PRA and insurers react to COVID-19

Life insurers in particular breathed a welcome sigh of relief on 11 March when, as part of a co-ordinated move with measures affecting banks and the budget measures, the Prudential Regulation Authority (PRA) announced that it would accept applications from insurers to recalculate the transitional measure on technical provisions (TMTP) as at 31 March 2020. If approved, a recalculation will undoubtedly improve insurers’ solvency capital positions.

The PRA’s announcement came in light of movements in risk-free rates since 31 December 2019 (the previous biennial date of permitted TMTP recalculation) and the fact that, in its view, the risks posed by COVID-19 are sufficient to meet a broad definition of a change in risk profile that for some firms may be ‘material’.

When Solvency II came into force, it included the TMTP, which was designed to help smooth the capital impact of Solvency II over a 16-year period. The TMTP gives insurers a fixed amount of regulatory capital that (among other things) offsets the day-one impact of the ‘risk margin’ (a controversial amount that significantly increases an insurer’s technical provisions), with that fixed amount running off linearly over 16 years. The risk margin is the discounted present value of capital costs and is therefore highly sensitive to interest rates.

But while the TMTP is a fixed amount, the risk margin is not – it has come under considerable criticism for being too large and too sensitive to interest rate movements (particularly in relation to business subject to long-term guarantees, such as annuities).

Significant interest rate falls can mean a sizeable increase in an insurer’s risk margin and, without a recalculation of the TMTP, this creates a severe weakening of its solvency position and a direct hit on own funds. On a recalculation, insurers may be able to reduce the capital they hold, in particular the assets to cover reduced technical provisions.

Recalculation of the TMTP is only permitted biennially or more frequently where the risk profile of the firm has ‘materially changed’. Following yesterday’s announcement, there is likely to be a flurry of activity from insurers making applications claiming exactly that.

While the recalculation of the TMTP is welcome, the potential impacts of COVID-19 are widespread. It is significantly affecting the operations and risk exposure for many businesses who will be looking to rely on their insurance cover to mitigate their losses. We are already seeing sporting events being cancelled, business being interrupted, and we expect to see an increase in claims made.

Insurers are taking steps to manage potential claims from the outset. For example, some have limited the cover they provide to new customers and paused sales of new travel insurance policies to protect against the spiralling costs of dealing with travel disruption caused by the outbreak.

This week we saw COVID-19 designated as a ‘notifiable disease’ in order to make it easier for business affected to make claims although it is arguable whether this will in fact cover many businesses who have taken out business interruption insurance.

At the moment, the general view in the industry is that COVID-19 itself is not likely to open the flood gates to costly pay outs. The concern is the threat insurers face from exposure to interest-sensitive assets, which the recalculation of the TMTP aims to address. Indeed, under Solvency II, all UK insurers should be capitalised to withstand severe events such as a pandemic and all firms should have in place contingency plans with the regulators to deal with circumstances such as this.