United Kingdom: Financial Sector Assessment Program-Detailed Assessment of Observance of Insurance Core Principles Issued by the International Association of Insurance Supervisors

The regulatory framework for insurance supervision in the United Kingdom is sophisticated and the authorities are leaders in supervisory techniques. Observance with the Insurance Core Principles (ICPs) is very high compared to peers with 17 ICPs observed and only 6 out of 24 ICPs determined to be largely observed and 1 partly observed.

Abstract

The regulatory framework for insurance supervision in the United Kingdom is sophisticated and the authorities are leaders in supervisory techniques. Observance with the Insurance Core Principles (ICPs) is very high compared to peers with 17 ICPs observed and only 6 out of 24 ICPs determined to be largely observed and 1 partly observed.

Executive Summary1

1. The regulatory framework for insurance supervision in the United Kingdom is sophisticated and the authorities are leaders in supervisory techniques. Observance with the Insurance Core Principles (ICPs) is very high compared to peers with 17 ICPs observed and only 6 out of 24 ICPs determined to be largely observed and 1 partly observed.

2. The insurance sector in the United Kingdom is highly developed, being the fourth largest insurance market globally, and with a penetration and density in the life sector considerably above those in peer markets. In terms of balance sheet assets, the size of the insurance sector amounts to 129 percent of U.K. GDP. However, since 2016 growth rates are muted and the number of licensed insurers has significantly declined, revealing trend of consolidation and restructuring.

3. Solvency ratios of U.K. insurers have been extremely stable since the implementation of Solvency II, well above regulatory thresholds, but consistently lower than those of European peers. Structural factors partially explain the lower solvency ratios, like e.g. the design of the GBP risk-free term structure which makes more usage of market rather than extrapolated data than the Euro one. In addition, U.K. insurers are significant users of internal models to calculate the required capital. While less than 20 percent of solo entities use either a full or a partial internal model, these insurers represent around 80 percent of the sector in terms of assets. On average, using an internal model results in capital savings of around one quarter. The use of the Matching Adjustment (MA) and the Transitional Measure on Technical Provisions (TMTP)—both integral parts of Solvency II—results in additional capital savings.

4. A top-down solvency stress test of 14 larger U.K. insurers showed vulnerabilities stemming from lower interest rates and equity price declines, particularly for life insurers. Increases in bond spreads are partly offset through the MA. A second scenario with rising interest rates would benefit the life sector, while the impact is more mixed for general insurers —especially in combination with higher inflation rates, their earnings would likely decline. With regard to liquidity risks, the FSAP found that life insurers are largely resilient to variation margin calls in their interest rate swap portfolio, but cash buffers at the group level differ markedly across firms. A more comprehensive analysis which incorporates liquidity drains and reduced market liquidity of certain assets, would however require more granular data and a monitoring framework, particularly for annuity writers and insurers with large derivative holdings—this should be considered in forthcoming liquidity plans.

5. The FSAP occurs at an important and historic time for the insurance sector in the United Kingdom and the regulatory framework for insurers in the United Kingdom. The industry has just weathered the COVID-19 pandemic with issues still to resolve in terms of Business Interruption (BI) insurance and catastrophe claims. When endorsed for use in the United Kingdom, IFRS 17 will involve a significant overhaul of insurers’ accounting systems, particularly for those who have long-term insurance contracts. This is a resource intensive change to accounting. It is important that supervisors monitor the implementation progress and ensure that those insurers lagging behind do not excessively pull resources from other critical projects and day-to-day risk management and control functions.

6. Brexit has occurred and those U.K. insurers wishing to continue their business in the EU either already had suitable subsidiaries in the EU or needed to establish suitable subsidiaries in the EU. The European Insurance and Occupational Pensions Authority (EIOPA) published recommendations to national authorities supporting recognition or facilitation of continued servicing of contracts existing at the end of the transition period that were not moved to EU-based subsidiaries. The EU have not made any decision on equivalence of the U.K. framework even though it is currently identical to the EU regulatory framework. Following Brexit, the United Kingdom is undertaking its Future Regulatory Framework Review (FRF) which will be important in setting out the objectives and responsibilities of the regulators in a context in which they are not part of the EU regulatory system. There are some clear benefits to proposals in the latest consultation on the FRF Review. Some proposed changes will need to be designed and implemented carefully to ensure that the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA) maintain focus on their primary objectives and can retain their operational independence. As part of this reform process. consideration should be given for the legislative framework for insurance supervision be simplified and streamlined, making it easier for firms to navigate.

7. The Solvency II Review is underway at the time of the mission and will enable better tailoring of the Solvency II framework to the unique characteristics of the U.K. market and address shortcomings identified since the introduction of Solvency II at the beginning of 2016. However, given that the United Kingdom has inherited legislation that puts highly technical matters such as the design and calibration of the risk margin and matching adjustment in legislation, the review does not allow sufficient space for the PRA to make policy judgements independently, and publicly. The Solvency II review consultation is Her Majesty’s Treasury (HMT) led and ultimate decision making is ministerial. One way forward to address the identified independence issue with the current legislative structure, would be to ensure that requests for advice from the PRA are made transparently by HMT and that the PRA can provide that advice in an independent and transparent way. Any variation in final policy compared to PRA advice would then be clear.

8. Macroprudential supervision of the insurance sector could be enhanced through a more structured and regular consideration of macroprudential risk of the insurance sector. While the Financial Policy Committee (FPC) requests deep dives and analysis of specific activities, the last sectorial deep dive for the insurance sector was undertaken in 2016. Regular reporting should be provided by the PRA Insurance Directorate on broad trends in the insurance sector that may have near-term or long-term consequences for the functioning of the insurance market and other financial sectors. A process, for example, inspired by the IAIS Global Monitoring Exercise (GME) and implemented in a domestic context might be appropriate and the process could be tied to the qualitative input required for the GME.

9. Reflecting the United Kingdom’s key role in global insurance markets the BoE should undertake a deep dive review on the role and potential systemic relevance of Lloyd’s and the London Market in international markets. Such a review should be done in cooperation with other supervisors and focus on substitutability and market share given London’s preeminent role in insuring specialist risks around the world.

10. Further work is required to complete the crisis management framework for the U.K. insurance sector and the mission supports the United Kingdom’s current proposals to develop a comprehensive insurer resolution regime. The United Kingdom has been able to successfully deal with the need for small and medium-sized firms to exit the market using the range of exit strategies available to market participants under U.K. statute and the tools available to the PRA. The Financial Services Compensation Scheme (FSCS) has been able to protect policyholders for a number of insurers unable to meet their obligations to policyholders. However, there is a less certainty over the United Kingdom’s ability to deal with the failure of a significant insurer or Internationally Active Insurance Group (IAIG), one that the PRA categorizes as a Category 1 insurer2. The PRA and HMT have acknowledged the gap created by the lack of a comprehensive insurer resolution regime. Resolution plans are not in place for all IAIGs. Resolution plans that are in place are constrained by the legal entity level of powers available to the PRA and would benefit from more focus on the group rather than UK legal entities. The mission supports the proposal to enhance the PRA’s toolkit for dealing with insurers in financial distress by adapting the write-down power in section 377 of the Financial Markets and Services Act 2000 (FSMA) to make it available before insolvency, to improve the process of this power’s application and extend the FSCS to protect the pre-written-down amounts. Crisis Management Groups should be put in place for all IAIGs. Currently these are in place for two of the three IAIGs and it is expected that the final one will be put in place in the course of 2022.

11. Overall, the PRA’s approach to supervision is sophisticated, structured and well anchored in its statutory objectives but one area of concern is a lack of on-site supervisory activity targeted at business processes within firms and discussions with frontline staff. Deep dive reviews do not always involve discussions with firm staff who do not hold senior positions. The PRA approach is very much anchored in senior management responsibility at regulated firms. Deep dive reviews may only involve extensive desk review of documentation and discussions with senior management. Section 166 reviews by skilled persons are undertaken as an alternative to some PRA- staffed deep dive reviews. The PRA should use the full range of its existing tools and so increase and deepen its on-site inspection activity and consider bringing in-house some of the deep dive reviews outsourced to skilled persons (cost recovery options for PRA resourced on-site inspections under FSMA should be explored). The section 166 review is a useful tool in a number of circumstances but the PRA’s use does cover the scope covered by other jurisdictions in their own on-site inspections.

12. Overall, the FCA’s approach to supervision of insurers with an emphasis on portfolio supervision and some dedicated fixed firm supervision appears an appropriate compromise in allocation of resources for a conduct regulator. The FCA should continue to review its approach to fixed and portfolio supervision to ensure effective risk-based approach to supervision in accordance with business needs and industry developments. In doing so, it should consider its recent reduction in fixed firm supervision in preference for more portfolio supervision in the insurance sector. The incremental resource implications of the FCA extending its fixed firm supervision to all PRA Category 1 and 2 firms appears minimal in the overall context of FCA supervision resources. Overall, insurance sector supervision is optimized where PRA and FCA information sharing is amplified for the most significant firms.

Assessment of Insurance Core Principles

A. Introduction and Scope

13. This assessment of insurance supervision and regulation in the United Kingdom was carried out as part of the 2021 Financial Sector Assessment Program (FSAP).

14. This assessment has been made against the Insurance Core Principles (ICPs) issued by the International Association of Insurance Supervisors (IAIS) in November 2019. The assessment includes standards of the Common Framework for the Supervision of Internationally Active Insurance Groups (ComFrame) included within the ICPs. Topical issues were also covered including the Solvency II Review, the Future Regulatory Framework Review, supervision of climate risks, Brexit, LIBOR transition and the transition to International Financial Reporting Standard 17 (IFRS 17). This long list of significant impending changes to the U.K. regulatory landscape for insurance demonstrates that this FSAP has occurred at a time of transformation.

15. In 2015, the IMF conducted an FSAP where a focused review of the insurance sector was undertaken rather than a full assessment against the ICPs. A technical note was published which contained a number of recommendations.3 Annex 1 contains a table of those recommendations along with progress made in addressing those recommendations. Progress against those recommendations was taken into account in the assessment against the ICPs.

B. Information and Methodology Used for Assessment

16. The level of observance for each ICP reflects the assessment of its standards. Each ICP is rated in terms of the level of observance as follows:

  • a) Observed: where all the standards are observed except for those that are considered not applicable. For a standard to be considered observed, the supervisor must have the legal authority to perform its tasks and exercises this authority to a satisfactory level.

  • b) Largely observed: where only minor shortcomings exist, which do not raise any concerns about the authorities’ ability to achieve full observance.

  • c) Partly observed: where, despite progress, the shortcomings are sufficient to raise doubts about the authorities’ ability to achieve observance.

  • d) Not observed: where no substantive progress toward observance has been achieved.

17. The assessment is based solely on the laws, regulations and other supervisory requirements and practices that are in place at the time of the assessment in June to November 2021. While this assessment does not reflect new and on-going regulatory initiatives, key proposals for reforms are summarized by way of additional comments in this report. The authorities provided a full and comprehensive self-assessment, supported by examples of actual supervisory practices and assessments, which enhanced the robustness of the ICP assessment.

18. The assessment necessarily focuses on the supervision and regulation of the largest insurers as these are of most concern from a financial stability perspective. As such the assessment of prudential supervision focused on the implementation of Solvency II. The supervision of insurers not subject to Solvency II has not been assessed. Firms not subject to Solvency II are known as ‘non-directive’ firms and while they account for 25 percent of authorized insurers, they account for a very small share of the U.K. market.4

19. In line with paragraph 50 of the Introduction and Assessment Methodology of the IAIS ICPs, the IMF and U.K. authorities agreed that ComFrame standards would be included in the assessment. The United Kingdom is the group-wide supervisor for IAIGs and therefore the ComFrame standards applicable to group-wide supervisors have been assessed as part of the assessment of each ICP that contains ComFrame standards.

20. The assessors are grateful to the authorities and private sector participants for their cooperation. The assessors benefitted greatly from the valuable inputs and insightful views from meetings with staff of the Bank of England (BoE), FCA, HMT, insurance companies and industry and professional organizations.

C. Overview—Institutional and Macroprudential Setting

21. Insurers are dual-regulated firms, meaning that they are regulated by the PRA and the FCA. The PRA and the FCA have responsibility for the supervision of a wide range of firms, the PRA for prudential matters and the FCA for conduct matters. The PRA regulates 138 life insurers and 245 general insurers. The FCA is the conduct regulator for about 51,000 firms and prudentially supervises about 49,000 of these firms which are solo-regulated firms.5 In the United Kingdom the Parliament establishes the legislative parameters within which HMT sets the regulatory perimeter through secondary legislation, specifying which financial activities should be regulated. The regulatory oversight structure is illustrated in Figure 1.

Figure 1.
Figure 1.

United Kingdom: Regulatory Oversight Structure

Citation: IMF Staff Country Reports 2022, 109; 10.5089/9798400206825.002.A001

Source: Bank of England and IMF Staff.

22. Insurance distribution activities are subject to FCA regulation and most entities carrying out these activities are solo regulated firms subject only to FCA supervision. The FCA is therefore also the prudential regulator for insurance intermediaries.

23. The two authorities have separate and independent mandates, set out in statute, reflecting the United Kingdom’s ‘Twin Peaks’ model. Under FSMA, the PRA’s general objective is to promote the safety and soundness of PRA-regulated firms. The PRA’s insurance objective is ‘contributing to the securing of an appropriate degree of protection for those who are or may become policyholders’. The PRA has a secondary objective (SCO) to facilitate, insofar as reasonably possible, effective competition in the markets for services provided by PRA-regulated firms in carrying on regulated activities. The PRA’s SCO became effective in March 2014. The SCO only applies to the PRA’s exercise of general functions which are: making rules under FSMA and technical standards under retained EU law, preparing and issuing codes under FSMA, determining general policy and principles by reference to which the PRA performs functions under FSMA. The SCO does not require the PRA to act in a manner that is incompatible with its primary objectives. The FCA must act in a way that is compatible with its strategic objective and advances one or more of its operational objectives. The strategic objective is to ensure relevant markets function well and insurance is one of those markets. The FCA’s operational objectives are to protect consumers, enhance market integrity and promote effective competition in the interests of consumers. The mandates and coordination arrangements between U.K. financial regulators are discussed further below in relation to ICPs 1 and 2.

24. This assessment occurs at a time when the objectives, powers, and responsibilities of the PRA and FCA are subject to possible change due to the U.K. Government’s consultation on the Future Regulatory Framework Review (FRF). The assessment does not formally take into account these proposals as the assessment is based on current laws and policies. However, the mission does make recommendations for the U.K. Government to bear in mind as it finalizes the FRF Review.

25. Other significant changes are occurring in the U.K. insurance sector as well as to the way in which the U.K. insurance sector is regulated. Currently, the Solvency II Review is underway and this is expanded upon in Box 1 below. The industry has also had to weather the impact of the COVID-19 pandemic, transition from LIBOR and modified business models and regulatory environment for international business due to Brexit. Equally, EEA insurers operating in the United Kingdom face a transition to a new domestic regulatory approach in the United Kingdom.

The U.K. Government is currently reviewing the Solvency II framework, coinciding with a review being conducted in the EU. The review in the United Kingdom is underpinned by three objectives:

  • to spur a vibrant, innovative, and internationally competitive insurance sector

  • to protect policyholders and ensure the safety and soundness of firms

  • to support insurers to provide long-term capital to support growth, including investment in infrastructure, venture capital and growth equity, and other long-term productive assets, as well as investment consistent with the U.K. Government’s climate change objectives.

A first call for evidence was launched by HMT in October 2020 with ten major areas for review, including the risk margin, the matching adjustment, and the calculation of the SCR.1

Respondents were strongly supportive of the Solvency II regime.2 Respondents considered that Solvency II had improved standards of risk management and reporting in the insurance sector as well as the overall standard of prudential regulation. No respondents argued that Solvency II should be replaced by a different regime.

Based on the responses, the U.K. Government:

  • sees evidence that many aspects of Solvency II are overly rigid and rules-based, and it

  • wants to see a prudential regulatory regime that is more proportionate and flexible so that it works more effectively, and outcomes can be delivered more efficiently.

  • believes such a regime would include a better mix of judgement and rules so that it can be better applied by the PRA, as well as by insurers.

  • sees consensus in the responses that the risk margin is currently too high and too volatile in the current low interest rate environment.

  • believes a reduction in the size and sensitivity of the risk margin to interest rates would diminish the incentive to reinsure longevity risk outside the United Kingdom.

  • agrees with the responses that there is a strong case to reform the risk margin which could free up resource on, and reduce the volatility of, insurers’ balance sheets.

  • agrees that reform would contribute to a dynamic, prosperous, and internationally competitive insurance sector.

  • thinks that the application process for the matching adjustment needs to be proportionate to the benefits and risks for insurers so that they can move flexibly and quickly to invest in eligible assets.

  • thinks, equally to the point above, that potential amendments to the matching adjustment need to be informed by the credit and other long-term risks insurers are exposed to, including through growing concentrations in illiquid, internally rated assets.

  • agrees that the requirements in Solvency II do not place disproportionate burdens on insurers, either in relation to the calculation of the SCR or model application processes.

The objectives for the Solvency II review align closely with the remit letter issued to the PRC on March 23, 2021. The remit letters issued by HMT pursuant to Section 30B of the Bank of England Act 1998 do not cause concern on their own as these are recommendations to which the PRC should have regard when considering how to advance the objectives of the PRA and the application of regulatory principles under FSMA. In this way, HMT’s recommendations must be considered in the context of the primacy of the PRA’s single general objective, its insurance objective, and its SCO. However, in the case of the Solvency II review, some aspects of the remit letter are elevated to objectives that the Solvency II review must meet. If the PRA was able to exercise its rule making powers under FSMA to make prudential policy for the insurance sector, including the technical aspects of Solvency II, these objectives would not have such primacy in decision making. The structure of the legislation, combined with the U.K. Government’s approach to the Solvency II review appear to constrain the independence of the PRA in its rule making power, transferring ultimate decision making to the ministerial level with objectives that do not align with the primacy of the PRA’s general objectives.

The PRA and HMT are working closely on the Solvency II review. HMT draws on the PRA for technical and supervisory expertise. This can be seen in the PRA conducting a Quantitative Impact Study (QIS) between July and October 2021 to support the Solvency II review. However, it is important to note that the scenarios specified in the QIS do not in themselves represent reform proposals. The data collection focused mainly on areas where different options would show an impact on insurers’ balance sheets, particularly (i) the calculation of the matching adjustment; (ii) the risk margin; and (iii) the Transitional Measure on Technical Provisions (TMTP). Participation in the QIS was on a voluntary basis. The QIS also contained qualitative questions to gather information to support the development of some areas of Solvency II reform that are less straightforward to assess quantitatively.

During the FSAP mission, it became clear through industry discussions and through reviewing news reports that the life insurance industry was critical of the PRA’s approach based on the calibration of the options for the matching adjustment. They used HMT’s objectives as a frame of reference to criticize the PRA’s approach which they took to be indicative of the policy options being considered by the PRA, despite the specific statements by the PRA that this was not the case

Sources: HMT and PRA.1 Other area include: calculation of the consolidated group SCR using multiple internal models; calculation of the TMTP; reporting requirements; branch capital requirements for foreign insurers; thresholds for regulation by the PRA under Solvency II; mobilization of new insurers; transition from LIBOR to Overnight Indexed swap rates.2https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/998396/Solvency_II_Call_for_Evidence_R esponse.pdf

26. The PRA undertook a strategic review over 1 year and the report was finalized during the FSAP mission. Implementation of the report comprises the PRA’s 2026 strategy with implementation of refinements to the supervisory approach through to 2022 and organizational transformation through to 2026. As such, any changes because of the strategic review are not in the scope of this assessment.

27. The FCA is undergoing a significant strategic move towards becoming an increasingly data driven regulator. It is working on a transition to cloud technology, and this will enable increased automation and data analysis. However, as that is a process currently underway, the mission understands this will impact on the FCA’s resources and future approach to regulation. However, the mission was only able to consider systems and processes currently in place in the assessment of the ICPs.

28. A significant emerging issue in insurance supervision around the world is how to incorporate climate risk into supervision in order to ensure insurers are appropriately taking climate risk into account in their risk management practices. U.K. Authorities have been thought leaders with respect to this emerging issue of concern for global regulatory authorities and Box 2 details the developments that have occurred in the United Kingdom since 2015.

Since Governor Mark Carney’s landmark speech at Lloyd’s of London in September 2015, U.K. financial regulators have been at the forefront of developments in introducing consideration of climate risk in supervision of insurers and banks. The speech coincided with the release of a report “The impact of climate change on the U.K. insurance sector: A Climate Change Adaption Report by the Prudential Regulation Authority”. This report set out the well-known analytical framework for considering climate change risk, defining physical risk, transition risks and liability risks. The PRA has continued to work domestically and with international counterparts to advance the agenda on incorporating climate risks into supervision and promoting identification and management of climate risks in the supervised financial sector.

The next landmark in incorporating climate risks into prudential supervision occurred with the publication of Supervisory Statement 3/19: Enhancing banks and insurers’ approaches to managing the financial risks from climate change. In this supervisory statement, the PRA set out its expectations regarding the strategic approach expected of banks and insurers in managing climate risk.

This Scenario analysis was then incorporated as part of the PRA’s 2019 Insurance Stress Test. On July 1, 2020, the PRA followed up with a ‘Dear CEO’ letter, providing industry-wide feedback regarding the PRA’s review of firms’ SS3/19 plans and to further clarify expectations which included an expectation that firms would fully embed their approaches to managing climate-related financial risks by the end of 2021.

The FCA and PRA established the Climate Financial Risk Forum (CFRF) in March 2019 to build capacity and share best practice across industry and financial regulators to advance the sector’s responses to the financial risks from climate change. The CFRF has membership of senior representatives from banks, insurers and asset managers and has observers from trade bodies. The CFRF established four technical working groups on disclosure, scenario analysis, risk management and innovation. The CFRF published a guide on June 29, 2020, that included a summary produced by the PRA and FCA along with four industry-produced chapters covering risk management, scenario analysis, disclosures, and innovation.

Subsequently, on October 21, 2021, the CFRF published its second round of guides adding detail to the previously released guides. Insurers are on a journey of moving from incorporating climate risk considerations in their risk management and governance processes at a rather basic level towards more sophisticated approaches and techniques and tools available are evolving with firms also facing significant challenges in terms of data availability.

The BoE has launched a comprehensive climate risk stress test in June 2021, underlining its pioneering role in analyzing the impact of climate change on the financial sector. The Climate Biennial Exploratory Study (CBES) aims to explore the impact of three different climate scenarios on the balance sheet of banks and insurers. In particular, the exercise assesses the risks arising from structural changes economies around the world are undergoing to achieve net zero emissions—transition risks—and risks associated with higher global temperatures—physical risks. The scenarios of early, late and no action built on a subset of the Network for Greening the Financial System (NGFS) scenarios and have a time horizon of thirty years, reflecting the longer-term nature of those risks.

The CBES is an exploratory exercise. Hence the focus is not on pass/fail, but on understanding business model challenges and contributing to improvements in risk management in the financial sector—a closer engagement of banks and insurers with their largest counterparties on their respective vulnerabilities to climate change is facilitated by this exercise. In December 2021, the FCA confirmed new rules for disclosures aligned with the Task Force on Climate- Related Financial Disclosures (TCFD) which applies to life insurers, assets managers, and FCA-regulated pension providers. This announcement followed a consultation in June 2021.

The rules for life insurers—in respect of assets managed or administered on behalf of clients and consumers in their capacity as asset owners—came into effect for the largest firms on January 1, 2022, and 1-year later for smaller firms (with over •5 billion in assets under management or administration). The disclosures include:

  • Entity-level disclosures which require an annual TCFD entity report to be made available in a prominent place on the firm’s website and

  • Product-level disclosures which require including a core set of climate-related metrics for the firm’s portfolio and products.

Sources: PRA and FCA.

Industry Structure and Recent Trends

29. The insurance sector in the U.K. is highly developed, particularly in the life sector where penetration and density are considerably above those in peer markets (Table 1). Globally, the United Kingdom represents the fourth largest insurance market. Gross written premiums amounted to GBP 271bn in 2020. The United Kingdom’s life insurance penetration rate (premiums to GDP) of 8.8 percent ranges considerably above the average for advanced markets (4.2 percent) and the European Union (3.6 percent). Life insurance density (premiums per capita) reached US$3,574 in 2020. In the general insurance sector, however, both penetration (2.3 percent) and density (US$949) are below the respective averages for advanced markets and the EU—this might partially be explained by a highly competitive retail general insurance market, lowering costs for policyholders. In terms of balance sheet assets, the size of the insurance sector also exceeds those of most peers in the EU, amounting to 129 percent of the GDP at end-2020, up from 111 percent at end-2016, and comparing against 72 percent for the EU-27 (Figure 2a).

Table 1.

United Kingdom: Insurance Penetration and Density

Life insurance penetration (premiums to GDP) is more than twice the average for advance markets, but less than half in the general insurance sector.

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Source: Swiss Re Sigma.
Figure 2.
Figure 2.

United Kingdom: Size and Structure of the Insurance Sector

Citation: IMF Staff Country Reports 2022, 109; 10.5089/9798400206825.002.A001

Sources: IMF staff calculations based on PRA and EIOPA.

30. The number of licensed insurers has significantly declined since 2016, indicating both a consolidation trend and the status quo of Brexit relocations (Figures 2b and 2c). At the end of 2016, a total of 465 insurers was authorized in the United Kingdom This number has declined to 370 insurers by end-2020, of which 126 were life insurers and 221 general insurers. Market consolidation prevails in the life sector, driven inter alia by the low interest rate environment which weighs on profits. Solvency II has also allowed and prompted consolidation of insurance activities, often within the same group. Insurers leaving the market clearly outnumbered new market entries particularly in the general insurance sector where international groups re-organized their operations in Europe. Still, 21 insurers were newly licensed from 2016 to 2020, mostly in the general insurance sector as well as insurance special purpose vehicles. The number of firms, however, is expected to rise again as EU insurers complete the restructuring of their U.K. business, approximately 140 EU insurers which previously undertook business in the United Kingdom through passporting arrangements are expected to apply for U.K. authorization to be able to continue undertaking U.K. business before the cut-off date of December 31, 2022. The PRA and FCA are currently processing these applications.

31. The concentration in the life insurance sector is moderately high but is very significant in the general insurance sector (Figure 2d). The three largest life insurers account for a market share of 39 percent in terms of assets and the largest ten groups for 75 percent. Concentration in the non-life sector is considerably higher reflecting the significant amounts of international business written in the UK—63 and 81 percent of the market share is held by the three and ten largest companies, respectively. However, the structure of the Society of Lloyds, as explained below, means that is made up of multiple self-directed entities rather than as a single entity.

32. Unit-linked policies are by a wide margin the most important life insurance product, shifting market risks to policyholders (Table 2). Gross written premiums in the life sector amounted to GBP 209bn in 2020, of which 124 bn related to unit-linked products. These policies resemble fund-like savings products, are more capital efficient for insurers, and can offer better returns to policyholders when interest rates are low, while also the downside risks are to a large extent borne by policyholders. Life reinsurance business is another important line with almost GBP 32bn gross written premiums in 2020. With-profit life business generated only GBP 6bn premiums. The most important non-life lines of business comprise property, general liability, and motor insurance with 31, 21 and 19 percent of gross premiums, respectively. In total, the non-life sector generated GBP 62 bn gross written premiums in 2020. Only around 85 percent in life business is retained by the primary insurers, indicating a relatively large share of life risks being transferred. Retention rates in non-life business are typically lower than in life, and amount to around 69 percent in the United Kingdom—particularly the extreme risks of natural disasters are reinsured with foreign insurers.

Table 2.

United Kingdom: Premium Income

Unit-linked insurance as well as reinsurance are the two dominant business lines in life insurance, while with-profit business records only marginal premiums. In general insurance, fire and other damage to property accounts for 31 percent of all gross premiums.

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Sources: IMF staff calculations based on PRA.

33. The Society of Lloyd’s (Lloyd’s) dominates the overall non-life insurance sector with its assets representing almost 50 percent of the sector’s assets. The Lloyd’s business is predominantly an international business with only 12 percent of its gross written premiums derived from the U.K. market in 2020.6 This makes the role of the U.K. regulators in supervising Lloyd’s one that is not just to promote domestic financial stability and protect policyholders, but it also involves an international role. These comments could equally apply to many London Market insurers as well. Box 3 sets out how Solvency II applies to the unique structure of Lloyd’s.

The Society of Lloyd’s is not an insurance company or a group, it is a statutory corporation incorporated by the Lloyd’s Act 1871. The Council of Lloyd's manages and regulates the affairs of the Society. The expression "Lloyd's" is also used to describe the market of Lloyd’s Members who undertake insurance business. Members act through insurance syndicates to underwrite insurance and reinsurance cover for policyholders. Syndicates are made up of Members who can be individuals, partnerships, or corporate entities. Syndicates are managed by Managing Agents. Members put up the underwriting capital against their share of insurance or reinsurance risk accepted by the Syndicate and a Member is only liable for their share of the profit or loss of those insurance and reinsurance risks. Syndicates have no separate legal personality from the Members collectively. Members join a Syndicate only for an underwriting year accepting risks incepting in that calendar year. Continued participation in a Syndicate means that a Member must join the subsequent calendar year of that Syndicate. A Syndicate calendar year remains open for three years and at the end of the third year is closed through a Reinsurance to Close (RITC) transaction usually into a subsequent Syndicate year.

The Corporation of Lloyd’s oversees the Lloyd’s market and provides the market’s infrastructure, including services to supporting its operations. The Corporation of Lloyd’s sets required standards and expectations against which market participants are regularly assessed. It also approves business plans and capital requirements for each of the Syndicates. Lloyd’s risk appetite framework expresses the aggregate level of risk that Lloyd’s is prepared to accept to achieve its strategic objectives and the Society of Lloyd’s monitors the Market’s risk profile against this framework. This market oversight applies to Managing Agents’ management of Syndicates and covers underwriting, governance, risk and operations, reinsurance, risk aggregation, reserve adequacy, investment, capital adequacy, model approval, conduct issues and compliance with other regulatory requirements such as monitoring for financial crime. The PRA and FCA engages with Lloyd’s on both its approach to and the effectiveness of its market oversights. The PRA and FCA also engages with Lloyd’s on oversight of individual Managing Agents. Lloyd’s and Managing Agents (as the most important controllers of prudential risk in the market) are authorized entities and as such are regulated by the PRA and FCA. The PRA and FCA regulates Lloyd’s and Managing Agents to the same standards as other regulated entities. Given the Society of Lloyd’s operates a market, the capital structure is designed to fit that structure and is referred to as the ‘chain of security”. The First Link is Syndicate-level assets, and the Second Link is Member’s Funds at Lloyd’s (FAL) which are referred to as ‘Several Assets’. These assets are held in trust for the benefit of policyholders and are used to cover policies written by a particular Member or assumed by the Member through the RITC process. The Third Link is the Mutual Assets which have three components: The Central Fund and Society of Lloyd’s Assets, Subordinated Debt and Securities and a Callable Layer. This structure is depicted below.

Syndicate Level Assets are primarily premiums held in trust through a premium trust fund (PTF) which includes all premiums received minus claims and expenses paid. Reserves for future liabilities are subject to independent audit and actuarial review. Where there are insufficient assets to meet liabilities, the Managing Agent makes a cash call on members and a Member’s FAL can be used.

Member’s FAL must be sufficient to support their underwriting at Lloyd’s. The level of FAL required to be held is based on syndicate capital requirement calculations which are allocated to Members based on their share of the Syndicate. The syndicate capital calculations are based on ultimate view of risk rather than the regulatory view of a 1-year time horizon. An uplift, typically 35 percent on this base capital calculation is added to ensure sufficient capital. The FAL is held in trust by the Society of Lloyd’s and is only available to meet the liabilities of that Member. A Member’s FAL is required to be replenished annually in June to meet their underwriting liabilities, a process called ‘coming into line’ but there is flexibility to request recapitalization before the next coming into line date, if necessary.

Requirements of Members to maintain sufficient FAL are requirements of Lloyd’s and are not a regulatory requirement of Solvency II.

The Central Fund is a fund of last resource to safeguard policyholders should a member fail to meet insurance liabilities in full. Access to the Central Fund is at the discretion of the Council of Lloyd’s. Members must contribute annually to the fund and special contributions can be required from time to time. Central Fund assets may be supplemented by a callable layer, up to 3 percent of a member’s overall premium limits in any year.

Solvency II requirements apply to both Lloyd’s and to Managing Agents. There are specific requirements applicable to Lloyd’s also set out in PRA Rulebook, SII Firms, Lloyd’s and further elaboration is made in Supervisory Statement SS12/15. Essentially Lloyd’s is required to manage each Member’s FAL, central assets and central liabilities, conduct supervision of member’s insurance business in order to achieve the same effect of conforming with the requirements of any rule when applied to a Solvency II insurer.1 Managing Agents are required to manage syndicates for each syndicate year to achieve the same effect of conforming with the requirements of any rule when applied to a U.K. Solvency II firm.2

Lloyds has two solvency capital requirements,3 the Market Wide Solvency Capital Requirement (MWSCR) which reflects both the aggregate member losses and the Central Fund losses as well as the Central Solvency Capital Requirement (CSCR) which reflects the Central Fund losses only. Lloyd’s must ensure eligible own funds held at Lloyd’s meet the MWSCR and this broadly maps to the Second Link and Third Link in the Lloyd’s Chain of Security. Centrally, Lloyd’s must meet the CSCR, and this broadly maps to the Third Link in the Lloyd’s Chain of Security. The PRA requires Lloyd’s to meet the CSCR and MWSCR but does not directly regulate Members FAL requirements. However, the way in which these are calculated and overseen by Lloyd’s has a direct impact on its own CSCR and MWSCR. The PRA’s regulatory focus is on Lloyd’s overall but as part of its supervision it will consider the internal Lloyd’s process to set Member FAL.

Managing agents must calculate notional SCRs (uSCRs) for each syndicate it manages which is allocated to members to inform members’ capital requirements.4,5 Lloyd’s requires the uSCR is calculated at the 99.5th confidence level on an ultimate basis using an internal model created by the Managing Agent. This process is overseen by the Corporation of Lloyd’s. Managing agents sometimes apply capital loadings where models may lead to insufficient uSCRs, and Lloyd’s may impose a capital load as part of its supervision process. The PRA oversees the Lloyd’s supervision of Managing Agent’s calculation of uSCRs. The PRA conducts significant reviews of the syndicate capital process.

A member’s capital requirement is determined by Lloyd’s based on the sum of their shares in syndicate uSCRs with some diversification allowance where a member participates in multiple syndicates. However, these are not regulatory requirements but are imposed by Lloyd’s on Members to ensure adequate funding of liabilities attributable to the Members and contribute to the overall funding of Lloyd’s.

The MCWSCR and CSCR is calculated using the Lloyd’s Internal Model (LIM) which is subject to the usual supervision by the PRA as described in relation to ICP 17. The LIM simulates losses by class of business, allocates these to syndicate, adds other syndicate risks (market risk, credit risk, operational risk, and additional central fund risk). If simulated syndicate losses exceed PTF, the excess loss is allocated to Members and if Member losses exceed their FAL then that is assumed to be a loss to the central fund. Additional central risks are added (operational, market risk on central assets and pension risk). The MWSCR is the 99.5th percentile member and central losses. The CSCR is the 99.5th percentile of central fund losses. MWSCR and CSCR are subject to Solvency II and PRA reporting requirements (MWSCR quarterly, CSCR is an NST which is currently annual).

Syndicate PTF and Member FAL are inputs to derive the funds available for a syndicate in the LIM before the LIM simulates losses to the Central Fund. It is important that uSCRs for syndicates are sufficient (therefore ensuring sufficient FAL) as lower levels of FAL would result in a larger CSCR for Lloyd’s to meet.

Contingent capital has been a significant source of capital for Lloyd’s but is decreasing in importance. Solvency II allows insurers to cover up to 50 percent of their SCR with Tier 2 capital including Ancillary Own Funds (AOF) such as Letters of Credit (LoC). AOF cannot be used to cover the MCR. Use of AOF requires PRA approval. LoCs are used by Members as part of meeting their FAL requirements. Lloyds has introduced an internal requirement that Members cannot have more than 50 percent of their FAL requirements met by LoCs. At year- end 2015, AOF was 40 percent of Available Own Funds, and this has been reduced to 22 percent by year-end 2020. LoCs are standard form instruments which require clean, irrevocable, and unconditional payment if Lloyd’s draws down on the LoC and Lloyd’s can do this without recourse to the Member. LoCs must have an expiration date of not less than four years. The instruments cannot be amended or canceled without Lloyd’s agreement and Lloyd’s is obliged to consult with the PRA and FCA if there are any changes to the terms of these instruments. Lloyd’s requires counterparties to the LoCs to have at least an A-/A3 rating across all the three major rating agencies; if the counterparty rating falls below that level then the LoC will no longer qualify as FAL. Lloyds has a history of successful draw downs on LoCs including during the 2008 financial crisis.

In 2018, Lloyd’s established Lloyd’s Insurance Company (LIC) in Belgium for the purposes of maintaining its business in the EU after Brexit. In December 2020, Lloyd’s transferred the Members’ non-life EU business written since 1993 to LIC by way of a Part VII Transfer. LIC is prudentially supervised by the National Bank of Belgium. As this assessment relates to business transacted in the United Kingdom, the way in which Lloyd’s transitioned its business to the LIC platform will not be explored in detail here.

Source: PRA.1 PRA Rulebook, SII Firms, Insurance General Application, Section 3.12 PRA Rulebook, SII Firms, Insurance General Application, Section 3.23 PRA Rulebook, SII Firms, Solvency Capital Requirement – General Provisions, Section 74 PRA Rulebook, SII Firms, Solvency Capital Requirement – General Provisions, Section 8.25 PRA Rulebook, SII Firms, Solvency Capital Requirement – General Provisions, Section 8.4

34. The structure of insurance sector liabilities illustrates the dominance of unit-linked life insurance products (Figure 3). For the whole insurance sector, technical provisions account for 89 percent of total liabilities. These technical provisions split further into traditional (including with profit) life insurance provisions (28 percent of total liabilities) and unit-linked provisions (55 percent). From 2016 to 2020, unit-linked liabilities increased by 17 percent, and therefore in line with the insurance sector’s total liabilities (+16 percent). Non-life technical provisions with their shorter duration account for only 5 percent of total liabilities.

Figure 3.
Figure 3.

United Kingdom: Insurance Liabilities

Citation: IMF Staff Country Reports 2022, 109; 10.5089/9798400206825.002.A001

Sources: IMF staff calculations based on PRA and EIOPA.

35. The asset allocation of U.K. insurers is characterized by relatively large holdings in government and corporate bonds (Figure 4). With a share of 55 percent, bonds are the dominant asset class when analyzing only the investments which do not back unit-linked liabilities—the share is higher in the general insurance sector (64 percent) than in the life sector (53 percent). Less than 2 percent of bond holdings carry a speculative grade rating, however there is also a large share of unrated fixed-income investments—this includes inter alia equity release mortgages. Generally, over the last years, a trend towards more non-traditional investments can be observed, such as mortgages and loans. Life insurers have also expanded their holdings in equity and participations (+18 percent from 2016 to 2020) and corporate bonds (+19 percent), while general insurers decreased their exposures in both these categories (-22 and -16 percent, respectively).

Figure 4.
Figure 4.

United Kingdom: Insurance Asset Allocation

Citation: IMF Staff Country Reports 2022, 109; 10.5089/9798400206825.002.A001

Sources: IMF staff calculations based on PRA and EIOPA.Notes: Credit quality steps (CQS) can be mapped against rating categories, e.g. CQS 0 = AAA, CQS 1 = AA, etc.

36. Investments are geographically diverse with only U.K. government bonds being a dominant domestic asset class. Domestic investments in total account for about 56 percent of all investments. Of these, around a quarter are government bonds, which are highly sought after particularly by life insurers who appreciate the long maturities to match their liabilities, as well as the liquid market. The largest single foreign jurisdiction to which U.K. insurers are exposed is the United States (17 percent of total investments), followed by Ireland and Luxembourg with 6 and 15 percent, respectively—these investments comprise mostly mutual funds. Such large investments outside the United Kingdom are also used to match liability exposures in foreign currency—non-life firms and reinsurers have significant USD and EUR liabilities, while the business of life insurers is more concentrated in the home market and hence in GBP.

37. Insurance sector growth rates have been muted recently, and premiums have been declining since 2018. Gross written premiums in life insurance grew by only 9 percent from 2016 to 2020 and even fell by 18 percent from a temporary peak in 2018. General insurance premiums declined by 6 percent since 2016. This development can to some extent be attributed to Brexit which led to some relocation of business, especially cross-border business into the EU.

38. Profitability is muted in the general insurance sector, and insurers depend on positive investment returns (Figure 5). General insurers in the United Kingdom are characterized by relatively high expense ratios, particularly due to the London market where the brokerage of reinsurance business is costly, thereby distorting the average for the general insurance sector. Combined ratios—the sum of loss ratios and expense ratios—fluctuate slightly above 100 percent which indicates underwriting losses and the necessity to compensate for these losses with profits stemming from investments. Despite heightened market volatility at the onset of the COVID-19 pandemic in the first quarter of 2020, investment revenues have remained strong, and constant streams of interest and dividends contribute to, on average, positive returns both in the life and the general sector (Box 4).

Figure 5.
Figure 5.

United Kingdom: Insurance Profitability

Citation: IMF Staff Country Reports 2022, 109; 10.5089/9798400206825.002.A001

Sources: IMF staff calculations based on PRA and EIOPA.

PRA Firm Engagement

During the COVID-19 pandemic, insurers' balance sheets proved rather stable, with solvency ratios declining only temporarily when markets became more volatile in February/March 2020.

U.K. life insurers benefited from the mitigating mechanics inherent to the Solvency II framework, most notably the matching adjustment which largely offset the impact of higher spreads on sovereign and corporate bonds. Still, earnings of life insurers declined due to lower new sales amid lockdown restrictions and lower consumer confidence. Higher mortality due to the pandemic had a slightly beneficial effect on annuity writers who would typically be substantially exposed to longevity risks. This impact has primarily arisen from experience profits (i.e., annuity payments not having to be paid during the year to policyholders who died, along with a slightly reduced number of in-force annuities at the end of the year), rather than from life insurers weakening their future longevity trend assumptions. In their engagement with firms, the PRA have emphasized the importance of taking a prudent approach to allowing for Covid-19 experience in future longevity assumptions.

General insurers were moderately affected in 2020. Claims increased massively in a few business lines, especially business interruption, event cancellation and travel insurance, but strict lockdown rules and reduced mobility also led to a notable reduction in motor insurance claims. Following the announcement of Government lockdown measures in March 2020 PRA supervisors began to engage with general insurers to assess the exposure from the lines of business likely to be impacted and business interruption claims where there was potential for contractual uncertainty where the FCA had sought to get clarification through the High Court. The PRA asked selected insurers to provide their own stress tests and combined these with other stresses on assets, including reinsurance recoverability and liabilities that may arise during the year to evaluate the resilience of the firms’ balance sheets and identify firms where supervision action should be focused.

The PRA maintained close communication with the FCA, and updated estimates were obtained following the High Court judgement in September 2020 and the Supreme Court Judgement in January 2021.

FCA Firm Engagement

At the beginning of March 2020, FCA supervisors began to engage with insurers and large intermediaries to understand the impact of the pandemic on their business model, ability to service customers, product availability and operational resilience. From March to December 2020, the FCA had in place COVID-19 firm engagement plans, under which contact was kept with key insurers and intermediaries on either a weekly or bi- weekly basis, as well as additional ad-hoc engagement with specific firms (for example, relating to business interruption or travel cover) as required. Supervisors’ calls with firms focused primarily on operational resilience.

Insurers and intermediaries were generally resilient to the ongoing challenges and changes that COVID-19 brought. Firms saw a significant increase in call volumes relating to some products, though they managed this by reallocating resources from other areas of their business.

As well as the U.K. lockdowns, the FCA also engaged with firms to understand the impacts of lockdowns in other countries (e.g., India), where some insurers had call centers or claims processing services.

Alongside the continued firm engagement strategy, the FCA also had regular engagement with sector trade bodies and international regulators and organizations, including IAIS and EIOPA as well as EU regulators, US, Canadian and Australia regulators. Insights were shared, including on the FCA’s approach to business interruption and the international reach of Lloyd’s and London market.

Business interruption insurance – The FCA sought clarification from the High Court as part of a test case, aimed at resolving the contractual uncertainty around the validity of many BI claims. Following the decision by the High Court in September 2020 and subsequent insurers’ and FCA’s appeals, the Supreme Court handed down its judgment on 15 January 2021. As a result, many thousands of policyholders had their claims for COVID-19 related business interruption losses paid out. As a result, over 32,000 policyholders have received over •1.25bn in claim payments for Covid-19 related business interruption losses (on 13 January 2022).

Guidance for insurance and premium finance firms – The aim of this guidance was to help customers who hold insurance products and who may be in temporary financial difficulties because of COVID-19. The FCA expected firms to review customers’ cover which could result in premium reductions due to changes in risk profile or the sale of an alternative product which would better meet the customer’s needs, as well as waiving fees associated with altering cover. Where amendments to the insurance cover do not help alleviate the financial difficulty, firms should grant a payment deferral of between 1 and 3 months, unless it is obviously not in the customer’s interests to do so. The guidance was first issued in May 2020, and subsequently updated in August 2020 and October 2020. It continues to remain in place.

Product value and coronavirus – The FCA issued guidance in July 2020, setting out expectations for insurers and insurance intermediaries to consider the value of their products. It highlighted what firms should do to identify any material issues from COVID-19 that affect the value of their products, and their ability to deliver good customer outcomes.

Cancellations and refunds – With an unprecedented number of cancellations of trips, holidays, and other events because of the pandemic, consumers are generally entitled to claim a refund from their travel or service provider. Consumers might also be able to make a claim with their credit or debit card provider, or their travel insurer. The FCA outlined its expectations of firms handling these types of claims and provided guidance for consumers in June 2020. Interventions were designed to ensure that insurance firms, and card providers, handle enquiries and claims from consumers in a way that minimizes inconvenience to the consumer.

Financial resilience survey – Between June and August 2020, the FCA issued the first phase of its COVID-19 impact survey to solo-regulated firms, to help it obtain information about firms’ financial resilience because of the pandemic. 3,370 insurance intermediaries responded to the survey in Phase 1. The survey was repeated after a 3 - month interval. A small number of insurance intermediaries were at risk of failing with the potential to cause consumer harm.

Dear CEO letter on adequate client assets arrangements – The FCA issued letters to CEOs of relevant firms, requiring them to review the adequacy of their client assets arrangements, in view of the current economic environment. Where deficiencies are identified, firms should take immediate action to rectify them, and notify the FCA of any material concerns.

Sources: PRA and FCA.

39. Solvency ratios of U.K. insurers have been extremely stable since the implementation of Solvency II, well above regulatory thresholds, but consistently lower than those of European peers (Figure 6). While being widely dispersed in both the life and the general sector, the weighted average SCR ratio has been hovering slightly above 150 percent since 2016. The average for the EU life insurers fluctuated between 200 and 250 percent, and EU general insurers recorded SCR ratios around 250 percent. There are several possible explanations for the relatively low SCR ratios, one of them being a risk-free interest rate term structure which is being used to calculate insurance liabilities—this curve is structurally lower for the GBP than for the EUR as it relies more on observed market rates and less on extrapolating rates towards an ‘ultimate forward rate’. The PRA is generally satisfied with the level of SCR coverage of UK insurers and actively monitors SCR ratios to ensure that these remain within risk appetite and above the regulatory minimum.

Figure 6.
Figure 6.

United Kingdom: Insurance Solvency Coverage

Citation: IMF Staff Country Reports 2022, 109; 10.5089/9798400206825.002.A001

Sources: IMF staff calculations based on PRA and EIOPA.

40. The impact of both the Matching Adjustment (MA) and the Transitional Measure on Technical Provisions (TMTP)—both integral parts of Solvency II—is substantial for the U.K. insurance market. 18 solo entities applied the MA as of end-2020. Without using the MA, the value of technical provisions would be GBP 42bn higher (+3 percent). Even more significant are the capital savings: The SCR would be higher by 44bn (+60 percent), and eligible own funds to meet the SCR would be lower by 37bn (-32 percent). The TMTP, as of end-2020, was used by 22 firms. Without using the TMTP, the value of technical provisions would be GBP 27bn higher (+2 percent). Eligible own funds to meet the SCR would be lower by 21bn (-18 percent), while the SCR would be higher by a rather moderate 3bn (+4 percent).

41. U.K. insurers are, compared to EU peers, significant users of internal models to calculate the required capital (Figure 7). While less than 20 percent of solo entities use either a full or a partial internal model, these insurers represent around 80 percent of the sector in terms of assets. On average, using an internal model result in a reduction of required capital of around one quarter.

Figure 7.
Figure 7.

United Kingdom: Calculation of the Solvency Capital Requirement

Citation: IMF Staff Country Reports 2022, 109; 10.5089/9798400206825.002.A001

Sources: IMF staff calculations based on PRA.

Key Risks and Vulnerabilities7

42. A top-down solvency stress test of 14 larger U.K. insurers, run by the FSAP team, showed the sector to be largely resilient, with some vulnerabilities stemming from lower interest rates and from equity price declines, particularly for life insurers. These vulnerabilities emerge even despite recent shifts of market risks to policyholders in unit-linked life insurance. The analysis applied two severe scenarios to insurers’ balance sheets as of end-2020, covering around 70 percent of the market. Insurance companies have a broad range of risk-mitigating mechanisms in place which cannot be fully captured in a top-down stress test. In times of financial stress, insurers have several options to restore their capital adequacy and/or their profitability, including changes in underwriting standards, in the reinsurance program or by withholding profits. An even more effective way to improve the solvency position relatively quickly is a de-risking of the balance sheet, e.g., by selling equity or high-yield corporate bonds and buying sovereign bonds instead—this change in the asset allocation can substantially reduce required capital. As the stress test assumed a static balance sheet, these types of management actions were not modeled.

43. In the “scarring” scenario, which assumes a further deterioration of the COVID-19 pandemic, life insurers are considerably more affected than general insurers . While all life insurers would still sufficiently cover their liabilities with assets, the excess of assets over liabilities declines by more than 15 percent for the median firm. Solvency ratios of two firms would drop below the 100 percent threshold, highlighting the need for recovery plans to be ready and effectively executable. The downward interest rate shift of the scenario increases liabilities, but this is partly offset by the MA which rises together with higher credit spreads. Among general insurers, the balance sheet impact is smaller, and solvency ratios remain well above 100 percent. The increase in corporate bond spreads contributes most to the reduction in available capital as it is not mitigated through the MA as is in the life insurance sector.

44. In a scenario of tightening financial conditions, the aggregate impact on both sectors is milder, and most life insurers would even see higher solvency ratios. The sharp increase in interest rates in the scenario generally compensates for losses on investment assets, as the impact weighs larger on liabilities which decline with higher discount rates. For most general insurers, the impact is minor, although interest rate exposures differ across companies—for the median general insurer, the SCR ratio declines marginally. The analysis, however, does not account for the effect of higher claims inflation on the earnings of general insurers, which would be likely according to the narrative of the scenario. Practical difficulties exist, though, in deriving claims inflation from observed consumer price increases, as the disruptions to global supply chains have shown during the course of 2021.

45. Life insurers are largely resilient to variation margin calls in their interest rate swap portfolio, but cash buffers differ markedly at the group level across firms. An analysis of five large life insurers shows that even sizable upward shifts in interest rates would not cause systemic liquidity stress, given existing sufficient buffers of cash and liquid assets.8 However, liquidity risks could increase when other derivative stresses besides interest rate swaps are combined with higher outflows following policy surrenders or catastrophe events, or from lower premiums. The PRA’s experience from March 2020 indicated that insurers used the full range of mitigating measures to preserve and increase liquidity. As an example, they stopped investing cash inflows and withheld dividend payments, but widely tried to avoid asset sales—this could be interpreted in a way that the regulatory incentives for buy-and-hold investments, particularly related to the matching adjustment, have worked in practice. To further analyze combined liquidity strains, exacerbated by reduced market liquidity and fungibility of certain assets, more granular data specific to liquidity is needed, particularly for annuity writers and insurers with large derivative holdings. The PRA has plans to obtain specific liquidity data from certain insurers, which would provide an opportunity to close these data gaps.

D. Preconditions for Effective Insurance Supervision

Sound and Sustainable Macroeconomic and Financial Sector Policies

46. The U.K. Government’s economic policy objective is to achieve strong, sustainable and balanced growth. Price and financial stability are essential pre-requisites to achieve this objective in all parts of the United Kingdom and sectors of the economy.

47. The Bank of England’s Monetary Policy Committee (MPC) sets monetary policy to keep inflation low and stable, which supports growth and jobs. Subject to maintaining price stability, the MPC is also required to support the U.K. Government’s economic policy. The U.K. Government has set the MPC a target for the 12-month increases in the Consumer Prices Index of 2 percent. The Bank of England’s Financial Policy Committee (FPC) identifies, monitors and takes action to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the U.K. financial system. The FPC also has a secondary objective to support the economic policy of the U.K. Government.

48. When the IMF Executive Board concluded the 2020 Article IV Consultation with the United Kingdom, Directors commended the enviable track record of the United Kingdom’s policy frameworks.9 In the accompanying Staff Report, staff noted that the authorities’ policy response to the COVID-19 pandemic was an excellent example of well-coordinated action. Staff were also supportive of monetary policy actions taken by the MPC.

A Well-Developed Public Infrastructure

49. The United Kingdom provides the financial services industry with a robust and stable legal system, skilled workforce, and well-developed public infrastructure. This includes:

  • a well-established insolvency framework

  • an efficient and independent judiciary

  • comprehensive and well-defined accounting principles and rules

  • a system of independent external audits

  • secure, efficient and well-regulated payment and clearing systems

  • efficient and effective credit bureaus and

  • public availability of basic economic, financial and social statistics.

Effective Market Discipline in the Financial Sector

50. The Financial Reporting Council (FRC) promotes transparency and integrity in business. It regulates auditors, accountants and actuaries and sets the United Kingdom’s Corporate Governance and Stewardship Codes. High quality corporate governance helps to underpin long-term company performance. The United Kingdom has some of the highest standards of corporate governance in the world, which makes the U.K. market attractive to new investment.

51. In terms of market discipline, the United Kingdom has an extensive presence of institutional investors and high involvement of major rating agencies and analysts. There are well-developed mechanisms that support market discipline, including a system of regular disclosure by public companies. For insurers, that was materially enhanced in 2016 through Solvency II implementation that set requirements for additional annual disclosures based on supervisory reporting (Pillar 3) and covers issues such as board composition and effectiveness, key functions, the role of board committees, risk management, remuneration and relations with shareholders. The PRA has set out expectations regarding external audit of the public disclosure requirement.10

Mechanisms for Consumer Protection

52. The FSCS is the United Kingdom's compensation fund of last resort for customers of authorized financial services firms. It may pay compensation if a firm is unable, or likely to be unable, to pay claims against it. This is usually because it has gone out of business and/or has been declared in default. The FSCS is independent of the U.K. Government and the financial services industry and was set up under FSMA. It became operational on 1 December 2001 (although it still covers claims from before this date which were protected under previous compensation schemes). The FSCS does not charge individual consumers for using the service. The FSCS covers policyholders for business conducted by firms which are authorized by the FCA and the PRA. Customers of European firms (authorized by their home state regulator) that operate in the United Kingdom may also be covered. The Financial Crisis Management MoU sets out the arrangements for dealing with crisis situations, and the COMP sourcebook of the FCA Handbook and the Depositor Protection and Policyholder Protection chapters of the PRA Rulebook set out when compensation can be claimed and relevant procedures. The FSCS currently covers:

  • deposits

  • insurance policies

  • insurance broking (for business on or after 14 January 2005), including connected travel insurance where the policy is sold alongside a holiday or other related travel (e.g. by travel firms and holiday providers) (for business on or after 1 January 2009)

  • investment business and

  • home finance (for business on or after 31 October 2004).

Financial Markets

The United Kingdom has a large and sophisticated financial services sector which is able to offer a full range of financial instruments to investors (including insurers). The U.K. Government offers a full range of debt instruments (including index-linked and a spread of maturities). Insurers have access to U.K. and international equity and property markets. Increasingly U.K. insurers are moving into alternative asset categories such as infrastructure and private equity. U.K. insurers make use of derivatives markets for risk management purposes.

Table 3.

United Kingdom: Summary of Observance with the ICPs

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Table 4.

United Kingdom: Summary of Observance Level

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E. Recommendations

Table 5.

United Kingdom: Recommendations to Improve Observance of the ICPs

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F. Authorities’ Responses to the Assessment

41. The U.K. authorities welcome the IMF’s comprehensive review of the United Kingdom’s insurance supervisory and regulatory framework. The assessment has come at an important time for the U.K. authorities as they continue to develop and transition to the new regulatory structure and supervisory approach following the United Kingdom’s exit from the EU.

42. The ambition of the U.K. authorities remains for the U.K. financial services sector to be the best regulated in the world, aligning competitive and innovative markets of unquestioned integrity with the highest standards of conduct.

43. The United Kingdom’s approach is centered on forward looking, judgment based prudential and conduct regulation. A key element of the U.K. approach is that it does not seek to operate a ‘zero failure’ regime. Rather it seeks to ensure that a financial firm which fails does so without significant disruption to the supply of critical financial services or a material negative impact on consumers. Therefore, the U.K. approach continues to be risk based, with resources devoted to those areas where the risk to financial stability and policyholder protection is the greatest. The U.K. authorities believe that the current level of scrutiny given to the supervision of smaller firms is appropriate, proportionate and is in line with their statutory objectives, including ensuring the safety and soundness of the U.K. financial system.

44. Once again, the U.K. authorities wish to express their support for the role of the FSAP in contributing to improvements in supervisory practices and promoting the soundness of the financial systems in member countries. The U.K. authorities look forward to continuing the dialogue with the IMF and other global counterparts to work to improve the stability and effective supervision of the global financial system.

Detailed Assessment

A. Detailed Assessment of Observance of the ICPs

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