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Recovery and resolution plans for insurers
Practical Law UK Articles 2-569-5225 (Approx. 13 pages)
Recovery and resolution plans for insurers
by George Swan, Wessel Heukamp, Lauren Honeyben and Priti Lancaster, Freshfields Bruckhaus Deringer LLP
| Law stated as at 01 May 2015 |
This article considers recent developments aimed at addressing systemic risk arising from the activities of insurers and focuses on the latest international, European and UK developments.
This article also considers the additional regulatory requirements that global systemically important insurers will be subject to, and the equivalent regime that is being developed within the EU and for domestically significant insurers within the UK.
This article is part of the global guide to insurance and reinsurance. For a full list of contents visit www.practicallaw.com/insurance-guide.
The G20 summits in Pittsburgh (2009) and Seoul (2010) concluded that systemically important financial institutions (SIFIs) should develop recovery and resolution plans as part of the solution to the "too big to fail" problem. The objective was to ensure that all such institutions had credible plans to recover from financial stress, but, if those plans failed, that regulators would have the tools to resolve them in a way that reduced recourse to taxpayer funds and limited the impact on the financial system.
Recovery and resolution planning is now well developed for banks and so the attention of regulators and policymakers has turned to considering whether non-bank financial institutions should be subject to similar requirements. This article looks at the developments and proposals for insurers.
Global systemically important insurers
The International Association of Insurance Supervisors (IAIS), under the purview of the Financial Stability Board (FSB), has been tasked with identifying global systemically important insurers (G-SIIs). Its initial proposals were originally published in 2012. They covered the proposed assessment methodology for designating G-SIIs and the proposed policy measures that would apply to them. These policy measures were finalised in July 2013 (IAIS Policy Measures).
The IAIS defines a G-SII as any insurer "whose distress or disorderly failure, because of their size, complexity and interconnectedness, would cause significant disruption to the global financial system and economic activity".
The IAIS's assessment methodology for G-SIIs was based on the following categories:
- Size.
- Global activity.
- Interconnectedness (direct and indirect inter-linkages with other components of the financial system, so that individual failure or distress would have repercussions around the financial system).
- Involvement in non-traditional insurance activities (such as financial guarantees and guaranteed long-term products), non-insurance financial activities (such as credit default swaps and derivatives) and certain products such as variable annuities. These are collectively known as non-traditional non-insurance (NTNI) activities.
- Substitutability (the extent to which another firm or group would be able to provide substitutes for its products in the event of its failure).
The extent of NTNI activities and interconnectedness with the wider financial system were identified by the IAIS as the two most important factors in determining G-SII status (with weightings of 45% and 40%, respectively) and the focus of the new policy measures appears to be directed at reducing the impact of these two factors. Non-life insurance is categorised as traditional insurance, which provides an insight as to why predominantly non-life focused global groups are not on the current list of G-SIIs.
Designation of G-SIIs
The list of G-SIIs is updated annually and published by the FSB in November of each year, starting in November 2014. Insurers will therefore be able to come on and off the list as their businesses change. This means that those who have been designated as G-SIIs this year will not necessarily be subject to the final higher loss absorbency (HLA) requirements, which will apply from 2019 onwards to those insurers designated as G-SIIs in November 2017.
No reinsurers have so far been included in the list of G-SIIs. A decision by the FSB, who will consult with the IAIS and national authorities, on the G-SII status of, and appropriate risk mitigating measures for, major reinsurers has recently been further delayed from July 2014 to the end of 2015. This reflects the fact that certain issues, for example those relating to substitutability and interconnectedness, are more complex for reinsurers than for insurers.
The following initial list of G-SIIs (identified based on year-end 2011 data collected by the IAIS) was published on 18 July 2013 and confirmed by the FSB in November 2014:
- Allianz SE.
- American International Group, Inc.
- Assicurazioni Generali SpA.
- Aviva plc.
- Axa SA.
- MetLife, Inc.
- Ping An Insurance (Group) Company of China, Ltd.
- Prudential Financial, Inc.
- Prudential plc.
Some specific groups currently identified as G-SIIs have indicated publicly that they have not been willingly so designated, including MetLife, Inc. who challenged the Financial Stability Oversight Council (FSOC) over its decision to add MetLife to the list of US SIFIs. Other groups have embarked on restructuring to ensure, among other things, that they are not categorised as G-SIIs in future years. Views remain mixed as to whether G-SII status will have a positive impact on an insurer's competitive prospects, cost of capital or financial rating. Rating agencies have commented that a G-SII designation could have a positive impact on a group's rating, due to the requirement for G-SIIs to hold more HLA capital.
Policy measures applicable to G-SIIs
The IAIS has proposed a number of measures which will apply to G-SIIs, each taking effect at different times:
- G-SIIs will be subject to enhanced supervision and will be required to develop a systemic risk management plan (SRMP) to reduce the systemic importance in advance of a crisis. The SRMP is in addition to insurers producing a recovery and resolution plan (RRP) (see below) and extends to increased co-operation between supervisors of G-SIIs. The IAIS published its "Guidance for Systemic Risk Management Plans" on 20 December 2013 (GWS Guidance). The GWS Guidance provides guidance to group-wide supervisors (GWS) on how they should direct applicable G-SIIs to develop SRMPs and in summary requires:
- the GWS to inform the relevant firm that it has been designated by the FSB as a G-SII and explain the key factors that have led to its designation;
- at the direction of the GWS, the G-SII must prepare its SRMP in a manner consistent with the IAIS Policy Measures and GWS Guidance. The SRMP should consist of a number of elements including (but not limited to) the following:
- information about liquidity management plans;
- recovery plans;
- information about certain intra-group transactions;
- an explanation of the triggers for recovery that require an assessment of recovery plans; and
- changes to strategy.
- the GWS to review the draft SRMP and proposed measures; and
- the GWS to invite review from relevant members of the Supervisory College.
- G-SIIs will need to establish crisis management groups (CMGs) composed of the relevant insurer's main regulators and will be required to prepare RRPs. They will be subject to resolvability assessments by the competent regulators and the adoption of institution-specific cross-border co-operation agreements among competent regulators. The IAIS proposed that resolvability may cover:
- effective separation of NTNI activities from traditional insurance activities;
- the possible use of portfolio transfers and run-off arrangements; and
- the application of policyholder protection and guarantee schemes (which apply already in some countries, including in the UK in the form of the Financial Services Compensation Scheme).
- G-SIIs will be required to meet certain group-wide capital standards. The development of the basic capital requirement (BCR) is the first step in the IAIS plan to develop a global capital standard. The timeline for the development of the BCR proposal is set out below (see box, Implementation timeline).
- The second step is the development of the HLA requirement. The IAIS has stated that the intention is for the HLA to build on the BCR to address additional capital requirements for G-SIIs to reflect their systemic importance. This so-called "HLA uplift" will apply to NTNI activities based on the extent to which they are separated from traditional insurance activities. Where NTNI activities are not effectively separated, HLA capacity may be calculated based on the NTNI activities in the consolidated insurance group (including the parent company), resulting in a greater HLA uplift. HLA measures will be subject to further consultation before they are finalised in 2015 and will apply to G-SIIs from January 2019. In September 2014, the IAIS published ten principles relating to the development of HLA:
- comparability: outcomes should be comparable across jurisdictions;
- G-SII risks: The HLA should reflect (but not be restricted to) the drivers of the assessment of G-SII status;
- internalise costs: the failure or distress of a G-SII may result in costs to the financial system and overall economy. The HLA should internalise some of the costs that are otherwise external to that G-SII.
- resilient: HLA should work and remain valid in a wide variety of economic conditions (including a stressed macro environment);
- going concern: the HLA and its foundation assume G-SIIs are going concerns;
- quality of capital: the HLA capital requirement is to be met by the "highest quality capital" (that is, permanent capital that is fully available to cover losses at all times on a going-concern basis);
- pragmatic: the design of the HLA must be pragmatic and practical, with an appropriate balance between granularity and simplicity;
- consistent: the structure of the HLA should be consistent and be applicable over the range of insurance and non-insurance entities it will need to cover, and over time;
- transparent: the level of transparency, particularly with regard to the final results provided and the use of public data, should be optimised; and
- refinement: the HLA will be refined in the light of experience and data gathered by the IAIS in the course of field testing exercise.
- The third step is the development of risk-based group-wide global insurance capital standards (ICS) which are due to be completed by the end of 2016 and which would be applied from 2019 to so-called Internationally Active Insurance Groups (IAIGs) (defined using the Common Framework for the Supervision of Internationally Active Insurance Groups (ComFrame criteria)). The FSB considers a sound capital and supervisory framework to be essential to support financial stability in the insurance sector. The ICS is intended to achieve this objective. However the interplay between the ICS and the BCR is yet to be seen.
- In September 2014, the IAIS published ten principles for the development of ICS with the main objective to protect policyholders and contribute to financial stability.
- In December 2014, the IAIS published a consultation paper seeking feedback on valuation, qualifying capital resources and an example of a standard method for determining the ICS capital requirement.
- The IAIS has issued two consultation papers on the BCR. The first consultation paper was published in December 2013. The IAIS provided its comments on the feedback it received to the first consultation in March 2014.
- In relation to the interaction of the BCR with existing group capital requirements, the IAIS states that it "does not rule out the possibility of the BCR, in at least some cases, being higher than jurisdictional requirements". The IAIS goes on to state that this statement "needs to be interpreted in the context of the base to which any additional capital requirements may be applied. A key aspect of the BCR is the need for global comparability".
- The IAIS is addressing this (with regard to insurance liabilities) by focusing on best estimate liabilities. It is intended that the interaction between the BCR and the ICS will be clarified following further work on the ICS.
- The IAIS published its second consultation paper on 9 July 2014, followed by a final report in October 2014. From the end of 2015 to 2018, G-SIIs will have to report on their BCR to their GWS. During this period, the BCR can be monitored and refined. The IAIS has explained that the approach it will adopt is as follows:
- each G-SII must report its BCR, at least annually, to its GWS in accordance with the IAIS field testing data collection process. Each G-SII should monitor its BCR and recalculate it whenever there is a significant change to its risk profile, or at the request of its group-wide supervisor;
- data that is reported should be sufficiently granular and include all exposure measures on all segments specified in the BCR, as well as information on the relevant jurisdictional group prescribed capital requirement that applies to the G-SII; and
- data should be verified by GWS before it is submitted to the IAIS.
Key issues for G-SIIs
Effective separation of NTNI activities
As a result of the recognition by the FSB and IAIS that traditional insurance activities do not of themselves make an insurer globally systemically important, the separation of any NTNI activities from the rest of the insurer's business is likely to be a key focus for G-SIIs. The ability to effectively separate (in the regulator's eyes) NTNI activities will reduce systemic importance and impact favourably on HLA requirements. What constitutes NTNI activities and "effective separation" will therefore require clearer guidance from the IAIS and regulators than that provided to date. Indications are that the following will be key factors in establishing whether NTNI activities have been effectively separated from the remainder of the insurer's group:
- Stand-alone capitalisation.
- The operational independence of management.
- Evidence of intra-group transactions with the NTNI entity being carried out at arm's-length.
- The absence of critical interdependencies existing between the different parts of the business.
The FSB has also stated that the separation must not result in the creation of a non-regulated financial entity.
Higher cost of compliance with enhanced supervisory requirements
The "higher supervisory bar" imposed on G-SIIs and the need to comply with increased reporting and capital requirements is likely to result in higher costs for G-SIIs, with those costs either being met out of their own resources or being passed on to policyholders. Some policyholders may be willing to pay this for the claimed "improved safety" of G-SIIs; others, however, may not.
In addition, it may become the case that the additional requirements imposed on G-SIIs will make non-G-SIIs wary of acquisitions that could result in them being designated as G-SIIs in the future. Others may restructure their businesses so as not to become a G-SII or to remove themselves from the G-SII list.
Recovery and resolution regimes for insurers
On 12 August 2013, the FSB published a consultation paper on the "Application of the Key Attributes of Effective Resolution Regimes to Non-Bank Financial Institutions", including insurers. The FSB's consultation paper is the first clear guidance on the application of recovery and resolution regimes to insurers and is intended as a point of reference for the reform of national resolution regimes.
Scope
The FSB states that: "Any insurer that could be systemically significant or critical if it fails and, in particular all insurers designated as G-SIIs should be subject to a resolution regime consistent with the Key Attributes". Therefore, these principles could also apply to non-G-SIIs who will be keen to understand how domestic regulators will apply the Key Attributes to them.
Powers of resolution authority
According to the FSB, the responsible resolution authority should have at its disposal "a broad range of resolution powers", including the power to:
- Carry on all or some of the insurance business (either in the existing entity or through the use of bridge institutions), including a wide range of powers to ensure maximisation of value and continuity of coverage for policyholders.
- Restructure liabilities, which covers an extremely wide range of powers from reducing future or contingent benefits or the value of contracts on surrender, to converting insurance liabilities from one type of insurance liability to another (for example, with-profits into unit-linked or reducing the value of inwards reinsurance).
- Carry out portfolio transfers (including the power to vary or reduce the value of the contracts transferred and to transfer associated reinsurance contracts).
- Suspend policyholders' surrender rights (that is, the power to suspend withdrawal rights or the ability to change insurer).
- Stay the rights of reinsurers.
All jurisdictions will also be required to have in place a privately financed policyholder protection scheme.
Recovery and resolution plans
As is the case for G-SIFIs, RRPs for insurers will focus on a "strategic analysis that identifies the firm's essential and systemically important functions and sets out the key steps to maintaining them in recovery and resolution scenarios". For insurers, such essential functions are described by the FSB as:
- The provision of critical types of insurance.
- The provision of services (such as actuarial, claims handling, policy administration or benefit payment).
- Essential hedging activities.
- Liquidity/funding support to other financial institutions.
- Intra-group transactions (such as reinsurance, funding or guarantees).
- Credit or financial guarantee insurance or non-insurance, such as credit default swap (CDS).
A range of recovery measures are proposed and should be considered by insurers, including:
- The sale of subsidiaries/portfolio transfers.
- Changes to reinsurance programmes.
- The strengthening of capital (such as recapitalisations or suspension of dividends).
- Changes to investment and hedging strategies.
- Changing terms and conditions/fees/charges.
G-SIIs will also be subject to regular resolvability assessments in relation to the feasibility of the resolution strategy.
European developments
New institutional arrangements
The European Systemic Risk Board (ESRB) was established in November 2010 and is responsible for the macro-prudential oversight of the financial system within the European Union (EU). Its role is to contribute to the prevention or mitigation of systemic risks to financial stability in the EU which arise from developments within the financial system.
The European Insurance and Occupational Pensions Authority (EIOPA) was established as part of the same package of institutional reforms. The tasks and competences of EIOPA include:
- The initiation and co-ordination of EU-wide stress tests to assess the resilience of institutions in the insurance and pensions sector.
- Addressing any risk of disruption in financial services.
- Developing a common approach for the identification and measurement of systemic risk.
- Conducting inquiries into the above institutions to assess potential threats to the stability of the financial system.
- The development and co-ordination of recovery and resolution plans, as well as preventive measures to minimise the systemic impact of any failure.
- Collecting information necessary to fulfil its tasks from the national supervisory authorities and, if necessary, directly from the above institutions.
At the EU level, the European authorities are in the process of establishing an approach to non-bank recovery and resolution, closely mirroring the FSB's international proposals. Responses to the consultations carried out so far have broadly agreed that there should be specific measures in place for the recovery and resolution of insurers. However, the development of concrete proposals to identify and address the systemic impact of insurers is less advanced than that of banks or even financial market infrastructure (FMI).
The draft recovery and resolution directive
In April 2014, the Directive 2014/59/EU establishing a framework for the recovery and resolution of credit institutions and investment firms (Bank Recovery and Resolution Directive) was formally approved. The directive proposes a number of measures including (but not limited to) the following:
- The requirement to prepare recovery and resolution plans.
- The removal of impediments to resolvability (such as intra-group exposures or corporate structures which fail to ring-fence critical functions).
- The establishment of measures (such as intra-group agreements) aimed at overcoming current legal restrictions to the provision of financial support from one entity within a group to another.
- "Bail-in", that is, the compulsory conversion of debt to equity where a firm or group is in financial difficulties.
The directive does not yet extend to the insurance sector, although it is anticipated that this will follow.
The deadline for transposition into national legislation was 1 January 2015, with bail-in provisions to enter into force no later than 1 January 2016. Schedule 2 of the Banking Reform Act 2013 introduced a bail-in tool. This was amended by the Bank Recovery and Resolution Order 2014, which entered into force on 1 January 2015, amending the bail-in provisions to bring them into line with the directive.
Developments within the UK
In the UK, there has been much debate about the need for a resolution regime for insurers. The jury is still out. The discussion has extended to the issue of policyholder protection in general, with particular focus on continuity of insurance cover.
HM Treasury proposals
In August 2012, HM Treasury published its own consultation paper, Financial sector resolution: broadening the regime (www.hm-treasury.gov.uk/d/condoc_financial_sector_resolution_broadening_regime.pdf). The paper included proposals relating to resolution in a number of different financial sectors including insurance. It commented:
"The case for insurers is less clear cut. The failure of an insurer may not trigger financial instability due to the cessation of its core insurance activities (although this would depend on its market share for critical products). But inter-linkages with other financial institutions may pose a threat."
The Treasury proposals in relation to insurance were less specific than in relation to other sectors (such as investment firms, central counterparties and financial market infrastructures). A number of ideas as to possible future initiatives were proposed which included:
- More flexible procedures for transferring liabilities from one (failing) firm to another (more healthy) firm.
- The power for the regulator to require a transfer of portfolio to take place (as opposed to merely sanctioning a proposal put forward by the firm).
- A general review of the insurance insolvency and run-off regimes.
- More protection for interests of policyholders in an insolvency, including:
- adjusting directors duties to bring them more closely into line with the objectives of financial regulation;
- triggering the insolvency regime at an earlier point than is currently the case; and
- changing the rules on valuation of claims in the insolvency by policyholders.
Response to HM Treasury proposals
The Treasury consultation drew a mixed response, which is summarised as follows:
"Most stakeholders considered that a comprehensive resolution regime, similar to that in place for deposit-taking institutions, would not be appropriate for insurers, arguing that the failure of an insurance company was unlikely to have systemic implications and that current regulation/legislation was already adequate."
UK regulatory reforms
Despite the debate on whether specific resolution tools are required for insurers, under the Prudential Regulation Authority's (PRA) Proactive Intervention Framework, RRPs will be required for insurance firms that reach "stage three" or beyond (that is, where significant threats to an insurer's viability or policyholder protection have been identified). In addition, the PRA will carry out resolvability assessments on all insurance firms. Insurers will also be expected to provide the PRA with information such as group structure, intra-group risk management and reinsurance arrangements.
In light of the fact that two UK insurers have been identified as G-SIIs, further consideration may be given by the PRA to whether further legislation and regulations are required in relation to the resolvability of insurers in the UK.
At present, the regulatory objectives of the PRA expressly address resolution issues. They include "seeking to minimise the adverse effects that the failure of a PRA-authorised person could be expected to have on the stability of the UK financial system" (section 2B( 3)(b), FSMA 2000 (as amended)).
This is aimed at creating a "non-zero-failure regime" within which the insolvency of significant firms or groups could be constructively managed. The "non-zero-failure" concept was endorsed as a theory many years ago by the Financial Services Authority (FSA), but the experience of the financial crisis demonstrated that it lacked a practical foundation.
PRA approach to supervision
Under the new regime, the PRA has a wide power to impose a requirement on a firm if it appears to the PRA that "it is desirable to exercise the power to advance any of the PRA's objectives". This power applies to firms whether or not they have been identified as systemically important, either on a national or international level. It is perhaps questionable, therefore, whether the PRA actually needs an explicit power to direct, for example, a transfer of portfolio, as suggested by the HM Treasury consultation.
When Directive 2009/138/EC on the taking-up and pursuit of the business of insurance and reinsurance (Solvency II Directive) comes into force (on 1 January 2016), the PRA can be expected to address any risks to the financial system arising from an insurer's activities within the supervisory review process (Article 36, Solvency II Directive) or in the process of approving internal models. In cases where that does not produce the required result, the PRA might then apply a capital add-on under Article 37.
Implementation timeline
Key implementation dates and timeframes | Action required (or intermediate activity) |
From January 2015 onwards | Confidential reporting of the BCR to GWS with access by the IAIS for the purpose of reviewing and refining the BCR (to be provided in conjunction with the IAIS field testing process). |
March to September 2015 | Field testing of ComFrame including ICS. |
June 2015 |
|
July 2015 | Implementation of systemic risk management plans (SRMPs) to be assessed. |
July/August 2015 | IAIS to analyse the second quantitative field testing submissions. |
November 2015 | HLA to be finalised. |
December 2015 | Consultation on ComFrame (including ICS) revised after second quantitative field testing. |
End 2015 |
|
July 2016 | Implementation of SRMPs to be assessed. |
End 2016 | Development of ICS to be completed by IAIS. |
2017/2018 | Further testing of ICS, BCR and HLA. |
January 2019 | G-SIIs designated in November 2017 to apply the HLA requirements. |
Contributor profiles
George Swan, Partner
Freshfields Bruckhaus Deringer LLP, London
T +44 20 7716 4695
F + 44 20 7108 4695
E [email protected]
W www.freshfields.com
Professional qualifications. England and Wales, Solicitor, 2003
Areas of practice George is a corporate partner in our Insurance Group, based in London. He works with many of the best-known and most respected companies across the insurance sector and has extensive experience in advising clients on a variety of legal issues, especially in complex situations. These range from M&A transactions and business transfers (including current and recent experience in the Lloyd's market) to restructuring and advisory work.
Publications. In addition to his transactional work, George has also written for publications on industry topics such as the influence of the Financial Ombudsman Service on insurance law, Solvency II and recovery and resolution in insurance.
Wessel Heukamp, Partner
Freshfields Bruckhaus Deringer LLP, Munich
)
T +49 89 20 70 24 20
F +49 89 20 70 24 40
E [email protected]
W www.freshfields.com
Professional qualifications. Germany, admitted to the Bar; New York, admitted to the Bar
Areas of practice. Wessel is head of the firm’s insurance practice and is a corporate partner in our Munich office. He deals with transactional and regulatory matters. He is known for his in-depth understanding of the economics driving a transaction and for his innovative approach in finding solutions that will work in practice.
As an experienced financial institutions sector lawyer, Wessel has developed a close working relationship with the German financial supervisory authority (BaFin). He also teaches corporate and regulatory law at The Ludwig Maximilians University of Munich.
Lauren Honeyben, Counsel
Freshfields Bruckhaus Deringer LLP, London
)
T +44 20 7785 5890
F +44 20 7108 5890
E [email protected]
W www.freshfields.com
Professional qualifications. England and Wales, Solicitor, 2006
Areas of practice. Lauren is a counsel in our Insurance Group based in London. Lauren works on domestic and cross-border M&A, corporate re-organisations and other corporate advisory and transactional work for a range of listed and unlisted corporate and institutional clients. She has varied sector experience but her particular focus is on the insurance, banking and consumer finance sectors.
Priti Lancaster, Corporate Practice Development Lawyer
Freshfields Bruckhaus Deringer LLP, London
)
T +44 20 7716 4671
F +44 20 7108 4671
E [email protected]
W www.freshfields.com
Professional qualifications. England and Wales, Solicitor
Areas of practice. Priti is a practice development lawyer in our Insurance Group based in London. Priti’s experience includes advising on non-contentious matters for financial institutions including M&A, portfolio transfers, reorganisations and restructurings, distribution arrangements and regulation and compliance. She has experience advising insurers and reinsurers on both domestic and cross-border activities.