Bank of England warns on soft market discipline, alternative capital

by Artemis on December 3, 2015

The Bank of England’s Chris Moulder, director of general insurance at the Prudential Regulation Authority (PRA), has warned the market to maintain its discipline in the face of continued soft reinsurance market conditions.

Speaking to the Westminster Business Forum in London, UK yesterday, Moulder explained some of the difficulties being faced by insurance and reinsurance companies, as competition continues to ramp up, while prices or rates soften.

His speech covered, among other topics, some of the “risks and consequences of soft markets for insurers and reinsurers and areas of supervisory interest for the PRA.”

Moulder also took the opportunity to reiterate the fact that the Bank of England is set to keep an increasingly close eye on the development of alternative reinsurance capital structures and insurance-linked securities.

He said that the Bank of England and PRA sees the maturity of “alternative capital structures” as an example of one of “a number of evolving risks in firms and for the wider sector.”

As we wrote earlier this week, the Bank of England said that it will review the ILS and alternative capital space in the first-half of 2016, saying that such practices can “create connections between insurance risks and other financial intermediaries.”

Moulder warned that insurers and reinsurers must maintain discipline in the face of increasing competition and softening reinsurance rates.

He said; “With persistently low interest rates and another year without significant natural catastrophes, competitive pressures in many sectors continue.   In several lines premium rates are continuing to fall and extended terms and conditions are being offered and accepted. In addition, there is an abundance of capacity, which in part is driven by capital market structures that allow investors increasingly easy access to specific insurable risks.”

He cautioned that; “Some insurers may be tempted to increase their reserve releases, rely on top line growth or purchase specific forms of reinsurance to meet business plan and market expectations of profitability.”

But noted that the Bank of England and the PRA had responsibility to; “Ensure firms continue to have an adequate level of resilience to meet current and future policyholder obligations.”

Moulder said that the Bank expects boards of insurers or reinsurers to challenge any such moves where a “strategy either threatens this objective, or where the strategy compromises the ability for adequate oversight.”

He said that the Bank wants to understand whether re/insurer boards are getting enough clarity on pricing trends in the market, enough to be able to assess; “Risk-adjusted rate changes, rate adequacy, claims inflation as well as changes in terms & conditions.”

He also said that as prices continue to soften and rates deteriorate, the Bank and PRA will work to “understand how boards ensure effective management of the conflict between business plan objectives, the firm’s pricing practice and setting of reserves.”

The Bank and PRA are also going to look for strong governance around new initiatives, moves into new lines of business, expansion into new regions, expansion of policies to include more than one line of business, multi-year or extended terms of coverage and new risks such as cyber.

On reserving in particular, the Bank of England PRA wants insurers and reinsurers to be able to “demonstrate strong governance around he reserve-setting process.”

At the same time the Bank and PRA want insight into reinsurance practices and usage, seeking “assurance that boards understand the risk transfer taking place and the extent to which the economic impact is adequately recognised in business planning, reserving and capital-setting.”

Moulder said that the Bank has become aware that reinsurance arrangements are becoming more complex in the market currently and that it will “expect appropriate treatment, both with respect to preparing regulatory statements, and with regards to capital requirements.”

“We expect Boards to ensure reductions in capital requirements properly reflect the real extent of risk transfer from the reinsurance arrangement,” he continued.

Moulder also explained that the Bank of England is going to want boards of insurers and reinsurers to ensure that capital levels are adequate, given the softened market can result in more risk being taken on.

“As the market continues to soften, the difference between the projected business plan and the expected underwriting results will tend to increase,” he explained. “Soft market conditions reduce the level of premium as a percentage of exposure.  All else being equal we expect that as premium rates reduce, the level of capital relative to exposure should increase.”

He also said that the Bank is aware of general insurers that are “increasing their risk appetite resulting in increased risk retentions, both at an account and line of business level.” Again this is a practice the Bank and PRA will keep a close eye on.

“We expect boards to understand and challenge the extent to which changes in limits diversification and the soft market contribute to changes in their firm’s assessment of capital requirements,” he stressed.

The speech went on to other topics of less interest to Artemis’ readers, but it is interesting to see the Bank of England PRA representative clearly laying out the fact that the Bank is aware that in a soft and competitive insurance and reinsurance environment, like we see today, there are risks emerging that need to be controlled by boards.

“We expect firms to engage proactively with the broad range of risks I have mentioned today. For me this means that firms need robust governance and monitoring arrangements to give boards the information to make the key judgements necessary to manage risk,” Moulder closed his speech by saying.

Engagement is key, as we’ve said before. But so is having the necessary risk controls in place internally, to ensure that soft market underwriting and reserving practices are not detrimental to capital adequacy going forwards.

Many of the Bank of England’s concerns align with the analysis of recent reinsurance renewal cycles, lower prices, longer duration covers, looser terms and conditions, dwindling reserve releases, centralisation of buying and other factors which can all affect capital requirements and make the picture between plan and actual results differ more greatly than anticipated.

It will be interesting to see how this plays out through the January renewals and into 2016.

Also read:

Bank of England to review ILS & alternative capital risks in H1 2016.

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