CP3/23 – Dealing with insurers in financial difficulties

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Responses are requested by Friday 31 March 2023.

The PRA prefers all responses to be sent by email to: CP3_23@bankofengland.co.uk.

Alternatively, please address any comments or enquiries to:
David Lamb, Capital and Compensation Standards Team
Prudential Regulation Authority
20 Moorgate
London
EC2R 6DA

1. Overview

1.1 This Consultation Paper (CP) sets out the Prudential Regulation Authority’s (PRA) proposed rules and policy in respect of the changes introduced by the Financial Service and Markets Bill 2022-23 (FSM Bill) to the Financial Service and Markets Act 2000 (FSMA) concerning insurers in financial difficulties.

1.2 The proposals in this CP would result in changes to the Policyholder Protection Part of the PRA Rulebook (PPP) (Appendix 1), the Policyholder protection Statement of Policy (FSCS SoP) (Appendix 2), the introduction of new PRA rules (Appendix 3), and a new SoP (PRA SoP) (Appendix 4).

1.3 The proposals in this CP introduce:

• new PPP Rules concerning how the Financial Services Compensation Scheme (FSCS) should operate in connection with a write-down and consequential amendments to the FSCS SoP;
• new rules concerning the notification of affected persons; and
• a new SoP setting out the PRA’s approach and expectations in relation to write-down applications and the appointment of write down managers.

1.4 Proposed legislative amendments dealing with insurers in financial difficulties are contained in the FSM Bill. The draft clauses in the FSM Bill require the PRA to take steps to implement the new regime for insurers in financial difficulties. This CP sets out how the PRA proposes to do this. The PRA’s primary objective of firm safety and soundness will be advanced by these proposals. The proposals aim to manage the risks posed by insurers in financial difficulties by allowing a firm to exit the market safely or return to viability, reducing the impact and cost of disorderly failure where an insurer is, or is likely to become, unable to pay its debts. These proposals also contribute to the insurance objective of policyholder protection by facilitating continuity of cover, enhancing policyholder protection through the use of FSCS top-up payments, and by setting robust expectations for how firms should engage in relation to the new regime.

1.5 This CP is relevant to all PRA-authorised insurers (other than the Society of Lloyd’s or friendly societies) with a Part 4A permission, regardless of their size or location. These proposals do not apply to EEA insurers in contractual run-off in the UK, as these do not have a Part 4A permission. This CP is also relevant to the FSCS, policyholders, and counterparties of PRA-authorised insurers, including secured creditors.

1.6 The PRA has a statutory duty to consult when introducing new rules (FSMA, section 138J), or new standards instruments (FSMA, section 138S). When not making rules, the PRA has a public law duty to consult widely where it would be fair to do so. 

1.7 In carrying out its policy making functions, the PRA is required to comply with several legal obligations. Appendix 5 lists the statutory obligations applicable to the PRA’s policy development process. The analysis in this CP explains how the proposals have had regard to the most significant matters, including an explanation of the ways in which having regard to these matters has affected the proposals.

1.8 ‘Have regard’ considerations which were significant in the PRA’s analysis included the principle that the PRA should exercise its functions transparently. By providing details about the PRA’s process and expectations in relation to write-down applications and the appointment of write-down managers, the PRA is improving transparency and predictability.

Background

1.9 In May 2021, HM Treasury (HMT) published the consultation document ‘Amendments to the Insolvency Arrangements for Insurers: Consultation’. This consultation document sets out proposals to enable the UK authorities to better manage insurers in financial difficulties. The proposed amendments include clarifications and enhancements to the court’s existing power, under section 377 of FSMA, to order a reduction of the value of an insurer’s contracts (a ‘write-down’) together with a change to the protection offered by the FSCS in the event of a write-down to allow the FSCS to make top-up payments in relation to eligible claims by protected policyholders.

1.10 In April 2022, HMT published the response document ‘Amendments to the Insolvency Arrangements for Insurers: Response to Consultation’ and in July 2022, the FSM Bill had its first reading. The FSM Bill (in clause 55 and Schedules 12 and 13, of the version as introduced into the House of Lords) makes provision for section 377 of FSMA to be replaced with a new set of provisions (proposed sections 377A-J and Schedules 19A-19C of FSMA, plus consequential amendments), giving effect to HMT’s proposals.

1.11 The new provisions will, in broad terms:

• align the condition for applying to court for a write-down order with the test for administration (ie where the firm ‘is, or is likely to become, unable to pay its debts’);
• allow the court to make a write-down order where this is ‘reasonably likely to lead to a better outcome for the firm’s policyholders and other creditors as a whole (compared with not making the order)’;
• create the role of a court-appointed write-down manager, to monitor implementation of the write-down plan;
• impose a six-month (extendible) suspension of certain termination rights under supply and financial contracts, and a stay on the surrender of with-profits and unit-linked policies (subject to appropriate exemptions); and
• introduce powers to provide FSCS top-up funding.

1.12 These amendments are due to come into force two months following Royal Assent to the FSM Bill.

Implementation

1.13 The PRA proposes that the implementation date for the changes resulting from this CP would be in or around July 2023. The actual implementation date will be set out in the Policy Statement following this consultation.

Responses and next steps

1.14 This consultation closes on Friday 31 March 2023. The PRA invites feedback on the proposals set out in this consultation. Please address any comments or enquiries to CP3_23@bankofengland.co.uk. Please indicate in your response if you believe any of the proposals in this Consultation Paper are likely to impact persons who share protected characteristics under the Equality Act 2010, and if so, please explain which groups and what the impact on such groups might be.

1.15 Unless otherwise stated, any remaining references to EU or EU-derived legislation refer to the version of that legislation which forms part of retained EU law.^{footnote [1]}

2. The PRA’s proposals

Policyholder Protection Rules and FSCS Statement of Policy

2.1 The PRA proposes to amend the PPP to reflect the changes related to write-downs that will be introduced to FSMA by the FSM Bill. The PRA also proposes to make changes to the FSCS SoP to give effect to the new rules.

2.2 Under the current rules in s.377 FSMA, on a write-down, all policyholders have their claims written down by a fixed percentage. If the firm then becomes insolvent, the FSCS looks at the written down amount to determine the amount of compensation payable. This runs counter to the position in an insolvency that is not preceded by a write-down. The FSM Bill sets out that the scheme manager (FSCS) should look at the pre-written down amount when determining: (i) the amount of any top-up payments in the case of a write-down; and (ii) compensation payments where a write-down is followed by an insolvency event.

2.3 While the FSM Bill sets out the general framework for the compensation scheme’s role in a write-down, the detail concerning how the FSCS operates is left to the PRA to provide for in its rules. The PRA rules setting out FSCS protection for insurance business are in the PPP. The PRA proposes to amend the PPP to reflect the changes introduced to FSMA by the FSM Bill and provide clarity to the FSCS by amending the FSCS SoP. The FSCS SoP is addressed to the FSCS in respect of its role as scheme manager of the policyholder protection scheme. It provides the FSCS with further information clarifying the PRA’s expectations in respect of the FSCS’ administration of the scheme. The PRA also proposes to make minor amendments to the FSCS SoP to reflect the new rules described below.

2.4 The PRA’s proposed amendments to the PPP Rules cover:

• Payment triggers – In accordance with the FSM Bill, the PRA proposes that the PPP Rules would oblige the FSCS to make top-up payments only when the court has issued a write-down order (WDO) and the insurer, acting through the write-down manager (WDM), has provided the FSCS with written notification of the write-down order. The FSCS would have no discretion whether to make the payments once it receives the written notification, and so would not need to carry out any cost benefit analysis. However, before any top-up payments are made, the firm and the FSCS would need to enter into a trust deed.^{footnote [2]} To avoid the risk of a WDO being made without a trust deed being entered into, which would mean the FSCS would not be able to make the top-up payments, the PPP Rules would make it clear that the FSCS could only release funds to the firm if the write-down manager acting on behalf of the insurer:
  1. has entered into a trust deed with the FSCS;^{footnote [3]} and
  2. opened a bank account to which top-up payments can be made.

The PPP Rules would specify a set of minimum required terms for the trust deed, to ensure that the top-up funds are only used to make top-up payments to FSCS eligible policyholders.

• Payment mechanics – The PRA proposes that payments would be made by the FSCS directly to the insurer for onward transmission to the policyholders. The PRA considers that requiring the FSCS to make the payments directly to policyholders would be administratively difficult for the FSCS. Obtaining details of the policyholders and administering payments would take considerable time and resource which would result in long delays in policyholders receiving payments and additional cost for the FSCS (and therefore levy payers), undermining the effectiveness of the new rules. The PRA proposes that the FSCS would ensure the insurer has sufficient funds on day one to deal with claims falling due, and then provide funds as and when required in a manner that is agreed between the FSCS and the WDM.
• Recovery rights – The PRA proposes that the FSCS would have a right of recovery against the insurer in respect of the top-up payments. The PRA considers that an additional recovery right is needed because, under the current regime, the FSCS only has a recovery right in respect of compensation payments. The top-up payments are akin to financial assistance, and therefore would not be subject to a recovery right under the current PPP Rules. To ensure that such a right does not reduce the chances of the firm returning to viability or having an orderly run-off and exit from the market, the PRA proposes that:
  1. the recovery right would only be exercised where, and to extent that, the WDO has been terminated or completely lifted by the court; and
  2. in valuing its liabilities, the insurer would not be required to take account of any expectation that the recovery right will be exercised.
• Declaring an insurer in default and final compensation – This would occur when the insurer has been through the write-down process but is not returning to viability, thus triggering an insolvency event. The PRA proposes that the FSCS would only be able to declare an insurer to be in default and provide compensation to policyholders if the WDO has been terminated or completely lifted by the court. The FSCS would not be able to declare a firm in default while a WDO is in force (even if only in part). However, if FSCS wishes to declare a firm in default, in accordance with chapter 10 of the PPP, it would be able to apply to the court for the WDO to be lifted. The PRA considers that the purpose of the WDO is to promote continuity of cover by maintaining an insurer’s solvency to provide it with a chance to return to viability or allow an orderly run-off and exit from the market. Allowing the FSCS to declare an insurer in default while it is still subject to a WDO could undermine this.
• Other rights – The FSCS would retain the right, on a discretionary basis, to use its other powers under chapter 4 and 5 of the PPP (to secure continuity of long-term insurance cover and provide assistance (including financial assistance) to insurers in financial difficulties). The PRA considers that retaining the right to secure continuity of cover and provide financial assistance would provide the PRA with additional tools to protect policyholders of insurers subject to a WDO.

PRA rules regarding notification of affected persons

2.5 The PRA proposes to introduce new rules concerning the notification of affected persons.

2.6 The proposed new section 377F of FSMA will set out the basis on which affected persons are required to be notified of the making and effect of a write-down order by the court. It will also state that an ‘affected person’ will be described in PRA rules. The notification requirement arises after the write-down order has been made and must set out the effect of the write-down order on affected persons, including but not limited to policyholders.

2.7 The proposed PRA rules would specify:

• who an ‘affected person’ is;
• what information they should be given; and
• how such notification should be made (ie its form and manner).

2.8 The PRA draft rules on notification of affected persons are set out in Appendix 3.

2.9 The PRA proposes that all affected persons should be notified of the making and effect of a write-down order. Any notification to policyholders should include details of the impact of the write-down order on policyholders’ rights and obligations in respect of their contract of insurance with the firm which is the subject of the WDO.

2.10 The PRA accepts there may be situations, usually on the grounds of proportionality or impracticality, where relevant reasons and supporting evidence are provided to support a waiver or modification of the above rules. The PRA can grant a waiver or modification in the usual way.

PRA SoP

2.11 The PRA proposes to introduce a new PRA SoP that would set out the PRA’s consent process for an application to court for a WDO and the appointment of a write-down manager.

The PRA’s proposed approach to consent to an application to court for a write-down order

2.12 It is ultimately for the court to determine whether to sanction a WDO under the proposed new section 377A of FSMA. For a WDO to be made, an application must be made to the court. To aid the court in its decision as to whether to make a WDO, the court must be provided with a write-down plan.

2.13 However, the PRA must first consent before an application can go to court. The PRA’s consent to the application does not in any way pre-judge the court’s determination. In all cases, the final decision to order a write-down and appoint a write-down manager remains with the court.

The key stages of the PRA’s consent process

The PRA’s consultation with the FCA

2.14 The PRA leads the process for consent to a write-down application to court but will consult with the FCA as set out in proposed section 377C(5)(b) of FSMA. The PRA proposes that it will assess a write-down application in pursuit of its objectives and engage with the FCA to ensure respective processes are conducted in an appropriately coordinated manner.

2.15 The PRA would review all write-down applications having regard to its statutory objectives.

2.16 The PRA proposes to require that all write-down applications include a draft write-down plan, to enable the PRA to assess the risks to its statutory objectives.

Factors to be considered by the PRA when assessing whether to consent to a write-down application

2.17 The PRA proposes it would consider in each case whether it is appropriate to consent to the write-down application proceeding to be put to court. To facilitate the PRA’s assessment whether to consent to the write-down application, the applicant should provide it with any initial documentary information on the write-down application in a way that allows sufficient time for the PRA to assess the write-down proposals. This should include the rationale for and broad outline of the write-down application including a provisional timetable. The applicant should also explain the type of business to be included in the write-down order and the scale and impact of the write-down on affected persons.

2.18 The PRA proposes that applicants should explain the reasons why a write-down application is compatible with the PRA’s statutory objectives. In particular, what alternative management actions have been taken or could be taken by the firm to ensure that policyholders have an appropriate degree of continuity of cover for the risks against which they are insured. Where the applicant is not the firm, the PRA proposes it would be interested to understand the firm’s view of the applicant’s write-down proposals and rationale.

2.19 The PRA recognises the diversity of insurers and the need to appropriately apply its proposed approach to the particular business of the firm involved when:

• assessing any adverse effects which may result from any disruption to the continuity of financial services as a result of the application proceeding; and
• considering the extent to which policyholders would have an appropriate degree of continuity of cover for the risks they are insured against if a WDO is made by the court.

Write-down proposals

2.20 A new requirement under the proposed section 377C of FSMA is that a write-down application can only proceed with the PRA’s consent. In deciding whether to give consent, the PRA proposes to have regard to the write-down proposals in the context of its statutory objectives.

The PRA’s participation in proceedings

2.21 Under proposed section 377D of FSMA, after a write-down application is submitted to court with the PRA’s consent, the PRA and the FCA are entitled to be heard by the court. The two regulators may provide the court with written representations setting out their respective views on the proposed write-down plan, for example, by way of a report to the court. The PRA proposes it would decide, in relation to each write-down plan, whether it is necessary or appropriate for it to prepare a report, considering its objectives and other relevant matters. Accordingly, the PRA proposes it may approve an application going to court but may still wish to appear in court to make submissions about the plan and seek orders.

The PRA’s consent to the write-down manager appointment (section 377G(4)) and statement of suitability (section 377G(5)(a))

2.22 The PRA proposes to have initial discussions with the firm to understand the scope, timetable, and nature of the proposed write-down application as well as the nominated WDM.

• The WDM is a court-appointed person, nominated by the firm and whose nomination is approved by the PRA, who will monitor the implementation of the write-down plan after the court makes a WDO.
• The PRA may consider having preliminary discussions with the nominee WDM about their views on the write-down proposals before the PRA determines if they are suitably qualified to undertake the role of WDM.
• The PRA will approve the nomination of the WDM in consultation with the FCA.
• An application to court for the appointment of the WDM can only proceed with the consent of the PRA.
• If the PRA considers the nominee WDM unsuitable, then it may nominate a WDM (which may include a member of PRA staff, usually where no appropriate third party can be identified in good time).
• While the PRA must consent to the nomination of the WDM, it is for the court to appoint the WDM.
• The firm will remain subject to regulation by the PRA and the FCA, and in control of the conduct of its business, and is ultimately responsible for compliance with the WDO and the implementation of the write-down plan.
• The WDM will be an officer of the court (and not, for example, an agent of the PRA).
• The WDM’s fee schedule will need to be approved by court as part of the appointment process, and will be treated as an excluded liability under proposed section 377B(1)(c) of FSMA.
• The WDM is able to appoint additional expertise (eg legal, accounting, or actuarial expertise).

2.23 The suitability of a person to act as a WDM depends on the nature of the write-down plan and the firm concerned. When reasonably practical, the intended applicant should choose their nominee for WDM in the light of the criteria advised by the PRA (see Appendix 4). The intended applicant(s) should then advise the PRA of their choice of WDM, unless the PRA requests them to defer nomination or decides to make its own nomination.

2.24 The notification of the proposed WDM should be made alongside the submission of the write-down application and plan to the PRA and accompanied by reasons why the applicant considers the nominee to be a suitable person to act as write-down manager. Relevant details provided should include information about the nominee’s experience and qualifications, the proposed terms and conditions of the nominee’s appointment, including any remuneration arrangements, and any current or previous professional or commercial arrangements with the firm and the applicant if this is not the firm.

PRA objectives analysis

2.25 The proposals in this CP are intended to ensure that the PRA’s rules and policy reflect the changes introduced to FSMA by the FSM Bill in connection with insurers in financial difficulties. The PRA’s proposed rules and policy would provide:

• firms and other applicants with clarity about the PRA’s process and expectations concerning the giving of consent to a write-down application proceeding, and the appointment of a WDM; and
• the FSCS, firms, and WDMs with the required detail on the steps that need to be taken once a WDO is made to allow the firm to notify affected persons, and the FSCS to both make and recover payments under the WDO.

2.26 This contributes to the PRA’s general objective to promote safety and soundness. Providing top-up payments to policyholders, and clarity around the PRA’s decision-making process, would increase the likelihood of the write-down power being used. In turn, this would increase the chance of an insurer in financial difficulties returning to viability or having an orderly run-off and exit from the market. It also contributes to the insurance objective of securing an appropriate degree of protection for policyholders by ensuring that protected policyholders are not worse off in a write-down (compared with the insolvency counterfactual), as they would be FSCS-protected in either scenario.

2.27 The PRA has assessed whether the proposals in this CP facilitate effective competition. The proposals are intended to allow an insurer to return to viability or have an orderly run-off and exit from the market, both of which promote effective competition by providing a mechanism for firms to be rehabilitated or allowed to fail safely and with less disruption.

2.28 The PRA’s secondary objective is also being reformed by the FSM Bill. Relevantly, a new competitiveness and growth objective is proposed, which may be in force around the time the rules and policy proposed in this CP are due to be implemented. Accordingly, the PRA has assessed whether the proposals in this CP facilitate the international competitiveness of the UK economy and its growth in the medium to long term. As these proposals facilitate rehabilitation and safe failure (as noted above), they may in turn make the UK a more attractive jurisdiction for the establishment of insurers, relative to jurisdictions that lack such mechanisms. Moreover, by providing the clarity and detail on processes as described above, the PRA is contributing to the certainty, predictability, and transparency of the regime. These proposals also contribute to UK economic growth by improving the likelihood that firms can exit the market safely or return to viability, while promoting continuity of cover for policyholders. This helps ensure that policyholders are appropriately protected for the risks they have insured, meaning insurers continue to play their role in supporting risk-taking and growth in the real economy.

Cost benefit analysis

2.29 The PRA has carried out a cost benefit analysis of the proposals by comparing the position under the proposed new write-down mechanism to the insolvency counterfactual. This is because the current write-down provision is not used. If we were to analyse the cost and benefits of the proposed new rules against the current regime, it would indicate an increase in costs as the top-up payments under the proposed new rules would relate to the pre-written down amount rather than to the post written-down amount. An increase in top-up costs would in turn result in an increase in the annual FSCS levy. The effect of the new rules is to align top-up costs with the position in an insolvency counterfactual. Further, if the new rules are compared to the insolvency counterfactual, it is likely that the FSCS’ administrative costs would decrease.

2.30 The cost to the FSCS of providing financial assistance is expected to be very similar to the costs associated with a write-down. In each case, the FSCS is providing the level of funding required to enable an insurer to meet its obligations to policyholders, either by increasing its assets (through financial assistance) or funding a reduction in its liabilities (through a write-down).

2.31 Furthermore, there are two mechanisms that should reduce FSCS costs in the event of a write-down, compared to insolvency. First, the intention of a write-down is to avoid the value-destruction and costs (including costs to the FSCS in administering individual claims) usually associated with insolvency, thereby maximising the resources available for distribution to creditors. As such, the difference between an insurer’s assets and its obligations to policyholders (plus costs), and therefore the level of funding and expenses the FSCS is required to incur, should be meaningfully lower following a write-down than in the event of insolvency.

2.32 Second, under these proposals, the FSCS would be able to pursue recoveries against the insurer for ‘top-up’ payments. The FSCS cannot currently pursue recoveries following the provision of financial assistance to an insurer (as it does not take over the claims of any particular policyholders). Therefore, should an insurer’s financial position subsequently improve and additional funds become available for distribution, the FSCS would be in a better position to recover some of its costs following a write-down.

2.33 Taking into account the costs the FSCS is currently likely to incur when an insurer enters financial difficulties, and the two mechanisms detailed above, it is expected that FSCS funding costs would not significantly differ in the event of a write-down. A reduction in FSCS funding costs is more plausible than an increase (given reduced value destruction and the possibility of recoveries). This would mean that the FSCS levy imposed on insurers is not anticipated to increase because of the proposed introduction of the write-down mechanism.

2.34 Given the number of assumptions required, and the lack of data available in relation to write-downs under section 377 FSMA, any quantitative analysis of FSCS funding costs under different insurer failure scenarios is unlikely to be meaningful. Similarly, the direct costs likely to be incurred by firms is difficult to meaningfully assess, and is more a function of the FSM Bill provisions than the proposals in this CP. In HMT’s impact assessment of the FSM Bill, the costs to firms were analysed. HMT noted (at paragraph 8.117) that attempting to generalise these costs into an annual figure based on an assumed number of write-downs would be speculative and potentially misleading.

2.35 As noted in HMT’s response document ‘Amendments to the Insolvency Arrangements for Insurers: Response to Consultation’ (paragraph 3.11), it is likely that an insurer undergoing a write-down would have had its effecting permission removed or limited, closing the insurer to new business. This, together with proposed provisions in the FSM Bill that prevent firms under write-down from dealing in assets, paying variable remuneration, or making distributions without PRA consent,^{footnote [4]} ensure that such firms cannot extract undue benefit following a write-down and do not expose new policyholders to the firm during the write-down.

‘Have regards’ analysis

2.36 In developing these proposals, the PRA has had regard to the FSMA regulatory principles, the aspects of the Government’s economic policy set out in the HMT recommendation letter from 2021 and the supplementary recommendation letter sent April 2022. The following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposal:

1. The principle that the PRA should exercise its functions as transparently as possible (FSMA regulatory principles): The proposals include the creation of new rules and a SoP. This would ensure that the FSCS, WDMs, and firms can understand what is expected of them under the new regime.
2. Competitiveness (HMT recommendation letters): The proposals would ensure that UK-authorised insurers in financial difficulties are given an opportunity to either return to viability or have an orderly run-off and exit the market. This should help maintain the UK as an attractive market for firms.
3. Competition (HMT recommendation letters): The proposals in this CP would improve the likelihood that firms can return to viability or exit the market safely. The PRA considers that the proposals would facilitate effective competition by allowing the exit of underperforming firms; therefore, creating more room for new firms or for existing firms to grow. The proposals would also increase policyholders’ confidence in purchasing policies from a range of insurers in the knowledge that they would be adequately protected should an insurer run into financial difficulties.
4. Growth, trade, and better outcomes for consumers (HMT recommendation letters): The new regime would ensure that policyholders receive a top-up payment funded by the FSCS in the event of a WDO, in contrast to the current regime where the FSCS does not provide any compensation when a policyholder’s claim is written down. The proposals in this CP set out how this top-up process will work.

2.37 The PRA has had regard to other factors as required. Where analysis has not been provided against a ‘have regard’ for this proposal, it is because the PRA considers that ‘have regard’ to not be a significant factor for this proposal.

Impact on mutuals

2.38 The PRA considers that the impact of the proposed rule changes on mutuals is expected to be no different from the impact on other firms. This is because mutuals are able to apply for a write-down in the same manner as any other in-scope firm.

Equality and diversity

2.39 The PRA considers that the proposals do not give rise to equality and diversity implications because their impact is invariant to type of firm or underlying policyholder.