The intention is that this will buy some time for potential purchasers to carry out proper due diligence, valuations etc., while ensuring that critical functions of the failing insurer can continue.

The third option is bail-in. The BoE will be empowered to bail in failing insurers by restructuring, modifying, limiting, or writing down the insurer's liabilities, including its policyholder liabilities. At the same time, the intent is to allocate losses to shareholders and subordinated debt holders and to recompense certain affected creditors via an interest in the equity of the firm.

Where Financial Services Compensation Scheme (FSCS) protected policyholders are written down, the FSCS will provide top-up payments to the same limits that would apply in an insolvency. A bail-in power exists under the bank resolution regime.

Any write-down would broadly follow the established creditor hierarchy. In liquidation, policyholders typically sit above unsecured creditors but below secured and preferential creditors. By following this hierarchy when applying the write-down, creditors ranking lower than policyholders in an insolvency will normally have their claims against the insurer fully written down or converted before policyholders are affected.

Finally, the BoE may place a failing insurer into temporary public ownership. This will be considered an option of last resort and the intention will be to return the business to the private sector as soon as circumstances allow. In practice, this route is likely to apply only if a very large insurer started to fail and no other bidders were available (as with the banks in 2008-2009).

Pre-resolution planning

The main day-to-day impact of the IRR will be a need for pre-resolution planning by the PRA, BoE and affected insurers. The PRA has stated that indicative work suggests that only a limited number of insurers will be within scope. Changes are afoot for many businesses, however, and not just those at the "back of pack".

Where applicable, planning will cover resolvability assessments and recovery and resolution plans (RRPs). Resolvability assessments will evaluate the feasibility and effectiveness of a number of resolution strategies to identify any barriers to the use of the proposed stabilisation options. This is a model that has been applied to banks and has necessitated a review of material contracts (such as reinsurance and outsourcing).

The "recovery" element of RRPs will continue to be managed by the PRA through firms' recovery plans (which kick in following a deterioration in capital) and exit plans (a 2023 priority for the PRA). Resolution planning will be an additional requirement. A resolution plan will be drawn up by the BoE for each relevant insurer.

The purpose of the plan will be to facilitate the effective use of the resolution powers. It will set out the proposed resolution strategy for a firm and an operational plan for its implementation. Insurers within scope will need to carry out additional work to support the creation of these plans.

The authors' experience of the banking sector suggests that those insurers within the scope of pre-resolution planning will need to dedicate a material amount of senior management time and other resources to liaise with the BoE and PRA in relation to their plans.

This article was first published in Thomson Reuters on 6 February 2023