Insurers have been told that regulators will prioritise resilience, COVID, climate change and credit risk in the year ahead.
In a letter to UK insurance CEO the Prudential Regulatory Authority (PRA) has set out its expectations for 2021 which will include a climate change stress test that will define its approach to climate change risks.
The letter which is jointly signed by the authority’s two Executive Directors, Insurance Anna Sweeney and Charlotte Gerken said the letter has taken the unusual steps of spelling out the priorities to enable firms to prepare.
“Our overarching aim is that the insurance sector continues to be able to provide financial protection and security to its customers when they need it,” it said. “The sector faces an unusually uncertain economic environment and a number of longer-term risks. Our focus will be on financial resilience; credit risk; the operational impact of Covid-19; risks resulting from the end of the transition period; and climate change.
“This is the first time we have set out our priorities for the sector in this way, and we trust it will be helpful as you seek to understand our areas of focus in 2021.”
It added the Covid-19 pandemic has had a significant impact on households, financial markets, and business operations.
“While the insurance sector has been resilient so far, the economic outlook remains uncertain,” it added. “It depends on the evolution of the pandemic and the measures taken to protect public health, as well as the response of households, businesses, and financial markets to these developments. Moreover, factors that may have been eclipsed by the pandemic remain live – whether geopolitical, long term demographic trends, sustained low interest rate environment, changes in conduct environment, or climate change.”
The PRA added the UK insurance industry will continue to change shape, for example via a shift to specialisation and Brexit related business transfers.
“The insurance sector has a crucial role to play in supporting economic recovery through provision of risk pooling to individuals and to businesses, both new and existing; long term investment; and providing security of retirement income,” added the letter. “Our goal is to exercise effective prudential supervision so that insurers adapt and respond to changes that threaten to disrupt their business models, while maintaining standards of governance, risk management, and resilience that result in the continued provision of vital insurance services to the real economy.”
On climate change the PRA said Five UK life insurers and six UK general insurers will participate in the Climate Biennial Exploratory Scenario (CBES), which will launch in June 2021.
“Its objective is to test the resilience of the current business models of the largest banks, insurers, and the financial system to the physical and transition risks from climate change,” it added. “CBES will focus on sizing risks, rather than assessing capital requirements and will facilitate the identification of gaps in firms’ data and the development of risk management processes. We expect firms not participating in the CBES to assess the impact of climate risk on their balance sheets in different scenarios and, from these, identify any major risks.”
It warned the outlook for credit risk remains highly uncertain and insurers are exposed to downgrades and defaults that would accompany any deterioration in credit fundamentals.
In view of the illiquid nature of much of the sector’s credit exposure, both through direct investments and counterparty risks in, for example, reinsurance contracts, the PRA said it expected boards to satisfy itself that the firm is resilient to a wide range of potential adverse credit scenarios in the short and medium term.
“Scenarios should vary in both severity and scope, encompassing for example both general deterioration via an economic downturn as well as deeper distress in sectors to which the firm has concentrated exposures or which are particularly exposed to current risks. The assessment of resilience should encompass both the firm’s capital position and the risk management of illiquid exposures – management of concentration risk in line with the requirements of the prudent person principle for example, and early engagement with potentially distressed debtors.”
“We want to see firms continue to improve the stress and scenario testing they undertake to inform boards and board risk committees’ decision making, including around risk and capital appetite, and strategy setting,” it added.
On operational resilience and outsourcing, the PRA said it will expect firms to consider the steps they will need to take to meet the standards that will be set during 2021.
“We encourage firms to implement the lessons learned from the pandemic, and review how their experiences during that time might impact development of operational resilience as a continuing discipline,” said the letter. “The Covid-19 pandemic has reinforced the importance of operational resilience of the financial sector. Firms have demonstrated a satisfactory level of resilience to date, but changes in working patterns have increased reliance on technology infrastructure.
“In response, we expect firms to place greater emphasis on resilience to cyber threats.”