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Capital Extraction by Run Off Firms


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Summary: Solvency II’s new capital requirements have resulted in the PRA issuing new guidance on capital extraction for run-off firms for the second time in under two years. I considers the PRA’s treatment of run-off firms and explains how insurers can tackle the main changes.

The background

Firms could be forgiven for thinking that the PRA’s supervisory statement of April 2014 (SS4/14) set out the PRA’s settled position on capital extraction for run-off firms in the general insurance sector. Instead, on 20 November 2015 the PRA issued a consultation paper including a revised draft supervisory statement. This update was perhaps inevitable to reflect Solvency II and the PRA claims that it does not represent a change in the PRA’s policy, but the guidance has materially changed. This will be relevant to all run-off firms in the sector.

When does the new guidance become “live”?

The consultation on the draft statement closed on 20 January 2016. However, “firms should consider the proposals… if they consider applying for a capital extraction between 1 January 2016 and the publication of the final statement.” In other words, the PRA intends to use the guidance set out in the draft statement from 1 January 2016, even though the statement is not yet final and even before the consultation period has ended! Nevertheless, firms with concerns should have raised them before 20 January 2016. Firms will remember that the PRA softened its stance on solvent schemes of arrangement following considerable industry protest (please see my article, PRA outlines tough solvent schemes approach, published on 1 May 2014 in Insurance Day).

What has changed?

The main changes compared to SS4/14 are as follows:

1. Requests to be made by the CEO or CFO only

The original supervisory statement stated that a request to extract capital should be made to the PRA by an approved person – the new draft statement refers to the CEO or CFO (and no-one else) making the request. This is unlikely to create an issue in practice – one would normally expect the CFO to have approved any such requests – but it indicates that the PRA puts the onus firmly on these two individuals to make any such request personally.     

2. ORSA as a starting point

Solvency II firms will be expected to review their financial position by reference to their Solvency Capital Requirement (SCR) and, crucially, its “overall solvency needs as required for inclusion in a firm’s ORSA”. Interestingly, the April 2014 statement referred to their solvency position, so the terminology has become broader but also the PRA intends to treat the ORSA as the starting point for all such capital requests, not just a guideline. The statement provides that the PRA does not expect to see requests for capital extractions which would lead to lower capital than the firm’s ORSA solvency needs, even if this figure is above the SCR.

3. End of the 200% test

The main industry concern surrounding the original supervisory statement was that the PRA would likely request an independent review if the extraction resulted in projected coverage of less than 200% above the ICA. Many felt that this figure was arbitrary and will welcome its disappearance. It has been replaced by a reference to the proposed extraction resulting in the projected financial resources in a “stressed scenario being less than either its overall solvency needs or SCR”. The PRA does not elaborate on this and “overall solvency needs” is of course a wide concept but Solvency II is a maximum harmonisation directive so this should not be an excuse for gold-plating. Or at least that is the theory. As for stress testing, this is now a fairly widely understood concept, used as part of the ICA in the Solvency I regime.

Concluding thoughts

Of course, for some firms the SCR or ORSA calculation may result in a higher capital requirement and for others, a lower or similar capital requirement but that is the consequence of Solvency II itself, not the new statement. It is welcome that the PRA has not again sought to impose a different capital test for run-off firms: no evidence of gold-plating there.

However, firms should bear in mind the PRA’s continuing emphasis on the accuracy of data and the 3 – 5 year projections. In determining whether to approve a request to extract capital, the PRA will take into account “any other information that the PRA deems to be relevant”. So firms (still) cannot be certain how the PRA will react to any particular request but the move away from a more formulaic test – and a reliance on Solvency II requirements as the benchmark – is a welcome change.

Report: How should you respond to developments in financial regulation this year?

Our team of financial regulation experts have produced a comprehensive report examining the key developments this year, including over 30 practical articles and a calendar setting out the key dates for your diary. Key topics covered include MiFID II, SMCR / SIMR, data protection and advice for regulatory interviews. Obtain a copy of Emerging Themes in Financial Regulation 2016.

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