Brexit – PRA consults on approach to UK branches of incoming insurers

On 20 December 2017, the Treasury, PRA and FCA clarified their approach to EEA-headquartered financial services firms wishing to carry on business in the UK post-Brexit. More recent evidence to the House of Commons Treasury Committee ("TC") sheds further light on the PRA's thinking. It also highlights the difficulty for the PRA of giving guidance to firms while so much uncertainty surrounds the UK's future relationship with the EU.

The PRA's consultation (CP30/17) on its approach to third country insurers, a separate “Dear CEO letter" and comments made to the TC on 16 January merit further comment.

Key points for firms discussed in this article include the following:

• Together, the PRA's papers and comments provide firms with a greater understanding of how the PRA expects incoming EEA firms to plan for Brexit.
• Comments made to the TC also recognise the additional costs associated with establishing and maintaining a UK subsidiary as compared to operating through a branch here.
• The PRA's proposed requirements for firms to subsidiarise are, nonetheless, worrying. In particular, applying a test based on the amount of a firm's FSCS-protected business appears to us to be flawed.
• It is not clear whether the PRA's comments relate to both new and in-force business. For a non-life insurer, in particular, a requirement to transfer all of its in-force business (much of which will have a duration of less than a year) to a newly-established subsidiary would result in considerable unnecessary expense.
• The PRA's approach makes a number of assumptions that may turn out to be incorrect. In particular, Sam Woods (CEO, PRA) warns that, if there is no cooperation between the remaining EU states and the UK post-Brexit, "we are not in the business of allowing branches, and firms would have to subsidiarise". This leaves firms unclear whether the approach being taken by the PRA today will change again in the lead-up to Brexit.
• EEA insurers that do business in the UK on a services-only basis are not covered by the PRA's comments. The difference between the EU law approach to the requirement for a services passport and the UK approach to "non-admitted" business means that some EEA insurers should not need PRA authorisation for their coverage of UK risks post-Brexit.

The PRA is consulting separately on its approach to banks (see CP29/17).

The deadline for responses to CP30/17 is 27 February 2018.  In the meantime, firms affected by the PRA's proposals should, if they have not already done so, begin to plan for obtaining authorisation for their activities in the UK.

1. PRA – the need for authorisation

CP30/17 describes the PRA's policy towards authorising and supervising non-UK insurers carrying on (or considering carrying on) insurance business in the UK and that do not benefit from passporting rights. A new Supervisory Statement is intended to supplement Supervisory Statement 44/15 “Solvency II: third-country insurance and pure reinsurance branches”.

The PRA's proposals have been designed in the context of the current UK and EU regulatory framework and its approach is intended to cover all third country firms, including those based in non-EEA jurisdictions. However, it also warns that EEA firms currently branching into the UK under the insurance passport will, subject to the outcome of EU/UK negotiations, need to apply for authorisation to continue to carry on those activities in the UK post-Brexit. The concern, of course, is how those firms can operate in the UK once they have lost passporting rights (assuming that is the result of the negotiations).

On 27 October 2017, the TC published its report on "The Solvency II Directive and its impact on the UK insurance industry". The focus of the report is on Solvency II but it is written against the background of Brexit. One of the TC's recommendations is that "the PRA should adopt pragmatic approaches such as granting provisional recognition to EU branches prior to Brexit".

"Temporary permission" regime

Consistent with the TC's recommendation, the Treasury has confirmed its commitment to ensuring that EEA firms can continue to operate in the UK post-Brexit. If necessary, this will include legislating to enable firms to obtain a “temporary permission” to continue their activities in the UK for a limited period after withdrawal. The Treasury will also legislate (again, if necessary) to ensure that contractual obligations, for example under insurance contracts written before Brexit, can be met (see our blog entry for 22 December 2017 for more on legacy business).

The PRA Letter indicates that the PRA only expects to use the Treasury's "temporary permission" regime as a fall-back. Instead, it will be ready to receive branch authorisation applications from this January. Mr Woods encourages incoming firms who have not already contacted the PRA to do so quickly as the authorisation process can take up to 12 months from the point of application. He does not address the position of those firms that may be required to transfer their in-force business to a newly-established UK subsidiary (see below). This is likely to involve a considerably more expensive and complex, and potentially much longer, process.

2. Branch authorisation – factors to be considered

The PRA lists a number of new factors which it will take into account alongside its existing requirements for third country branch authorisation. In particular, these factors are directed at establishing the "supervisability" of the insurer and include, for example, whether:

• the home jurisdiction's prudential supervision regime is "broadly equivalent";
• there is sufficient supervisory cooperation with the home supervisor (this factor is particularly important); and
• UK policyholders will be given "appropriate" priority in an insolvency and there is no discrimination against policyholders whose business is written in the UK on a winding up of the insurer.

The PRA does not comment at length on the need for supervisory cooperation in CP30/17. Sam Woods' comments to the TC on whether the PRA's approach is consistent with the very different tone struck in EIOPA's opinion of 21st December on cross-border legacy business are, however, revealing.

Mr Woods agreed that the PRA's approach "is robust to a number of outcomes". One concern for the PRA, however, will be if there is no agreement by the end of March on a transition period. Another issue will be how much cooperation there is between the UK and the EU post-Brexit. The PRA's concern is that its ability to supervise the branch of a non-UK firm diminishes if there is no cooperation with that firm's home state supervisor. Mr Woods states:

"If we get no co-operation at all, which is not my expectation, ultimately we are not in the business of allowing branches, and firms would have to subsidiarise."

It is not clear how widely these comments are intended to apply but it is difficult to see how, in the time available, it would be possible to authorise the number of new subsidiaries that would be needed if Mr Woods' comments were intended to apply to all incoming firms. It would also be difficult to reconcile that approach with the current rules on UK branches of non-EEA insurers. On the need for cooperation, it would perhaps be helpful if the PRA could make more explicit its commitment to working with EEA authorities in relation to the companies it supervises. Political constraints may, however, limit its ability to give such reassurance. If so, this would be regrettable.

Two additional factors the PRA will use in its assessment of a branch, but which are not to do with "supervisability", are:

• the scale of UK branch activity that is covered by the FSCS and whether the PRA is satisfied that insurers liable to pay into the FSCS would be able to absorb that amount of loss; and
• the impact of the failure of a firm with a UK branch on the wider insurance market and financial system in the UK.

In summary, the PRA confirms that it will, in some circumstances at least, require incoming firms to conduct their UK business through a local subsidiary instead of through a branch. Its approach is likely to be particularly unhelpful for large retail businesses.

Scale of UK branch activity covered by the FSCS

Where a firm is likely to have more than £200 million of FSCS-protected liabilities, the PRA's default approach will be to require that firm to subsidiarise. Given the requirement for industry to pick up any FSCS costs associated with an insurer failing, the PRA argues that it needs to have greater oversight over a firm that poses greater systemic risk to the UK. It believes that the levels of FSCS-protected liabilities a branch has provide a "straightforward measure" of that risk.

We do not know yet whether the FSCS regime will change to reflect the UK's exit from the EU. However, applying the current rules, policies written by a non-UK insurer through a UK branch are protected if the risk or commitment they cover is situated in an EEA state (including the UK), the Channel Islands or the Isle of Man. Post-Brexit, this may change (for example, risks or commitments situated in an EEA state other than the UK may not be covered) but this outcome cannot be assumed. Either way, it seems likely that at least some EEA firms will, post-Brexit, exceed this level of FSCS-protected liabilities.

In the context of Brexit, the PRA's change in policy may mean that an EEA insurer that currently operates through a UK branch without PRA authorisation will have to transfer that business to a UK subsidiary (which may itself need authorisation if it is a new company) under the relevant home state's law on transfers of business. This is likely to be considerably more complex and costly than simply applying for a new branch authorisation in the UK and it may take much longer. On an ongoing basis, subsidiarisation is also likely to be considerably more onerous than operating through a UK branch. The PRA's approach appears to be more restrictive than some Member States, at least, who have not placed explicit restrictions on their willingness to authorise third country branches going beyond those envisaged by the Solvency II "third country" regime. It should also be recognised, however, that most EEA states do not have insurance guarantee schemes that are as all-encompassing as the FSCS.

UK insurers may also find that their Brexit restructuring options are more limited following the PRA's announcement. For example, some UK insurers may have considered transferring the entirety of their business to an EU hub (under a Part VII transfer or through the redomiciliation of an SE) and then operating their UK business through a UK branch. This may no longer be possible if the business exceeds the PRA's threshold for FSCS-protected liabilities.

Evidence given to the TC goes some way to explaining why the PRA feels it must clamp down on UK branches of EEA firms in the way envisaged. However, we wonder whether this concern is misplaced. The reality is that, post-Brexit, its powers over an incoming branch of an EEA insurer will be greater than at present. The insurer will also still be supervised by a competent, Solvency II-compliant supervisor so there is no rational reason for considering the risk to the FSCS to be greater than it is today (at least, assuming a suitable level of inter-regulator cooperation is agreed). Even if some new factor were thought to be necessary in the assessment of authorisation applications, that factor should be weighed against all of the others. The PRA seems to suggest, however, that the level of FSCS-protected liabilities will be decisive of the need to subsidiarise even if the remaining factors point the other way.

Finally, a test based on a firm's level of FSCS-protected liabilities appears to us to be a very crude measure of risk, particularly for long term business, given that history shows that calls on the FSCS in this sector of the insurance market are extremely rare. For example, the risks associated with £200 million of unit-linked liabilities and £200 million of annuity policies are very different, as can be seen from the capital requirements attaching to each.

Impact of branch failure on the wider insurance market and financial system

Where a branch's FSCS-protected liabilities fall below the £200 million threshold, the PRA may nonetheless require the business to subsidiarise because of the systemic risk it brings to the UK. The risk a firm poses to the PRA's objectives in this context will be assessed according to the:

• ability of policyholders to obtain substitute products offering a similar level of protection;
• branch's importance in the market, looking particularly at market share in a niche market;
• level of connectivity of a branch in the industry it operates within; and
• significance of the UK operations to the firm's overall business.

The PRA argues that a retail life business is most likely to be regarded as "systemic" in these terms. This is because the failure of a single business will usually affect the ability of a large number of policyholders to receive benefits from annuity and other long term insurance policies for many years. As the purpose of the FSCS is to protect against precisely this risk, it is not clear why a further hurdle needs to be set even where the level of FSCS liabilities does not reach the £200 million threshold.

Insurers operating in the commercial sector may also be required to subsidiarise if they have a large market share in a niche market, leaving policyholders with little hope of finding alternative cover if that insurer fails.

The PRA does not expect any of the UK branches of non-EEA insurers currently operating in the UK to be affected by the introduction of this new "systemic" test. It does not, however, extend that comment to EEA firms that currently passport into the UK and who are likely to be affected.

Finally, the PRA's failure to mention pure reinsurers explicitly is surprising given the importance of their role in the UK and the more concentrated market in which they operate.

3. Services business

CP30/17 is directed at third country branches and does not refer to EEA insurers that currently carry on activities in the UK under the services passport. On one reading, comments made by Sam Woods in paragraph 5 of the PRA Letter suggest that the requirement for UK authorisation will extend to all EEA firms who currently passport into the UK. However, his comments are limited to firms who "carry on PRA-regulated activities in the UK", which seems to preserve the current jurisdictional scope of the UK regime. Comments in relation to services business made in paragraph 18 of the PRA Letter should be read in the light of the same qualification.

This should mean that EEA insurers who can satisfy themselves that their activities fall outside the UK regime post-Brexit can avoid the need for any authorisation here. To take a different approach would, in our view, be inconsistent with the basic prohibition in FSMA, as applied to all other financial services activities and products, and legal authority in the UK. It would also place EEA insurers on an unequal footing with other non-UK insurers who already carry on insurance activities in the UK on a "non-admitted" basis.

4. Concluding comments

Firms have welcomed the UK government's reassurances that the UK will remain "open for business" and that it will ensure that obligations under contracts, including insurance policies, existing at the date of Brexit can continue to be met.

Other comments made by the PRA are also supportive of EEA firms wanting to do business in the UK, irrespective of where Brexit negotiations end up. In evidence given to the TC, Sandra Boss (External Member, Prudential Regulation Committee) states:

"Most of the committee members agree … that taking branching as our primary assumption where possible is consistent with the way that we want to be an open economy and want to be cognisant of the additional costs that are associated with subsidiarisation."

Further: 

"We were quite comfortable that to subsidiarise early would be a disproportionate step, and that is one of our considerations."

Nonetheless, we think that the PRA's approach raises concerns for firms, some of which could usefully be addressed in their responses to CP30/17.

Finally, there is little that the UK authorities can do at this stage of the EU/UK negotiations to help UK insurers who stand to lose passporting rights into the EU once the UK leaves the single market. The PRA Letter refers to "positive results" yielded by a European Council meeting on 14-15 December, including "agreement of the need to negotiate an implementation period during which firms could be able to continue undertaking cross-border activity between the UK and EU in much the same way as today".

The EIOPA opinion on cross-border legacy business (see comments in our blog dated 22 December) is less encouraging. This suggests, on the contrary, that UK insurers will need to take steps to ensure that obligations to EEA policyholders can be met post-Brexit and there is little that the UK government can do to help them without broader agreement with EU authorities.