UK insurance companies are being warned to make sure they’re resilient enough to weather the effects of the Covid-19 pandemic and rising inflation.

In a letter to CEOs, the Prudential Regulation Authority (PRA) says that risk and resilience are its top two priorities for 2022 – and it expects insurers to have the right risk management policies in place to “address the challenges of a changing economic and claims environment.”

The letter, which is signed by the PRA’s executive directors of insurance supervision, Anna Sweeney and Charlotte Gerken, updates life and general insurance companies on the regulator’s priorities for them this year, and sets out the steps it wants them to take to meet those priorities.

“Our overarching supervisory aim is that, in good times and bad, the insurance sector can continue to provide financial protection and security to policyholders,” say Sweeney and Gerken. “Insurers’ risk management needs to keep pace with the demands of a complex interaction of external risks, and with the changes insurers are making to their businesses, in order that the sector continues to be financially and operationally resilient.

“…[T]he UK insurance industry continues to change shape, including a shift to specialization. While recognizing benefits from the latter, increased concentrations in business and/or operating models bring vulnerabilities that need effective risk management and mitigation.”

Financial resilience

Financial resilience is the PRA’s number one priority during 2022, due to the continuing effects of the coronavirus pandemic on the UK economy making resilience “paramount” to enabling the financial system to carry on supporting families and businesses.

Sweeney and Gerken acknowledge that the full impact of Covid-19 on credit portfolios hasn’t been felt yet, and recovery will likely be “uneven” across different sectors as government support programs come to an end. Consequently, all life and general insurance providers need to closely monitor credit risk within their portfolios and the effect on provisioning; some are facing greater exposure to credit, concentration, and liquidity risk because they have made writing long-term annuity business more profitable by backing their liabilities with a greater proportion of higher spread assets.

“We expect your board to ensure that you have a clear understanding of exposure to credit downgrades and defaults, the impact this would have on your financial position, and your ability to recover from losses.”

Anna Sweeney and Charlotte Gerken, executive directors, Prudential Regulation Authority

“We expect your board to ensure that you have a clear understanding of exposure to credit downgrades and defaults, the impact this would have on your financial position, and your ability to recover from losses,” Sweeney and Gerken tell insurers in their letter. “You need to have adequate risk management in place in relation to this risk, with the board setting appropriate risk appetites, ensuring these appetites are put into practice throughout your business, and assessing your position against a range of scenarios.”

Higher-than-usual rates of economic inflation predicted for 2022 would require insurers to monitor the associated risks and understand the impact on their cost of claims. The PRA expects them to also monitor rates of social inflation, and consider the potential impact of both on their financial resilience and factor it into “prudent” reserving decisions.

The regulator also expects retail general insurance companies to manage the impact on their business models of the updated rules on pricing. In the letter, it says that it will monitor the rules’ impact on business models and underwriting practises across the insurance market, and it expects firms to continue underwriting “on a sustainable basis.”

The insurance sector’s resilience will be assessed with an Insurance Stress Test – a key priority for the PRA that it expects insurers to fully engage with.

Operational resilience

The second item on the PRA’s list of priorities for 2022, the importance of enhanced operational resilience has been demonstrated by the pandemic. According to Sweeney and Gerken, Covid-19 is reinforcing the importance of insurers’ ability to “prevent, adapt and respond to, and recover and learn from” disruptive incidents.

They say that the PRA will continue to challenge insurers to develop “dynamic, effective” risk and control frameworks to manage hybrid working and operational disruptions, including cyberattacks, according to their size and structure. It expects them to strengthen their cyber security measures and to test their resilience to cybercrime.

The PRA has introduced new supervisory expectations on outsourcing and third-party risk management, requiring firms to keep an up-to-date register of their outsourcing arrangements, to strengthen its expectations on operational resilience and to make services provided by third parties, such as cloud computing, more resilient. Sweeney and Gerken say in their letter to insurers that it is “critical” that they ensure that the services they get from third parties can remain within impact tolerances.

“Climate change presents a material and increasing financial risk to firms and to the financial system. Minimizing the future risks from climate change requires action now and remains a key PRA priority,” say Sweeney and Gerken in their letter, noting that some insurers have made good progress in embedding the PRA’s supervisory expectations but progress has been inconsistent.

This year, they added, the PRA will incorporate supervision of climate change’s financial risks into its core supervisory approach, informed by data gathered from last year’s Climate Biennial Exploratory Scenario (CBES) and assessing how firms manage climate-related financial risks.

“We see the objectives of the review as mutually reinforcing: growth, innovation, and investment can be best delivered by an insurance sector on a sound prudential footing.”

Anna Sweeney and Charlotte Gerken, executive directors, Prudential Regulation Authority

Instructing insurers to take a “forward-looking, strategic, and ambitious approach,” the PRA adds: “As our collective understanding of climate-related risks, data, tools, and best practice evolves, we expect firms to refine and innovate to better integrate climate-related financial risk management across their organization.

“There could also be benefits from insurers conducting further research on emerging climate-related financial risks. This includes, for instance, the potential impact of litigation risk on their balance sheets and the impact of physical risks on assets and liabilities.”

Next on the PRA’s list of priorities for 2022 is regulatory change, particularly the review of Solvency II.

Thanking insurers for their engagement with the review so far, Sweeney and Gerken say that the PRA is continuing to work with the UK government on the review, to deliver a package of reforms that reduces firms’ regulatory burden and contains incentives aligned with prudent risk management and government priorities.

“We see the objectives of the review as mutually reinforcing: growth, innovation, and investment can be best delivered by an insurance sector on a sound prudential footing,” they add.

The PRA is also working with the government on a targeted resolution regime for the insurance sector, one that will ensure that issues with insurers can be resolved “in an orderly manner” to reduce the risk to PRA objectives. And it is exploring ways to improve the way it authorizes ILS vehicles and other wholesale insurance firms, so that the process and timescales reflect the risks.

Diversity and inclusion

According to Sweeney and Gerken’s letter, the PRA expects to process around 150 applications for authorization for third-country branches by insurers currently in the Temporary Permissions Regime, during 2022/23. 

The PRA is urging firms to cooperate with it openly and transparently so that these applications are processed, and decisions made, as quickly as possible.

The final priority for the PRA this year is diversity and inclusion, which its letter says enables the insurance sector to be more resilient and links directly to its objectives by bringing a mix of views, perspectives, and experiences to firms.

“An inclusive culture where staff can freely raise concerns and participate appropriately in decision-making can reduce the risk of groupthink, encourage debate and innovation, and support the safety and soundness of firms,” Sweeney and Gerken say. They urge insurers to understand where they have gaps within their organizations and consider how they can close them.