UK regulator right to retain flexibility to force changes on internal models

The UK's prudential regulator is sensible to maintain the flexibility to force companies to adjust their internal models and increase capital buffers in response to developing risks, even at the risk of a legal challenge in European courts, according to regulatory experts.

The comments come as it emerged that the Prudential Regulation Authority (PRA) is planning to use a system of 'early warning indicators' in its supervisory work on insurers' internal models, which may go beyond the Solvency II framework.

PRA chief executive Andrew Bailey said in a letter to a House of Commons committee that the indicators would be analogous to the leverage backstop for banks featured in Basel rules, and would be used to alert supervisors "as to potential threats to solvency from [Solvency II internal] models being used to pare capital requirements".

The Association of British Insurers (ABI) declined to comment on the regulator's intention to go beyond European regulation and impose additional requirements on firms, which may put UK insurers at a competitive disadvantage vis-à-vis companies operating in the continent.

But experts say there are good reasons for national authorities to be able to identify developing risks that are not properly captured by internal models and preserve the power to ensure that a company's capital buffers remain adequate.

Janine Hawes, head of Solvency II at KPMG in London, says: "If a firm's risk profile changes and the PRA believes the company should have amended its internal model to deal with that, then the PRA wants to be able to spot and address that. There is a lot of sense to that: the capital requirement should reflect the ongoing risks."

Under Solvency II, companies can make material changes to their internal models provided they obtain approval from their supervisor. But it remains unclear whether national regulatory authorities will have discretion to force changes to approved models, says Hawes.

"The big question is how much flexibility national regulators will be allowed. Eiopa [the European Insurance and Occupational Pensions Authority] could build something along these lines into [level 3] guidelines, so all supervisors have to consider how they will assess the ongoing suitability of the model," she adds.

Lawyers say the early warning indicators are not being positioned as a capital requirement, but as a 'traffic light' signal to make supervisors aware of risks. As such, it will be "more difficult to describe it as a derogation" from Solvency II, says Michael Wainwright, partner at law firm Eversheds in London.

This seems to be in line with the PRA's line of reasoning. Bailey said he believed the PRA will be able to implement this supervisory mechanism within the Solvency II framework. However, he promised to do so even if that were not the case and "accept the risk of EU challenge".

This would not the first time Bailey has taken a hard stance towards Europe. He has already called for similar discretion to impose additional capital requirements on banks operating in the UK, in an effort to counter concerns about the over-reliance on internal models.

Bailey also expressed concern with Solvency II being a "maximum harmonised directive", meaning that, unlike Solvency I, national regulators are not expected to supplement it with additional requirements, such as those brought in through the Icas regime in the UK.

He warned that the issue of maximum harmonisation would be a "battleground of the future" as the judgement-based approach to supervision of the PRA comes up against "narrow interpretations of EU law".

Regulatory experts say it is important for national regulators to maintain the flexibility to introduce requirements to reflect the demands of current economic and market conditions. They point to differences between the speed at which markets change and the slow process of decision-making in Europe.

"The world is pretty dynamic and if you are going to be an effective regulator, then you also want the ability to move quickly where you have concerns," says Hawes. "The need to get an agreed EU-wide solution, even in its quickest form of Eiopa guidelines, would slow down the regulators' ability to react."

Wainwright agrees national regulators "need to preserve flexibility and responsiveness to introduce new controls on insurer's prudential requirements and capital, which are not explicitly embedded on Solvency II", even at the expense of European harmonisation.

"The prudential soundness of insurance companies is important enough that it should be regulated properly, even if that means there will be significant differences in how countries are going to achieve that," he says.

That scenario may well become a reality in the next few years. Wainwright says maximum harmonised rules will not be enforced before the Solvency II directive is fully implemented, which is not expected to happen before 2016 due to the delays in the discussions around Omnibus II. It may take even more time if the German authorities obtain a 10-year transitional period for implementation.

"I expect the Financial Policy Committee and PRA will, in practice, be able to impose extra capital requirements, at least in the short term. The problem might arise a decade from now, but it is so far away into the future that any new regulatory tools will have been tested by then and either adopted at a European level or abandoned," says Wainwright.