It’s not the plane, it’s the pilot - speech by Shoib Khan

Speech

Good morning.

Thank you for the invitation to speak at today’s Westminster Business Forum policy conference. I will start with something that I know fellow regulators, risk professionals and actuaries love – a caveat. A caveat that I won’t be focussing today on Solvency UK^{footnote [1]} given that several of my colleagues at the Bank of England have spoken about it in recent speeches^{footnote [2]}. What I will say here is that robust regulation, which maintains the UK’s strengths relative to international standards, remains a core pillar of our ability to remain internationally competitive and attract growth, and that the Prudential Regulation Authority (PRA) will faithfully implement the Government’s proposed reforms^{footnote [3]}. Today, I would like to discuss the unique combination of risks that our industry currently faces and how we, as prudential supervisors, are working to ensure that insurers are ready to maintain their safety and soundness and protect policyholders.

I’m going to focus on three areas: firstly, how insurers’ use of models needs to extend beyond model mechanics; secondly, why assessing the availability of management actions is an important part of stress testing; and thirdly, why all insurers should plan early for an orderly exit.

The world and the risk landscape for insurers has developed rapidly over multiple dimensions in recent times. 2022 saw the ‘polycrisis’ of the continued impact of the coronavirus pandemic; an unexpected war in Ukraine; a sudden repricing in UK government debt; and a step change in UK interest rates not seen for many years. And very recently, fragilities in the resilience of some international banks have been exposed. The context within which UK insurers now operate is well outside the conditions that have prevailed since the global financial crisis. These operating conditions impact insurers across multiple dimensions including credit, underwriting, operational, capital and liquidity.

Of course, insurance executives have many decades of experience in navigating different challenges and will assure me that the sector has proved its resilience through past crises. I put to you that the combination of stresses facing the sector today is unique, and it is right to ask if we are ready to navigate the challenges facing the sector today and in the future.

This idea of navigation brings me to my analogy – which, as you all know, is the key ingredient to any PRA speech – and I’m sure that executives and non-executives of insurers will have no problem imagining themselves as pilots for the next 15 minutes or so. So, let’s look at the flight path in a little more detail.

• At this forum last year, my colleague, Alan Sheppard, spoke to you about the work that the PRA is doing to help insurers ‘take off’ in the UK^{footnote [4]} – whether that is through the authorisation of third-country branches, insurance-linked securities or more traditional entities. Openness to innovation is a key feature of insurance activity in the UK, and a proportionate approach to prudential regulation supports that. In his speech last month^{footnote [5]}, Sam Woods, the deputy governor for prudential regulation explained that we propose: to raise the threshold at which smaller firms are required to enter the Solvency UK regime; to remove branch capital requirements for international insurers operating in the UK; and to simplify expectations around the UK ISPV regime. We are proposing these actions to ease ‘take-off’ for new entrants until they grow enough to be safely ‘in-flight’.
• For the vast majority of insurers who are safely ‘in-flight’, the questions I would like to pose to them are:

1. are they ready for unprecedented operating conditions;
2. do they know their key vulnerabilities, from various sources of stress and in various combinations; and
3. are they ready for volatility in variables that they have been treating as near constants?

• At some point in their flight path, every insurer will hit turbulence or periods of stress. In such conditions, we ask if they have enough fuel in the tank, and are ready to implement the contingency actions that they have lined up ex ante – especially if competitors are taking the same action simultaneously?
• And finally, we should be confident that every flight will have a safe landing. This will be a reality for most firms at some point in their existence, so firms should be ready to make the mindset shift from recovery to exit; and be equipped with exit plans that will allow for an orderly end which protects policyholders and ensures financial stability.

Flying has, in fact, several similarities to the insurance industry: they are both inherently complex and critical to the functioning of the global economy. Both sectors, to the outsider, also seem rather unremarkable – airline passengers are blissfully unaware of the risks of flying at 600 mph, mitigated by years of pilot training and maintenance programmes; and guided by a global network of air traffic controllers, diligently watching their radar screens and ready to intervene at the right moment.

Today, from the PRA’s perspective in air traffic control, I will talk to you about these themes in more detail and the roles that we expect Boards and executives to play in the different stages of an insurers’ flight path.

Use of Models

Every insurer should have a robust and embedded approach to risk management. This allows Boards and executive teams to be confident in their ability to manage the business safely in a variety of operating conditions. As we have seen over the past year, operating conditions can change rapidly, driven by combinations of internal and external variables.

Models play a critical role in the way insurers manage their risk. They take a vast array of inputs, indicators and expert judgement to produce quantitative narratives which articulate how the future might play out. Now, many of you will assume that I am referring to approved internal models that firms use to calculate the Solvency Capital Requirement (SCR)^{footnote [6]}.

Indeed, the PRA encourages firms to develop their own internal models, particularly where firms have bespoke risks which are not captured by the standard formula – that’s why we plan to implement a significant streamlining of the rules for internal model approvals, which currently require nearly 200 tests; and instead shift the focus to key principal-based requirements. Also, a streamlined process for considering model changes will help firms keep these models up-to-date and more dynamic.

But in fact, my message on models applies much more broadly. Common examples of models used by insurers include third-party natural catastrophe models used in pricing and reserving; economic capital models used to make business decisions; and models used to carry out stress testing. What these models have in common is their ability to drive business decisions made by Boards and executives.

The capability, limitations and intended use of models must, however, be well-understood by those relying on them. In our January 2023 letter on supervisory priorities^{footnote [7]}, we reminded insurers to reassure themselves of the continued validity of their models, including the extent to which model risk management principles for banks^{footnote [8]} applies and whether current validation remains robust in the face of multiple concurrent stresses.

To put it another way, we would never expect our insurers to rely solely on autopilot. Let me unpack what I mean by that.

Firstly, users of a model should consider whether the factors inside and outside of the business have moved on since the model was first designed. As operating conditions move closer to the boundary of what models were originally designed for, their outputs become less reliable and less informative. I would assert that even the most experienced industry practitioners amongst us have not experienced the combination of stresses that firms face today. Whilst I’m not saying that firms should rewrite their models, observed step changes in factors such as longevity, inflation and the impacts of climate change on natural catastrophe events are cause to reassess key assumptions and give greater weight to other non-modelled factors.

Secondly, users of the model should understand that events in the future may not be reflected in historical experience. We don’t have to look back too far to see an example of this. Only last year, the UK’s financial sector was shaken by the rapid repricing of long-term gilts, requiring the Bank of England to take action to reduce risks of contagion to credit conditions for UK households and businesses^{footnote [9]}. Furthermore, models might be misleading in the midst of a crisis – to use the same example, the fact that you have just witnessed a 1-in-100 year rise in gilt yields does not necessarily mean that you would not see a similar rise the next week. Unprecedented events such as these remind us that the need for action – in this case, the provision of liquidity – can arise suddenly, unexpectedly, and assets may not perform as they traditionally have.

And thirdly, users of a model must understand the intended use of the model and its outputs. Model use should focus beyond one biting scenario to understand how different combinations of stressed inputs can lead to modelled outputs that are just as severe.

Whether it is due to a change in weather conditions, a faulty indicator or worse, pilots need to know the limits of their models. That includes understanding how reliable models are in different circumstances; how model output can be validated; and, how to use the information that models tell you about the distribution of risk around a central scenario. Knowing these limits allows pilots to balance the use of autopilot with manual control, and we expect firms and their Boards to actively do the same.

Stress testing

Stress testing by extrapolating historic events – such as past hurricanes or economic shocks – provides a valuable complement to the models used to calculate the SCR. Used well, it allows Boards to understand the firm’s resilience to plausible, adverse events. In turn, this can help inform a firm’s risk appetites – the zone within which it can operate safely and confidently – as well as the adequacy of a firm’s risk mitigants, such as reinsurance.

The PRA recently carried out the Insurance Stress Test 2022 (IST22) exercise for a number of the largest insurers which aimed to assess sector resilience to severe but plausible scenarios, guide supervisory activity and enhance the PRA’s and firms’ ability to respond to future shocks. Reassuringly, the exercise concluded^{footnote [10]} that the industry is resilient to a range of PRA-specified scenarios. In aggregate, the life insurance sector’s solvency coverage in stress fell from 162% to 123% and the general insurance sector’s solvency coverage remained above 120% in all scenarios.

But this exercise was not just about understanding whether individual firms are resilient to our scenarios. Sector-wide stress testing allows comparability across firms and our exercise highlighted common gaps in modelling, data and risk management. For life insurers, the exercise highlighted the potential for concurrent management actions across the sector which might limit their feasibility if all insurers call on the same action at once. For general insurers, there were a number of areas for improvement in quantifying losses from natural catastrophes where current practice could lead to a misestimation of scenario impacts.

The point on management actions is worth exploring further.

Even the most skilled pilots will find themselves in trouble. In fact, they train for it – just as insurers carry out stress tests and check the viability of their management actions. They are always ready to deviate from the flight plan and enact a range of management actions such as changing direction or altitude to avoid in-flight hazards. Bad weather, technical issues or passenger disruption can mean that planes may have to divert to somewhere other than their planned destination. This becomes challenging when a number of aircraft are impacted, and they have all inadvertently chosen to fly into the same calmer airspace to recover. Suddenly, a plan viable for one pilot is no longer achievable when all others are thinking exactly the same.

Through IST22, we saw evidence that many insurers would look at similar management actions to manage risk in an adverse scenario, such as relying on their ability to trade out of sub investment grade bonds. In response, insurers should continue to use stress testing to understand their vulnerabilities to a range of severe scenarios; and should extend the exercise to include regular maintenance by checking and rechecking the viability and availability of management actions. Furthermore, they should understand the range of management actions that can be held in reserve, in case those actions that they had relied upon are ultimately not available.

To further improve our view from air traffic control, the Bank of England will run an exploratory system-wide exercise to investigate the behaviours of a range of sectors – including banks, central counterparties (CCPs), insurers and a range of funds – in response to a severe but plausible stress to financial markets. We will investigate how the type of behaviours and market dynamics we found in the insurance stress test can occur in other financial sectors and how they can all interact to amplify shocks in markets and potentially bring about risks to UK financial stability. More detail will be available in the Record of the Financial Policy Committee published on the 29 March.

Ease of exit

All the stress testing in the world can’t guarantee that insurers will be able to operate unscathed – real-world scenarios may not follow the flight paths neatly mapped out for them in flight simulators, or may even be more severe than estimated in a stress test. With that in mind, insurers need to plan for the most unpredictable events so that they can respond promptly and effectively.

For most insurers, a key decision in such circumstances will be at what stage to stop writing new business. It’s natural to see writing new business as the way out of a difficult financial position, but sometimes attempts to do that might make things worse. Do Boards recognise when continuing to write new business is a good idea, and when it isn’t? By planning in advance for this eventuality and considering which metrics might be most relevant in reaching that decision, insurers can have a clearer idea of the conditions under which ceasing new business may be the most sensible course of action, particularly where capital or liquidity conditions are difficult.

The concept of recovery is generally well understood by insurers – it’s how an insurer, blown off-course by adverse weather conditions, can recover its previous flight path and resume profitable trading. But often less well understood is resolvability; when weather conditions are sufficiently bad for a protracted period that the only safe course of action is for the insurer to end the flight prematurely. But this needs to be done by landing in a safe and orderly fashion, and that may mean a different airstrip and time to that envisaged in the flight plan.

Insurers should understand that there will be a point beyond which continuing to push for recovery will not only be fruitless but could make it more difficult for the insurer to exit the market in an orderly way and, in the process, harm policyholders. As we have previously stated^{footnote [11]}, the PRA is increasing its focus to ensure that insurers can exit the market without causing disruption to policyholders or excessive calls on the Financial Services Compensation Scheme (FSCS). The next step on that journey, planned for later this year, is the release of a PRA Consultation Paper (CP) which will flesh out our approach to exit planning and explain what we are expecting to see from insurers.

Insolvency is usually problematic for insurers – not only can it impose significant costs on the FSCS and non-FSCS protected policyholders but, in the case of the UK’s most significant firms, it risks creating market disruption. This applies particularly where an insurer writes large amounts of business or constitutes a highly concentrated proportion of a particular market, so that its exit would mean significant disruption. The PRA, together with His Majesty’s Treasury (HMT), is working to ensure that where other exit routes are not available, firms can exit the market in an orderly way.

An important part of that work is the legislation HMT is introducing to facilitate use of Section 377 of the Financial Services and Markets Act (FSMA)^{footnote [12]}, making it easier for a court to write down a failing insurer’s liabilities and clarifying that any written-down liabilities are subject to the same FSCS protection as before the write-down. That change is expected to land this summer. But for a small number of insurers, facilitating an orderly exit might require a specific resolution regime of the type already available for banks and CCPs. That’s why the PRA is actively supporting the work being done by HMT to create an Insurance Resolution Regime (IRR) – think of this work as the provision of life jackets so that even if the worst comes to the worst, and the plane is forced down in difficult terrain, all passengers emerge safely. HMT published a CP on its proposals in January^{footnote [13]} , and I encourage all insurers to respond. We hope and expect that the regime would only be used rarely, but pressing forward with the IRR is an important priority for the PRA. Its existence will not only bring the UK into line with relevant international standards, but provide more confidence about the UK’s insurance market, which will make the UK a more attractive place for insurers – and those transacting with them – to do business.

Conclusion

I will keep my conclusion short and remind you – the Boards and executive of insurers, who share a responsibility for safety and soundness and policyholder protection – to remain guarded against complacency and stay alert of the changing environment around us.

Using the guiding principle of ‘it’s not the plane, it’s the pilot’, insurers share an important responsibility in looking beyond the mechanics of their models and risk management processes. This includes knowing when model inputs and outputs are not correctly reflecting prevailing conditions, being confident that management actions will be available when called upon, and knowing that your firm can achieve a safe and orderly exit.

Thank you for your time. I hope you’ve had a pleasant flight.

I am grateful to Anooj Dodhia, Nick Parish, Mathesh Sripraba, Beth Rees, Mike Beattie and Alan Sheppard for their assistance in helping me prepare this speech. I am also grateful to Abigail Caldwell, Miranda Hewkin Smith, Nimra Mahmood, Abigail Allin and Lucy Allen for their support and comments.