Financial resilience of UK Insurers

Hot on the heels of its supervisory priorities letter to insurers, which highlighted the importance of financial resilience, the PRA has published the results of its Insurance Stress Test (IST). The test applied PRA-specified scenarios to both life and general insurance (GI) firms' solvency positions in order to assess their resilience to market stresses.

Reassuringly, the PRA found that the UK insurance sector is resilient under the scenarios, subject to 'a number of mitigating measures'. There are, however, key lessons for firms to take away from the exercise, and the results should not lead to complacency. The takeaways that warrant further action or consideration by insurers are explored below.

for life insurers in the IST, the impacts of credit downgrades, property shocks, and longevity improvement were the largest drivers of decline in solvency coverage, with solvency ratios falling from an aggregate of 162% to 123%. Matching adjustment (MA) benefit and the transitional measure on technical provisions (TMTP) helped offset the impact of the stresses, and firms' reinsurance arrangements and management actions also helped to 'dampen' the impact.

Overall, aggregate coverage remained solvent on a regulatory basis. However, life insurers should still be concerned by the IST results as a number of them breached 100% solvency and each of the IST mitigants contains vulnerabilities that could affect coverage in a real-world event:

• Solvency II approvals — while the MA benefit increased and offset most of the corresponding falls in asset values within the MA portfolio, the deterioration on firms' balance sheets was not observed until assets started to downgrade. Therefore, the MA does not automatically reflect market fluctuations. This is one of the key concerns the PRA has been hoping to correct through the — now shelved — proposals to introduce a Credit Risk Premium (CRP) into the Fundamental Spread as part of the UK reforms of Solvency II. The PRA's analysis of the stress test results confirms that it continues to view the sensitivity of balance sheets to changes in credit spreads as an area of concern. Insurers will want to keep an eye on how the PRA will make use of the “safeguards” proposed by HM Treasury as an alternative to the CRP. In the meantime, firms may want to consider adjusting how their risk management frameworks allow them to monitor and respond to such distressed asset vulnerabilities. This includes having Board-approved quantitative risk tolerance limits, and functions that can monitor movements in assets and make interventions to stay within these agreed limits. Additionally, the TMPT benefit will expire on 1 January 2032. Given firms' reliance on this to maintain solvency, they should review their capital management plans to ensure adequate coverage as the benefit phases out and reaches the end of its 16-year tenure. When submitting phasing-in plans to the PRA, insurers should be clear on how they intend to cover the Solvency Capital Requirement (SCR) with eligible own funds.
• Reinsurance — while the PRA did not find concentrations to any specific entities or jurisdictions, it cautioned that uncertainties in claims frequency and inflation, as well as asset valuation volatility, all risked downgrading the financial performance of the reinsurance industry in 2023. Firms will want to monitor both the financial and strategic stability of their reinsurance counterparties, especially where these counterparties provide material risk mitigation services.
• Management actions — in a real-world stress, firms will not be implementing their management actions in isolation; other market participants will also be executing their plans, such as selling sub-investment grade assets. Firms should therefore re-consider the feasibility of their existing management actions and how they could be realistically implemented in a stressed environment. Without such consideration, firms could face material business and solvency challenges. It is vital that Boards are involved in the review of and, if necessary, changes to such actions, especially where the actions need to consider market liquidity and trading costs.

Three natural catastrophe (NatCat) scenarios and three cyber scenarios were applied to GI firms in the IST. In aggregate, GI firms were able to maintain solvency above 120%. Reinsurance was the primary mitigant for losses. As for life insurers, given the uncertain outlook for reinsurers' financial performance in 2023, it is key that GI firms actively manage both their related-party and third-party counterparties — especially in light of hardening global reinsurance and retrocession markets. GI firms may therefore want to revisit their risk appetites and consider what this environment could mean for their retained risks and corresponding net losses.

Additionally, firms should note that numerous entities breached 100% solvency coverage in both the NatCat and cyber scenarios. Again, this demonstrates that impacted firms will need to take action despite the overall resilience of the sector, which for NatCat and cyber are unsurprising, given the increasing frequency and severity of events for the former risk, and the infancy of the latter. The key vulnerabilities for individual firms to address are:

• Modelling gaps — while the industry's approach to quantifying losses has become more sophisticated since the PRA's first NatCat stresses in 2015, there are gaps in quantifying secondary perils¹ and post loss amplification², as well as adjusting for factors like claims inflation (the latter of which will likely not come as a surprise to the market). Firms may therefore want to reassess their models, as mis-estimation in these areas could lead to higher than anticipated losses. For example, to address claims inflation, insurers could consider how it is manifesting in their business (e.g. via court settlement costs, property repair costs etc), monitor its effects across different books of business, assess the appropriateness of existing reserving techniques (e.g. firms may want to reintroduce explicit inflation-adjusted reserving techniques and consider whether prior year reserves may be exposed to inflation), and maintain feedback loops between claims, reserving, capital modelling and underwriting / pricing.
• Maturity of expertise for a relatively new peril — while the GI firms were resilient to the PRA's cyber scenarios, individual firms varied in their assessment of scenario likelihoods, tail risks, and the implications of contract uncertainty. This latter point will chime with insurers, as the disputes over COVID-19-related business interruption cover in recent years serve as an, all too present, reminder of the risks of policy wording uncertainty. Firms offering cyber underwriting should therefore revisit these areas, as they will want robust modelling capabilities and definitive policy language if they plan to achieve their target levels of market coverage and maintain policyholder confidence

The UK insurance sector can take some comfort from its overall financial resilience to the PRA's stress test, but this should not lead to complacency at individual firm level. The IST revealed multiple vulnerabilities for both life and GI firms, and, as the PRA cautioned, the IST did not capture 'changes in the external and economic environment during 2022' — highlighting the importance of continuing stress and scenario analyses at firm level.

Insurers can expect another IST within the next year, with the PRA planning to engage with both life and GI firms in Q2 and Q3 2023 respectively on the detail of the next exercise.