The Prudential Regulation Authority (PRA) recently published a letter addressed to CEOs summarising the regulator’s findings from the Insurance Stress Test 2022 exercise (IST 2022). This letter included a breakdown of stress impacts in aggregate across all firms and the common themes they need to be aware of.
Life insurance impacts
In the letter, the PRA highlighted that 16 UK-regulated life firms across 12 groups took part in the IST 2022. This exercise comprised a stress scenario of severe market shocks and improvements to life expectancy, specifically designed to focus on life insurers with significant exposure to annuities.
The test found that the aggregate capital surplus of life firms fell from £34.2 billion to £18.4 billion (28 percentage points) due to market shocks, and continued to fall from £18.4 billion to £12.3 billion (12 percentage points) due to the additional longevity shock, with two of the 16 firms seeing their solvency capital ratio fall below 100%. A further three firms saw their solvency fall to a level where material actions, such as capital injection, would be required to bring SCR coverage back to within target risk appetite.
The PRA also observed that firms’ Matching Adjustments (MAs) did “not automatically take account of market signals relating to elevated credit risk at the point where they start to come through.” As fundamental spreads remain unchanged under stress, total solvency coverage across all participants improved during the initial spread shock. However, the subsequent downgrade impact was the largest single contribution to solvency coverage deterioration.
Essentially, in this kind of delayed downgrade scenario, firms could find themselves with a ticking timebomb of distressed corporate bonds that isn’t reflected in their balance sheets. The PRA noted that “firms need to have adequate risk management in place in relation to [credit downgrade] risk”.
While the 2019 IST also contained significant downgrade stress, the PRA’s message to chief executives is more direct this time. The letter issued for IST 2019 noted that “most firms are sensitive to a severe downgrade stress of this kind, but that it would be manageable, particularly given that firms have a range of management actions available to absorb losses which tend to arise over a reasonable timeframe”. Last year a consensus wasn't reached on proposed changes to the operation of fundamental spreads within the Solvency II reforms. The PRA had set out plans to link fundamental spreads to current spreads, increasing the default allowance under a credit spread widening stress.
Under those plans, the profile of the stress impact for this exercise would have changed, bringing in much of the negative impact after the initial credit shock. While, in his recent speech to the ABI, Sam Woods (PRA Deputy Governor) committed to not trying to “reverse-engineer” the effect the PRA had been looking to achieve, firms should expect the PRA to continue to pay close attention to the operation of the MA under stress.
Insurance: PRA focus on recovery planning
The letter also raised liquidity as a key concern, with life insurers stating they would look to liquidate £8-9 billion of sub-investment grade assets in order to protect solvency under stress. In particular, the PRA stated that firms should “consider how realistic it is for them to be able to sell assets in conditions following a market-wide stress where there may be few willing buyers”. This signal comes four months after the Bank of England’s actions to stabilise Gilt markets in the wake of rising government borrowing costs causing collateral calls on pension scheme liability-driven investments.
Additionally, on the theme of management actions, the PRA highlighted that few firms appeared to consider the interdependency of management actions, such as how the capital required to restore target solvency coverage depended on completing asset trades.
Reinsurance also played a big part in mitigating the impact of longevity stress. No concerns were raised about this reinsurance with the PRA stating that “reinsurer concentrations are well diversified” and that “no immediate concerns have been identified regarding the financial security/stability of the reinsurance arrangements in place”.
Many firms relied more heavily on the transitional measure of technical provisions (TMTP) under stress. As the industry approaches the halfway stage of the run-off of TMTP, the PRA urged firms to “review their phasing-in plans to cover the SCR with eligible own funds when TMTP expires".
It's important to highlight that the hot topic of the last 12 months, inflation, wasn't addressed quantitatively in IST 2022. However, firms did provide commentary on the impact inflation may have in the coming year. While direct impacts aren't expected to be significant, many called out second-order impacts on the economy as a concern.
Climate risk: PRA publish ‘Dear CEO’ letter on SS3/19
Seventeen general insurers and 21 Lloyd’s syndicates, as well as Lloyd’s of London, took part in IST 2022, which assessed the impact of a set of three severe natural catastrophes (nat cats) and three cyber losses. These entities accounted for just under three-quarters of the UK general insurance sector. The overall SCR coverage ratio remained above 120% in all scenarios.
A further three firms saw their solvency fall to a level where urgent management action, such as capital injection, would be required to boost SCR coverage.
Nat cat risks
The nat cat-related stresses considered the following scenarios: US hurricanes, California earthquakes, and UK windstorms and floods. This exercise highlighted that insurers’ approaches across the sector have become more sophisticated since the first nat cat stress tests in 2015. Specific aspects that entities were able to address particularly well included the quantification of earthquake ground-motion uncertainty and the UK west coast storm surge.
Despite the modelling improvements, a number of modelling gaps were still identified, including the quantification of loss modifying factors such as claims inflation, post-loss amplification and secondary uncertainty. Post-loss amplification captures the effect of a cat event increasing costs, for example, due to a material shortage increasing repair costs. Secondary uncertainty refers to the uncertainty in the amount of loss given the cat event has occurred.
Only around 50% of participants fully captured secondary uncertainty in the scenarios, while this was not captured at all by the remaining 50% of participants. Post-loss amplification was fully captured by around 75% of participants, with around 20% of participants partially capturing it. The PRA has noted that these modelling gaps remain an area of interest, and it encourages firms to reflect on the limitations of their models and any need to remedy gaps in the models.
The cyber-related stress tests considered the following scenarios: cloud outage, mass data exfiltration, and systemic ransomware. It was apparent from this exercise that the perceived likelihood of the cyber scenarios varied significantly across participants. For example, the difference in opinion of the likelihood of a 7-day global cloud outage ranged from a perceived 1-in-50-year event to a 1-in-475-year event. Although the PRA notes, this isn't unusual for a relatively new product, the PRA encourages the market to ‘develop greater consensus to ensure capital comparability across the sector’.
Another finding is that non-affirmative loss, often known as ‘silent cyber’, has reduced significantly compared to the stress tests carried out in 2019. Non-affirmative exposure relates to the risk of a loss where the peril has not been explicitly considered and/or priced for during underwriting. Although several firms reported no non-affirmative losses, the PRA encourages insurers to ‘continue to robustly assess and actively manage this exposure’.
The ability to assess the impacts of contract uncertainty was mixed among participants. A number of firms were unable to identify the implications should key exclusions not hold, and overall this was variable. The PRA encourages boards to be aware of this uncertainty and its associated impacts. Boards should ensure exposures continue to be managed within their risk appetite.
The IST 2022 highlighted that UK non-life insurance entities are materially dependent on the global reinsurance market in order to mitigate losses. There's an ongoing reliance on the ‘availability, contractual performance, and structural suitability’ of reinsurance arrangements, as well as the stability of the reinsurance counterparties, following a catastrophe, whether nat cat or cyber. The PRA has stated that in response to the IST 2022 findings it will undertake ‘targeted supervisory investigations with selected firms to assess potential reinsurance risks to their financial and business model stability’.
General insurance firms demonstrated stronger governance processes compared to Life firms. Roughly a quarter of general insurers, mostly from the London Market, had their results approved by their board prior to submission. In comparison, none of the life insurance firms that participated in the stress testing exercise had obtained board approval prior to submission. The PRA stresses the importance of board scrutiny and discussion, and it encourages greater board engagement.
The PRA intends to discuss the timing for the next exercise in Q2 for life firms and Q3 for GI firms. The next life exercise will see results published for selected individual firms as “an opportunity to enhance the effectiveness of market discipline in complementing prudential standards and to give market participants continued confidence in them as counterparties.”
Firms should expect this next exercise to build on the themes covered in the PRA’s letter setting out their priorities for 2023. Therefore, credit risk should remain an important part of Life stress testing, with a greater focus on liquidity risk.
For general insurers, we would expect non-natural catastrophe risks, including emerging risks, to make up a significant part of stress tests. Insurers should reflect on the limitations of their models and any need to remedy modelling gaps.