Insurers need to prepare for a crucial year of PRA engagement

Who this blog is for:

Board members and senior executives of life and general insurers, in particular those in risk, finance and actuarial teams.

At a glance

• The PRA’s Insurance Stress Test 2022 (IST22) results and its Insurance Supervisory priorities for 2023 provide insights into the areas of concern it identified in the sector for the year ahead. These documents are closely linked to the Solvency II reforms (“the reforms”) announced by HMT in December and analysing the three of them together as well as individually will provide insurers with additional, richer insights.
• In 2023 insurers should expect the PRA to challenge them on a range of issues highlighted in the documents under analysis. Most firms will need to prepare to engage meaningfully with this challenge including in relation to gaps or issues identified in stress test results.
• For life insurers, the reforms sit at the centre of the focus areas. The PRA has confirmed it plans to engage with the insurance industry during 2023 ahead of its detailed consultation on the reforms. This engagement will be crucial for insurers trying to influence the outcome of the reforms, in particular how the PRA applies and implements its new PRA supervisory tools.
• The IST22 results indicate that the matching adjustment (MA) compensates life insurers for losses driven by widening spreads and it is slow to react to market signals of increased credit risk. This is an area of focus for the PRA and will be relevant to the attestation tool outlined in the reforms.
• General insurers rely significantly on reinsurance to mitigate their risks. The PRA will expect general insurers to monitor the performance and structural suitability of their reinsurance protection as well as concentration risks.
• Finally, the PRA notes that 48% of insurers submitted their stress test results to the PRA without Board review or sign off. Given the growing importance of stress testing as a supervisory tool, firms will need to improve their associated governance and risk management arrangements.

Context

In this paper we bring together our insights from the PRA’s IST22 and its recently published insurance supervisory priorities, and outline what they may mean for insurers as they prepare for significant engagement with the PRA throughout 2023.

Our view is that insurers need not only to review and respond to each of the supervisory priorities letter, the IST results and the reforms but should also look at the three individual elements as a single, mutually-reinforcing package. The IST results have clearly and unsurprisingly informed the PRA’s supervisory priorities, so these initiatives are closely linked. But we also see a strong link to the reforms, in that if insurers respond effectively to the PRA’s concerns this may influence how the PRA applies and implements the new tools it will gain from the reforms.

PRA engaging with the industry throughout 2023

Late in 2022, HMT published its consultation response on SII reform following a year of arduous negotiations between industry, the PRA and Government. The outcome was seen as favourable to the industry, with the risk margin reduction set to go ahead for both life and general insurers. The much-debated reform to the MA, strongly advocated by the PRA, did not proceed, leaving the mechanics of its calculation broadly unchanged except for an increase in its sensitivity to credit ratings. Instead, HMT has proposed granting the PRA a new set of supervisory tools to enable it to monitor and respond to the impact of the reforms. These new tools include the publication of individual stress test results and a requirement for a senior manager to attest formally that the Fundamental Spread (FS) reflects all retained risks, and that the MA reflects only liquidity risk. Parallel to this, firms will be able to apply to the PRA to include a capital add-on if they find that their MA understates credit risk. The Government will legislate to ensure the PRA has the powers necessary to implement these tools.

The PRA recently announced its 2023 insurance supervisory priorities, stating that it will be engaging with industry throughout 2023 to shape the details of the reforms ahead of consulting on the rules. The priorities included a range of areas that are connected to the PRA’s new tools and the reforms more generally. Examples include the PRA’s focus on how current capital models are operating in conditions different to those at the time the model was developed, a thematic review of the bulk purchase annuity (BPA) market to seek assurance over risk management disciplines, and the expectations that insurers should re-evaluate their liquidity risk in the event of market volatility or dysfunction. Given the interconnectedness of many of these priorities, we expect the PRA to consider carefully firms’ responses to its priorities as it formulates the detail of the reforms.

IST22 findings relevant to all insurers

In the context of the development of the reforms, the IST22 results provide important insights into the PRA’s areas of concern and where it is likely to focus its engagement with firms.

The PRA signalled future scenarios will include the impact of the high inflationary environment and liquidity risk. Firms are expected to take them into consideration in their own 2023 stress testing programmes. As part of this, the PRA expects general insurers to assess uncertainty around future claims settlement costs. Insurers will be expected to factor general and social inflation into their pricing, reserving, business planning and capital modelling. Following the Liability-Driven Investment shock in late 2022 the PRA is concerned about gaps in insurers’ liquidity risk frameworks. Insurers therefore need to test their liquidity buffers against potential market dysfunction.

The PRA also expressed concern around the level of governance of firms’ IST22 submissions. No life insurers had their stress test results approved by the Board prior to submission; the picture was better for general insurers, but Board approval was still just below 50%. The PRA expects greater board engagement and visibility in these exercises, and given the PRA’s ability to make individual firms’ stress test results public in the future, insurers need to take these messages on board.

Looking beyond stress testing, in its 2023 priorities the PRA highlighted the central role of models in supporting risk assessments. We expect firms will be asked to provide a range of information to support discussions about the reforms, much of which will be generated by models. The PRA expects firms to consider the extent to which the model risk management principles for banks set out in Consultation Paper 6/22 could be applied to insurers. Strong model governance is central to model risk management. The PRA wants assurance that the data firms and the PRA itself rely on for decision making has been subject to the right level of challenge and scrutiny by firms and their Boards.

Specific messages for life insurers: Matching Adjustment, TMTP and management actions

For life insurers, the main drivers of deterioration in their solvency positions under stress from the IST22 were credit downgrades, property shocks and longevity improvement (for annuity firms). It is of particular concern to the PRA that the impact of widening spreads and the subsequent fall in asset values is largely compensated by MA increases, therefore insulating firms from the impact of a credit deterioration scenario until assets are downgraded. This reinforces the PRA’s concerns that the MA is slow to react to market signals of increased credit risk. The PRA will focus on how insurers respond to distressed assets in their MA portfolios, and how boards set appropriate risk appetites across a range of scenarios. This is consistent with the PRA’s plan to conduct a thematic review of the BPA market to seek assurance that risk management is keeping pace with the risks and growth ambitions associated with that market.

Another area of focus for the PRA will be the reliance of life insurers on Transitional Measures on Technical Provisions (TMTPs) under stress. TMTPs will run off by 1 January 2032, and the PRA expects firms to have robust plans to replace this source of solvency coverage over the next few years. Finally, most life insurers counted on a range of management actions to mitigate the impact of a stress. However, the PRA found some actions too optimistic. These include for example relying on the ability to sell billions of assets that have been downgraded and replace them with investment grade assets, at a time when all market participants are trying to do the same. The PRA also found that interdependencies and trading costs were commonly overlooked as part of the management actions strategy. Insurers should therefore take into consideration the potential behaviour of other market participants at a time of stress (market liquidity and amplifications) and review the credibility and feasibility of their proposed actions under stress.

The work the PRA conducts in the areas above is likely to influence the application and implementation of the new tools under the reforms to varying degrees. It could be argued that the better the quality of the information and analysis that insurers provide in relation to MA and credit risk, feasibility of management actions and TMTP phase-in plans, the more proportionately calibrated the tools are likely to be.

Specific messages for general insurers

For general insurers, the results showed that the main risk mitigation tool was reinsurance. The PRA expects firms relying materially on their reinsurance programme to monitor closely its performance, structural suitability, and the potential concentration risk arising from it. As part of its supervisory priorities, the PRA expects firms to consider the Prudent Person Principle for reinsurance risks, including assessing the reinsurer’s resilience over the period of exposure and the potential impact of a major loss event where concentration risk could crystallise.

In relation to catastrophe and cyber risk modelling, the exercise identified several areas where general insurers’ modelling had improved since the first IST in 2015. However, some aspects of modelling still require further development. For example, there is not yet consensus in the cyber insurance market about the potential size of losses in extreme scenarios (the PRA identified great variability in assumptions). Firms also struggled with contract uncertainty and assessing whether exclusions are likely to hold. The PRA concluded that exposure management capability in relation to non-natural catastrophe risk (including cyber) is immature, with some firms unable to size potential losses appropriately or demonstrate effective risk mitigation measures. Firms should expect PRA scrutiny to improve practices and risk management in this area.

Next steps and conclusion

The PRA will be engaging with life and general insurers in Q2 and Q3 of 2023 respectively to discuss timing and development of the next IST. Before then, firms should review their submissions to the IST22 in light of the findings, what we know so far about the reforms and PRA’s expectations. The PRA also expects Boards to assess whether any of the issues and gaps identified in the IST22 findings apply to their firm, and commission an action plan to address them.

In the current economic and geopolitical environment, stress and scenario testing are set to be a key tool for the PRA and indeed other regulators to monitor insurers in the future. The publication of individual firms’ results will bring the exercise to a level of prominence and public scrutiny never seen before in the insurance market, making engaging with the PRA ever more important. For life insurers, many of the priority areas the PRA has identified for the year ahead will also influence how the SII tools are implemented. Insurers have the opportunity to engage constructively with the PRA as it decides how to apply and implement its new tools. The better the data and analysis that insurers can provide, the more proportionate and risk sensitive the outcome is likely to be.