When U.K. insurers observe they cannot comply with requirements under Solvency II, there are detailed steps that one must take.

Feargal Ryan, European counsel in Skadden’s Financial Institutions Group, and host Rob Chaplin, head of the firm’s Financial Institutions Group in Europe, break down insurers’ obligations. They explain differences between the Solvency Capital Requirement (SCR) and Minimum Capital Requirement (MCR) and examine the Prudential Regulation Authority’s (PRA’s) requirements.

💡 Meet Your Host 💡

Name: Robert Chaplin

Title: Partner, Insurance at Skadden

Specialty: Rob primarily focuses on transactional and advisory work in the insurance sector. He advises on mergers and acquisitions, disposals, joint ventures and strategic reinsurances. He also counsels on regulatory issues, with an emphasis on Solvency II. 

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💡 Featured Guest 💡

Name:  Feargal Ryan

What he does: Feargal advises on a wide range of insurance-related transactions, as well as regulatory issues in the insurance sector.

Organization: Skadden

Words of wisdom: “The first and most critical step is to initiate a frank and open dialogue with the PRA. Once there is any observation of actual or potential non compliance with the SCR, the insurer should detail all material matters impacting upon the insurer's financial difficulty, as well as any matters that may, in the short, medium, and or long term, impact upon the financial condition of the insurer.”

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The Standard Formula is a podcast by Skadden, Arps, Slate, Meagher & Flom LLP, and Affiliates. This podcast is provided for educational and informational purposes only and is not intended and should not be construed as legal advice. This podcast is considered advertising under applicable state laws.

From Skadden, The Standard Formula is a Solvency II podcast for UK and European insurance professionals. Join us as Skadden partner Robert Chaplin leads conversations with industry practitioners and explores Solvency II developments that matter to you.

Welcome back to The Standard Formula Podcast. I'm your host Rob Chaplin. And today we're exploring the Solvency II framework for insurers who are faced with financial difficulty. To help us navigate this subject, I'm happy to be joined by my colleague Feargal Ryan, who is a European Council in the Financial Institutions Group here in London. Feargal, what do we particularly mean when we speak about insurers who are in financial difficulty in the context of Solvency II?

Where we refer to insurers and difficulty in the context of Solvency II, we're referring to insurers that are either failing or are likely to fail to meet their solvency capital requirement, i.e. SCR, or a minimum capital requirement, i.e. MCR.

Thanks, Feargal. Let's talk about non-compliance with the SCR and the MCR one at a time. Starting with the SCR, what happens when an insurer observes that it is no longer in compliance with the SCR or there is a risk of non-compliance? What are the immediate steps that the insurer is obliged to take?

The first and most critical step is to initiate a frank and open dialogue with the PRA. Once there is any observation of actual or potential non-compliance with the SCR, the insurer should detail all material matters impacting upon the insurer's financial difficulty, as well as any matters that may in the short, medium, and/or long-term impact upon the financial condition of the insurer. Following an observation by the insurer of non-compliance with the SCR, the insurer is required to take measures necessary to achieve compliance within six months from the observation. Also known as the SCR recovery period. The PRA may extend the SCR recovery period at its discretion by three months. The insurer is also required to prepare and submit a recovery plan for approval by the PRA within two months from the observation.

The recovery plan must be detailed and include particulars or evidence concerning at least, A, an estimate of management expenses, including general expenses and commissions. B, an estimate of income and expenditure in respect of direct business, reinsurance acceptances, and reinsurance sessions. C, a forecast balance sheet. D, an estimate of financial resources intended to cover the technical provisions, the SCR and the MCR. And finally, E, the insurer's overall reinsurance policy. A recovery plan may not be required if the insurer adopted prompt recovery measures which restored SCR compliance within two months. And the PRA deemed these measures adequate to preserve a sustainable solvency situation.

Additionally, the PRA may request from the insurer, as part of the recovery plan, an analysis by the insurance company of the key causes of non-compliance and of any material shortcomings in the risk management system, including forecast balance sheet. The PRA may further extend the six-month, or nine-month if extended, SCR recovery period in an exceptional adverse situation that affects the insurers representing a significant share of the market or of the affected line of business. Following Brexit, the function of declaring an exceptional adverse situation has been transferred in respect of UK insurers from the European Insurance and Occupational Pensions Authority, or EIOPA, to the PRA. Rob, we briefly touched upon the extension of the SCR recovery period following an exceptional adverse situation. Could you go into a little bit more detail on this, including factors that the PRA will take into account in considering whether to grant an extension?

Of course. Thanks, Feargal. After an exceptional adverse situation has been declared by the PRA, the PRA may extend the SCR recovery period by up to seven years. The goal of granting such an extension is to ensure that macro prudential considerations are appropriately balanced against the need to avoid unduly jeopardizing the protection of the policyholders and beneficiaries of the insurer concerned. We should note that just because an exceptional adverse situation has been declared, it does not mean that any insurer will be automatically eligible for an extension. The insurer must be affected by the situation. For example, a fall in the financial markets will likely have a major negative impact on most insurers. While by contrast, a persistent low interest environment is likely to affect mainly life insurers.

In determining we an extension should be granted, the PRA should take into account the following key factors. One. The impact of an extension on policyholders and beneficiaries of the insurer. Two. The extent to which the insurer is affected by the exceptional adverse situation. Three. The means available to the insurer to re-establish compliance with the SCR and the existence of a realistic recovery plan. Four. The causes and degree of SCR non-compliance. Five. The composition of own funds and assets held by the insurer. Six. The nature and duration of technical provisions and other liabilities of the insurer. Seven. The availability of any financial support from other insurers within the group. Eight. What measures the insurer has taken to limit the outflow of capital and the deterioration of its solvency position. Feargal, we've covered what an insurer needs to do after observing SCR non-compliance, including coming up with a recovery plan, but we haven't talked about how their recovery will be monitored. Could you explain this in more detail please?

Thanks, Rob. Insurers are required to submit a progress report every three months, setting out the measures taken and any progress made to establish the level of eligible own funds covering the SCR or to reduce their risk profile. In some cases, the extension of the SCR recovery period may be withdrawn. This may happen if the progress report shows no significant progress in re-establishing the level of eligible own funds covering the SCR or reducing their risk profile between the date of observance of SCR non-compliance and the date of the submission of the progress report.

In determining whether significant progress has been made, the PRA should determine whether the insurer is still likely to meet its recovery plan and take into account at least one, whether the insurer failed to implement any measures it has committed itself to make without justification, and two, whether the insurer failed in making significant progress on any of the objectives to be achieved in every three months as a result of the proposed measures that were included in the recovery plan. Additionally, the PRA may also revoke or reduce the extended SCR recovery period where the circumstances underlying the extension have changed so that the PRA would've granted a shorter extension or no extension under the new circumstances. Rob, what happens when the insurer fails to re-establish SCR compliance within the recovery period, whether extended or not?

Thanks, Feargal. The PRA has the power to take all measures necessary to safeguard the interests of policyholders. If SCR compliance is not restored within the prescribed, PRA may impose additional measures which may vary depending on the specific circumstances. For example, the PRA has the power to vary the permissions of insurers. That is by removing the insurer's authorization to affect new contracts of insurance. Or in other words, place the insurer into runoff. The PRA's measures should be proportionate, taking into account the level of SCR non-compliance, the duration of the deterioration of the insurer's financial condition, and the sustainability of the applied measures by the insurer to restore its solvency. Feargal, we talked about SCR non-compliance in great detail, but what about MCR non-compliance?

Thanks, Rob. Similar to what we talked about earlier, where an insurer observes actual or potential non-compliance with the MCR, it should inform the PRA immediately. The insurer will then have a month submit for approval a short-term realistic finance scheme to restore within three months the eligible basic own funds so that they're at least at the level of MCR or reduce its risk profile to ensure MCR compliance. However, unlike with SCR non-compliance, extension is not possible. Regardless of whether an exceptional adverse situation has been declared by the PRA. PRA expects that firms failing to meet the MCR to act in a way to avoid significant systemic disruption while also protecting vital economic functions and ensuring appropriate protection of policyholders. Note that this expectation takes precedence over the interests of shareholders and creditors, but importantly, not policyholders. Rob, now that we've covered non-compliance with MCR and SCR, why don't you give us an overview of the powers of the PRA in dealing with insurers and difficulty?

Thanks, Feargal. The PRA has pre-existing powers under the Financial Services and Markets Act 2000 to suspend the insurer's permission and to impose any requirements, limitations, or restrictions as the PRA considers appropriate on that permission. These measures include prohibiting free disposal of assets, withdrawing authorization, and withholding of the insurer's solvency certificate. Feargal, why don't you talk us through each of these?

Thanks, Rob. If an insurer does not comply with the SCR or MCR or any technical provisions, the PRA has the power to restrict or prohibit the free disposal of assets of the insurer in exceptional circumstances where it thinks the financial condition of the insurer will deteriorate further. The PRA may withdraw an authorization to perform certain regulated activities under various circumstances, including where the insurer no longer fulfills the authorization conditions and where the insurer concern fails seriously in its obligations. The PRA is obliged to vary the permission of the insurer if it fails to comply with relevant capital requirements, including the MCR. And if the insurer, one, did not submit a finance scheme at all or, two, has submitted a finance scheme, but the scheme is manifestly inadequate, or three, if after the scheme has been approved by the PRA, the insurer has failed to comply with the finance scheme within three months from the date it becomes aware of the non-compliance.

The effect of such variation is to remove the regulated activity of effecting contracts of insurance as principle. The UK regime allows the deployment of a run-off strategy to address insurers that have no realistic prospect of returning to solvency by allowing the PRA to withdraw their authorization to write new business, allowing the insurer to retain the necessary permissions to run off its existing business. However, the PRA also requires any such insurer to bring its business to as close to compliance rapidly and orderly and in a manner consistent with policyholders' best interests. With this in mind, the PRA may encourage an insurer to explore executing an LTT followed by a Part VII transfer to bring as much finality as possible to the business of the insurer.

Thanks, Feargal. The last measure is the withholding of a solvency certificate. If an insurer has been required to submit a recovery plan due to breach of SCR or a finance scheme due to breach of MCR, the PRA must not issue a solvency certificate in respect of that insurer for as long as it considers that the rights of the policyholders of that insurer or contractual obligations of that insurer are under threat. Feargal?

Yeah. Rob, there have been some interesting updates in the UK in this area. Could you walk us through these?

We pleasure, Feargal. You're absolutely right. The UK has two concurrent regulatory initiatives in this area. One is the proposed creation of a resolution authority within the Bank of England as part of setting up the UK's own Insurance Resolution Regime or IRR. And the other is the PRA's consultation on the supervisory expectations of insurers to adequately plan for recovery and solvent exit. Let's go through these in turn. The IRR proposal has been led by the HM Treasury, the attention being to create a framework for pre-resolution planning. This will involve a new resolution authority housed within the Bank of England. This new resolution authority will assess whether an insurer is failing or likely to fail and should therefore be subject to its stabilization powers. The reach of the IRR is envisaged to be broad and should in principle cover all UK authorized insurers. Though the HM Treasury expects that only a subset of insurers such as those providing critical functions will be subject to the IRR in practice.

We expect the PRA to adopt a similar approach to the EU in evaluating what constitutes a critical function. That is a function that can't be substituted within a reasonable time or at a reasonable cost. And the inability to perform the services by the insurer would likely have a significant impact on the financial system and the real economy. The IRR would sit on top of existing approaches to recovery and resolution. The IRR proposal contains resolution conditions broadly similar to those under the EU regime. These include the PRA's failing or likely to fail evaluation of an insurer, of the likelihood of recovery, of whether it is necessary to exercise its stabilization powers having regard to the public interest in advancing the statutory resolution objectives, and whether those objectives will be met if its stabilization powers are not exercised. The PRA's stabilization options are also broadly similar to those under the EU regime.

These include, one. Transfer of an insurer's shares or assets to a private purchaser. Two. Establishing a bridging institution to allow additional time for a prospective purchaser to perform due diligence and valuation while the insurer maintains critical functions. Three. Restructuring, modifying, limiting or writing down the failing insurer's liabilities in order of creditor preference, including insurance liabilities. So the insurer's capital coverage can be restored to a sufficient level to allow a solvent runoff. And four, finally, as a last resort and temporary measure, temporary public ownership.

In addition, the PRA also has powers to establish an asset management vehicle for the run-down or non-performing or difficult-to-value assets. And to carry out insurance administration procedures, which will give the PRA the ability to use its stabilization tools while ensuring the continued operation of the insurer's critical functions. The IRR proposal also contains provisions for pre-resolution planning. For example, re-insurers or insurers will need to conduct ongoing recovery and resolution planning, which should set out the proposed resolution strategy for the re-insurer or insurer, and an operational plan for implementation, including what stabilization powers will be applied and how. The plans should be updated annually or more frequently if there are changes to the firm's structure, strategy or operating condition. Feargal, why don't you explain the recent development on exit planning in the UK?

Sure, Rob. The PRA currently does not have any formal guidance on exit planning for insurers and we expect this ongoing regulatory initiative to fill the gap. Under proposed regime, the PRA will expect firms to start considering how they might exit the market if needed. This regime will likely cover all Solvency II firms, though its impact on firms will vary by the type of firm. Smaller insurers will likely be most impacted as they will likely be required to either put together exit plans for the first time or to revise their existing plans significantly to meet any upcoming supervisory expectations. By contrast, Category I and Category II firms likely already have exit plans in place, but these will need to be checked against the clarified supervisory expectations.

As part of exit planning, PRA will require firms to consider, one. The short and long-term systemic impact on policyholders in the event of failure. Two. Stress and scenario tests to identify potential exit triggers and the underlying scenarios and likely outcomes. Three. The potential impact of insolvency on their business and critical services provided, including contemplating the business operating model and structure and identifying feasibility resolution strategies. Four. Ease of access to key assets and records. Five. Potential barriers to a firm's resolvability with reference to including the nature of capital instruments and structure, legal entity structure, interconnectivity and reliance on key suppliers. Six. The potential need to undertake preemptive actions/necessary changes to structure operations where there are potential barriers to orderly resolution. And seven. The board's understanding of their directors legal responsibilities and the implications of moving from recovery to resolution.

That's an excellent note to end on and brings us to the end of what we have to say today. Thank you for joining us. We hope you will continue to tune in for future episodes. In case you've missed it, our last episode covered valuation of assets and liabilities, and our next topic will be on public reporting. If you have any questions or comments on any of the topics we spoke about today or Solvency II in general, do please feel free to contact us. Thank you, and we hope you'll join us next time.

Thank you for joining us on The Standard Formula. If you enjoyed this conversation, be sure to subscribe in your favorite podcast app so you don't miss any future episodes. Additional information about Skadden can be found at skadden.com. The Standard Formula is a podcast by Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates. Skadden is recognized for its deep experience in representing insurance and reinsurance companies and their advisers on a wide variety of transactional and regulatory matters. This podcast is provided for educational and informational purposes only and is not intended and should not be construed as legal advice. This podcast is considered advertising under applicable state laws.