Insurers warned exit planning a must in a world of unique risks

The Bank of England’s director of Insurance Supervision has warned insurers they need to be ready for an era of unique risks and it includes having a clear strategy for exit if needed.

Shoib Khan was speaking in Westminster when he warned that insurance CEOs and directors could not simply rely on past experience to say their businesses remained resilient.

“The world and the risk landscape for insurers has developed rapidly over multiple dimensions in recent times,” he said. “2022 saw the ‘polycrisis’ of the continued impact of the coronavirus pandemic; an unexpected war in Ukraine; a sudden repricing in UK government debt; and a step change in UK interest rates not seen for many years. And very recently, fragilities in the resilience of some international banks have been exposed.

“The context within which UK insurers now operate is well outside the conditions that have prevailed since the global financial crisis. These operating conditions impact insurers across multiple dimensions including credit, underwriting, operational, capital and liquidity.”

Khan continued: “Of course, insurance executives have many decades of experience in navigating different challenges and will assure me that the sector has proved its resilience through past crises. I put to you that the combination of stresses facing the sector today is unique, and it is right to ask if we are ready to navigate the challenges facing the sector today and in the future.”

He said for the vast majority of insurers who are safely ‘in-flight’, the questions he would like to pose to them are:

(i) are they ready for unprecedented operating conditions.

(ii) do they know their key vulnerabilities, from various sources of stress and in various combinations; and

(iii) are they ready for volatility in variables that they have been treating as near constants?

“At some point in their flight path, every insurer will hit turbulence or periods of stress. In such conditions, we ask if they have enough fuel in the tank, and are ready to implement the contingency actions that they have lined up ex ante – especially if competitors are taking the same action simultaneously,” Khan cautioned. “And finally, we should be confident that every flight will have a safe landing. This will be a reality for most firms at some point in their existence, so firms should be ready to make the mindset shift from recovery to exit; and be equipped with exit plans that will allow for an orderly end which protects policyholders and ensures financial stability.”

He said flying has, several similarities to the insurance industry: they are both inherently complex and critical to the functioning of the global economy. Both sectors, to the outsider, also seem rather unremarkable – airline passengers are blissfully unaware of the risks of flying at 600 mph, mitigated by years of pilot training and maintenance programmes; and guided by a global network of air traffic controllers, diligently watching their radar screens and ready to intervene at the right moment.

He said every insurer should have a robust and embedded approach to risk management. “This allows Boards and executive teams to be confident in their ability to manage the business safely in a variety of operating conditions,” Khan added. “As we have seen over the past year, operating conditions can change rapidly, driven by combinations of internal and external variables.

“Models play a critical role in the way insurers manage their risk. They take a vast array of inputs, indicators and expert judgement to produce quantitative narratives which articulate how the future might play out.”

Khan said the PRA encourages firms to develop their own internal models, particularly where firms have bespoke risks which are not captured by the standard formula.

“That’s why we plan to implement a significant streamlining of the rules for internal model approvals, which currently require nearly 200 tests; and instead shift the focus to key principal-based requirements. Also, a streamlined process for considering model changes will help firms keep these models up-to-date and more dynamic.”

He said the capability, limitations and intended use of models must, however, be well-understood by those relying on them.

“To put it another way, we would never expect our insurers to rely solely on autopilot,” said Khan. “Firstly, users of a model should consider whether the factors inside and outside of the business have moved on since the model was first designed. As operating conditions move closer to the boundary of what models were originally designed for, their outputs become less reliable and less informative.

“I would assert that even the most experienced industry practitioners amongst us have not experienced the combination of stresses that firms face today. Whilst I’m not saying that firms should rewrite their models, observed step changes in factors such as longevity, inflation and the impacts of climate change on natural catastrophe events are cause to reassess key assumptions and give greater weight to other non-modelled factors.

“Secondly, users of the model should understand that events in the future may not be reflected in historical experience. We don’t have to look back too far to see an example of this. Only last year, the UK’s financial sector was shaken by the rapid repricing of long-term gilts, requiring the Bank of England to take action to reduce risks of contagion to credit conditions for UK households and businesses.

“Furthermore, models might be misleading in the midst of a crisis – to use the same example, the fact that you have just witnessed a 1-in-100 year rise in gilt yields does not necessarily mean that you would not see a similar rise the next week. Unprecedented events such as these remind us that the need for action – in this case, the provision of liquidity – can arise suddenly, unexpectedly, and assets may not perform as they traditionally have.

“And thirdly, users of a model must understand the intended use of the model and its outputs. Model use should focus beyond one biting scenario to understand how different combinations of stressed inputs can lead to modelled outputs that are just as severe.”

He added that insurers needed to ensure they had considered the worst case scenarios.

“All the stress testing in the world can’t guarantee that insurers will be able to operate unscathed – real-world scenarios may not follow the flight paths neatly mapped out for them in flight simulators, or may even be more severe than estimated in a stress test,” he explained. “With that in mind, insurers need to plan for the most unpredictable events so that they can respond promptly and effectively.

“For most insurers, a key decision in such circumstances will be at what stage to stop writing new business. It’s natural to see writing new business as the way out of a difficult financial position, but sometimes attempts to do that might make things worse.

“Do Boards recognise when continuing to write new business is a good idea, and when it isn’t? By planning in advance for this eventuality and considering which metrics might be most relevant in reaching that decision, insurers can have a clearer idea of the conditions under which ceasing new business may be the most sensible course of action, particularly where capital or liquidity conditions are difficult. “

Khan continued: “Insurers should understand that there will be a point beyond which continuing to push for recovery will not only be fruitless but could make it more difficult for the insurer to exit the market in an orderly way and, in the process, harm policyholders.”

He concluded by reminding  boards and executives of insurers, “to remain guarded against complacency and stay alert of the changing environment around us.

“Using the guiding principle of “it’s not the plane, it’s the pilot”, insurers share an important responsibility in looking beyond the mechanics of their models and risk management processes. This includes knowing when model inputs and outputs are not correctly reflecting prevailing conditions, being confident that management actions will be available when called upon, and knowing that your firm can achieve a safe and orderly exit.”