Lloyd’s and the Lloyd’s Market Association (LMA) – Written Evidence (FRS0028)

1. Summary

I.            Our overriding concern regarding insurance regulation and supervision following Brexit is the retention of access to the EU Single Insurance Market, on terms as close as possible to those in existence today – i.e. passporting. 

II.            The most straightforward way to do this would be for the UK to remain a member of the EEA. If the UK does not pursue this option, its future relationship with the EU should include an agreement for mutual insurance and reinsurance market access, based on continued alignment of the UK’s insurance regulatory regime with that of the EU.

III.            Decisions are already being taken by UK-based insurers to move business activity outside the UK, including by establishing subsidiaries in other EU member states, affecting UK jobs and turnover.

IV.            If there is insufficient time to negotiate a UK – EU agreement before the UK is due to leave the EU, it is essential that a transitional arrangement is agreed. Such an arrangement should retain the status quo, so far as possible and needs to be agreed very soon.

V.            It is in the overriding interests of policyholders and therefore essential that the UK and the EU seek to address the problems that will arise post-Brexit from insurance contracts written by insurers on a passporting basis pre-Brexit. This should ensure that all obligations can be met, especially payment of claims to policyholders post Brexit

VI.            We would not support an approach to insurance regulation in the UK which sought substantially to revise the existing regime, based on Solvency II. This would give rise to unnecessary costs and upheaval and would probably make it impossible to retain market access between the UK and the EU. At the same time, we believe that there is scope to make detailed adjustments to Solvency II in the light of experience, providing market access is maintained. 

VII.            EU financial legislation includes provisions relating to the “equivalence” of third country financial regimes (the UK will be a third country once it leaves the EU). In general, these provisions do not provide market access to third country undertakings. 

VIII.            Nevertheless, in some areas equivalence can be useful. Solvency II contains provisions on reinsurance equivalence and, after Brexit, it would facilitate the ability of UK-based undertakings to provide reinsurance in the EEA if the UK obtained reinsurance equivalence under Solvency II.   

2. Introduction

1.     We appreciate the opportunity to submit evidence to the House of Lords EU Financial Affairs Inquiry into the future of financial regulation and supervision following Brexit. This evidence is submitted on behalf of Lloyd’s and the Lloyd’s Market Association (LMA).

Lloyd’s and the Lloyd’s Market Association

2.     Lloyd’s is a society or corporation of members constituted under the Lloyd’s Acts 1871 – 1982. It operates as an international insurance and reinsurance market, based in London. Lloyd’s is regulated in the UK by the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA), in accordance with the Financial Services and Markets Act (FSMA).

3.    The Lloyd’s members who underwrite insurance and reinsurance business are organised into syndicates, which are managed by Lloyd’s managing agents. Currently there are 83 syndicates and 53 managing agents in the Lloyd’s market. Managing agents are members of the LMA, which represents the interests of the Lloyd’s community, providing professional and technical support to its members.

4.    In 2016, the Lloyd’s market’s aggregate gross written premiums amounted to £29.9bn, on which it made a profit of £2.1bn before tax[1]. Nearly all these premiums relate to non-life insurance and reinsurance business: a small amount of life insurance is underwritten in the Lloyd’s market on a “pure protection” basis, but life premiums constitute less than 1% of the market’s premiums overall. Consequently, this response focuses on the regulation of non-life insurance and reinsurance.

5.    Lloyd’s is at the centre of the London insurance market, the global centre for commercial and speciality insurance. In 2015, the London market’s total gross written premiums were £71bn and it employed 35,000 people in London and 17,000 elsewhere in the UK[2]. Most of its business is international:  for example in 2016 85% of Lloyd’s premiums originated outside the UK[3].    

Insurance and insurance regulation

6.    Insurance is a key financial service in the UK and of significant importance to the economy. Insurers generate revenue, provide employment and support economic activity generally by allowing businesses and private individuals to transfer financial risks in return for a premium. Risks are thereby pooled and uncertainty reduced, benefiting the wider economy.

7.    Regulation is an important element in insurance markets. Nearly every jurisdiction worldwide regulates insurance undertakings, to ensure that they conduct business fairly and have the financial strength to pay claims and provide benefits to their customers under insurance contracts. Insurance regulation aims to protect policyholders and usually takes account of the stability of financial systems[4], although it is widely recognised that “traditional” non-life insurance activities do not pose systemic financial risk. The International Association of Insurance Supervisors (“IAIS”) summarises the purposes of insurance regulation as:

8.    “A sound regulatory and supervisory system is necessary for maintaining a fair, safe and stable insurance sector for the benefit and protection of the interests of policyholders, beneficiaries and claimants (collectively referred to as policyholders…) as well as contributing to the stability of the financial system.”[5]

9.    Insurance is fundamentally concerned with spreading risk: “upon the losse or perishinge of any Shippe there followethe not the undoinge of any Man, but the losse lightethe rather easilie upon many, then heavilie upon fewe. …”[6]. Provision of insurance and reinsurance on an international basis across borders is an essential element in a strong, financially-secure global insurance industry. It encourages the growth of large, financially secure insurance undertakings capable of assuming big risks and means that risks are spread more widely outside national borders, whilst business and private individuals have greater choice in providers and products.

10.           Because they are regulated activities, international insurance and reinsurance require their providers to have authorisation to operate across border under national laws and regulatory systems – “market access”. This means that national supervisors must be confident that the undertaking concerned does not pose a threat to local policyholders or financial stability. Confidence is facilitated by international supervisory co-operation and alignment of regulatory approaches between jurisdictions. 

11.           It is clearly appropriate for a country to consider the impact of its financial regulatory system on its financial sector, and to seek to avoid unnecessary regulatory burdens. At the same time, it is valuable to retain regulatory alignment and co-operation with other jurisdictions, especially when this underpins market access. The UK should therefore think very carefully about the full impact of any changes it makes to its financial regulations after it has left the EU.      

12.           The priority issue for Lloyd’s and the LMA is market access. They therefore support continued alignment between the insurance regulatory systems of the UK and the EU after Brexit.  

3. Responses to questions raised

Current regulatory regimes

1.      What is your overall assessment of the EU financial services regime, in light of its current application to the UK? To what extent is it effective, and for whom?

1.1.          Our overall assessment of the EU’s financial services regime, in light of its application to the UK’s non-life insurance and reinsurance sector, is broadly positive. It provides an environment in which policyholders have appropriate protection and access to a wide range of insurance products in competitive markets, whilst insurance and reinsurance undertakings can carry on business profitably. We elaborate on this below and outline the benefits to policyholders and insurance undertakings, as well as highlighting recent reforms and their impact. 

The EU Single Insurance Market

1.2.          The EU’s insurance regulatory regime establishes a Single Insurance Market under the EU’s Treaties and grounded on Treaty principles, in particular freedom of movement of capital and services and freedom of establishment. Insurance and reinsurance undertakings and intermediaries established in EU Member States[7] can establish and provide services throughout the EU without additional authorisation from host country authorities. For the Lloyd’s market, important features of the Single Insurance Market are:    

• Recognition of Lloyd’s as a single insurance undertaking: (“the association of underwriters known as Lloyd’s”), which constitutes a legal form of undertaking to carry on reinsurance, life and non-life insurance.
• Authorisation in the home member state: to take up the business of insurance or reinsurance is valid for the entire EU.
• Financial supervision of insurance and reinsurance undertakings: is the sole responsibility of the home member state. 
• An insurance undertaking can establish a branch in another member state (the host member state) or pursue business there on a freedom of services (cross-border) basis, after completing simple, straightforward notification processes. The undertaking does not have to maintain technical provisions or capital in the host member state and generally does not have to submit material supervisory returns there.

1.3.          The Single Insurance Market requires a uniform legal framework, laid down by the EU through directives and regulations. Supervision of individual undertakings is a member state competence, although the European Insurance and Occupational Pensions Authority (“EIOPA”) provides a co-ordinating role.

1.4.          The EU’s insurance regulatory framework developed over many years: there have been four generations of insurance directives since the 1970s. The single European licence for insurance undertakings – a key element in the Single Insurance Market – arrived in 1994, when the Third Life and Non-Life Directives came into force. At this stage, EU insurance regulation took a “minimum harmonisation” approach, leaving much scope for variations between member states’ regulatory regimes. The Solvency II regime now in force takes a “maximum harmonisation” approach, reducing – but not eliminating – differences in regulatory approach between member states.

1.5.          The Single Market for insurance and reinsurance intermediaries is a more recent development, dating back to October 2004, when member states were due to transpose the Insurance Mediation Directive (Directive 2002/92/EC) into national laws. The Insurance Distribution Directive (Directive (EU) 2016/97) replaces it in February 2018.

Benefits of the Single Insurance Market

1.6.          The Single Insurance Market means that insurance and reinsurance undertakings based in the UK have access to a market of over 500 million people, accounting for 24% of the world’s GDP[8]. Expenditure on insurance is linked to economic activity and development and national prosperity: the EU includes many wealthy countries and insurance spend is relatively high. In 2016, 5 of the 10 countries worldwide with the highest per capita premiums were in the EU[9]. The Single Insurance Market is the second-largest non-life insurance market in the world, after the USA, responsible for 26% of global non-life premiums[10]. The Single Market broadens the availability of insurance products to EU citizens, from a wider range of providers than are present in purely national markets, reducing prices and enhancing customer options.    

International insurance business

1.7.          As a single insurance market made up of several individual national markets, the EU is unique. Most national systems of insurance regulation require undertakings to be authorised locally and to comply with local prudential regulatory requirements.

1.8.          This is a factor of major importance to Lloyd’s. Lloyd’s is an international market, with a portfolio of over 80 licences/authorisations allowing Lloyd’s underwriters to trade in other jurisdictions. These licences are an important element in Lloyd’s commercial success. Lloyd’s depends on (mostly non-UK) investors providing capital for Lloyd’s businesses, because they believe that Lloyd’s, with its extensive suite of licences, is a competitive platform for international insurance and reinsurance business. The threat, due to Brexit, of losing 30 of these authorisations – representing access to 30 EEA national markets – is therefore a big concern to Lloyd’s.

1.9.          In recent years, emerging markets in Latin America, Asia and Africa have been growing faster than the developed markets in which Lloyd’s is particularly well represented. However emerging markets usually maintain strict restrictions on the ability of foreign insurance undertakings to carry on business. They often prohibit cross-border activity and, if they permit foreign insurers at all, require them to establish local fully-capitalised subsidiaries, imposing costs and inefficiencies which the EU Single Insurance Market eliminates.

1.10.     These regulatory barriers present particular challenges for Lloyd’s, in view of its unique structure and operational shape. Difficulty in writing business on a cross-border basis affects all London market insurers: the London market saw its premiums from emerging markets decline from USD 10.5bn in 2013 to USD 9.3bn in 2015[11].   

1.11.     Reinsurers also face restrictions on cross-border business. The Global Reinsurance Forum (GRF) produces a report on reinsurance trade barriers every six months. Its latest report identifies 30 major territories which have implemented, or are in the process of implementing, barriers to the transfer of risks through global reinsurance markets[12].       

1.12.     Lloyd’s must therefore deal with significant regulatory burdens in non-EU markets, whereas – in terms of market access - the EU Single Insurance Market is its ideal prudential regulatory regime. If no EU – UK agreement is negotiated to retain market access, Brexit means that Lloyd’s will face new regulatory barriers to EEA markets and therefore a significant escalation in its international regulatory burden. 

1.13.     Lloyd’s and many UK-based insurance companies are making contingency plans by setting up subsidiaries in the EU, but this is not an efficient substitute for a UK marketplace which enjoys EU single market access.  In the longer term, UK efforts should be directed at expanding the single market concept internationally, and abandoning this cornerstone of EU regulation is a giant step backwards.              

Solvency II[13]  

1.14.     Solvency II is a harmonised, risk-based EU-wide insurance regulatory regime, which member states implemented from 1 January, 2016. It builds on industry best practice in risk management to reduce inappropriate risks. Its design recognises that the management of insurance firms is a key element in their safety and soundness and it promotes good governance and internal controls, encouraging better risk management through requirements such as regular own risk and solvency assessments (ORSAs).

1.15.     Under Solvency II, regulatory capital requirements can be calculated either by using a standard formula (appropriate for most insurance undertakings) or, with supervisory approval, internal models, which better reflect the risk profiles of non-standard undertakings. This flexibility helps to ensure better matching of capital and risk. Overall (and now the heavy initial development costs have been expended), we believe that Solvency II is a sound regulatory regime, which ensures appropriate policyholder protection without imposing an undue regulatory burden on insurers.     

1.16.     UK regulatory thinking was an important factor in the design of Solvency II. Solvency II built on the UK’s pre-existing system of Individual Capital Adequacy Standards (ICAS) and UK supervisors, Government departments and insurers provided significant input to Solvency II’s development process. UK insurers were firmly supportive of Solvency II’s fundamental principles, even when they criticised detailed aspects of its implementation.

1.17.     It is too early to assess Solvency II’s wider impacts, as it has only been fully implemented in the UK and other EEA member states since January 2016. The general impression of its short-term impact is positive: since January 2016, there have been no failures amongst UK-based insurance undertakings, whilst a diverse range of insurance products is widely available in the UK and most businesses and citizens can find the insurance cover they want at a price they can afford. It will be appropriate to assess the regime after the practicalities of Brexit have been concluded, on the basis of a longer post-implementation period.   

1.18.     We consider that there are elements of Solvency II that could be revised, to the advantage of insurers and their clients, since regulatory costs falling on insurers are ultimately borne by insurers’ customers. Examples include:

         Reducing the complexity and extent of its Pillar III supervisory reporting requirements.

         Introducing greater flexibility to regulatory processes for obtaining permission to change internal models.

         Removing requirements for firms using internal models to calculate their SCR using the standard formula.

         Aligning the Solvency II Balance Sheet with Generally Accepted Accounting Principles (GAAP).

1.19.     We think that most EU insurance undertakings and supervisors would agree that Solvency II should be adjusted in the light of experience of its application. We note that the European Commission has already initiated a review of the standard formula and we are confident that the regime can be enhanced, to the benefit of undertakings and policyholders alike.       

Insurance Distribution Directive

1.20.     The Insurance Distribution Directive (“IDD”) was agreed in 2016. EU member states are required to transpose it into national law by 23 February 2018 (i.e. before the UK is likely to leave the EU). Currently, the UK’s regulatory regime for selling insurance, like that of other EU member states, reflects the Insurance Mediation Directive (“IMD”).

1.21.     The IMD applies to insurance and reinsurance intermediaries only. The IDD also applies to insurance and reinsurance undertakings. It introduces enhanced information and conduct of business requirements, including product oversight and governance requirements and a new Insurance Product Information Document (IPID) for non-life products.

1.22.     As the IDD has not yet been applied to the EU’s insurance sector, it is impossible to assess its efficacy. Furthermore, unlike Solvency II, it is a “minimum harmonisation” directive, giving individual member states scope to add additional regulations at national level. It is therefore more difficult to talk of a single EU regulatory regime for distribution than is the case for Solvency II’s prudential regime.

1.23.     An important benefit of the IDD is that it incorporates passporting arrangements for intermediaries, facilitating the conduct of business across borders by UK-based intermediaries. The distribution networks of Lloyd’s and the London market depend on intermediaries, so this helps Lloyd’s and London market firms to obtain business from other EU member states.

1.24.     The IDD’s implementation across the EU will support the conduct of business in the Single Insurance Market. Regulation of sales practices is more difficult to harmonise between nations than prudential regulation, because different countries have different business cultures and customer expectations, so they set customer protection boundaries in different places. The IDD is the product of intensive negotiation between member states and is probably as far as they are prepared to go in terms of harmonising their rules for conducting insurance business.

1.25.     There is concern in the insurance market about the timing of IDD implementation. The EU will probably agree detailed regulations under IDD only by the end of this year. This will give regulators in the UK (i.e. the FCA) only a very short period to implement the necessary changes to its Regulatory Handbook. Insurers and intermediaries will not therefore have sufficient time to make the necessary adjustments to their own processes and systems. A number of industry organisations, including Lloyd’s and the LMA, are therefore writing to HM Treasury asking it to seek a delay in the implementation of the detailed regulations concerned.             

Implementation of EU insurance regulation in the UK

1.26.     As noted earlier, the UK has been an important influence on the development of the EU’s insurance regulatory regime. The UK’s prudential regulations for insurance and reinsurance undertakings properly reflect the Solvency II regime and the FCA is currently consulting on implementing the IDD.

1.27.     Nevertheless, there are areas where the UK’s regime imposes particular burdens on UK undertakings which are not based on EU legislation. An example is provided by Pillar III supervisory reporting. Solvency II requirements in this area have been extended beyond that required by Solvency II by the PRA (see PRA Policy Statement PS2/15 Solvency II: a New Regime for Insurers; 12 Reporting – National Specific Templates), imposing a very significant UK-specific burden going beyond Solvency II requirements.

1.28.     Other problems can reflect the impact of case law on regulatory provisions. One example is the legal restrictions on the conduct of business in the UK by an EU-based subsidiary of a UK entity. These make it necessary for such a subsidiary to establish a branch in the UK, even though it does not intend to sell insurance in the UK.         

2.      Are current EU proposals on banking and financial services in your view positive for financial stability? How do you expect the EU’s regulatory framework to evolve in the coming years?

Financial stability in the EU

2.1.          It is important to differentiate between banking and insurance when considering financial stability. Prudential regulation of insurers has different aims from prudential regulation of banks. Although, in both cases, financial and operational soundness is monitored to prevent insolvencies, in insurance the main aim is protecting policyholders and other beneficiaries whereas in banking the main aim is preventing systemic risks. The PRA recognises that “In general, firms carrying out traditional insurance activities do not pose risk to the system in the same way as banks”[14]. Consequently, developments in the EU’s regulatory regime for non-life insurance are unlikely to affect financial stability in the EU.    

Evolution of the EU’s insurance regulatory framework             

2.2.          We do not expect substantial changes to the Solvency II regime in the next few years, since it was implemented less than two years ago and has proved broadly satisfactory. 

2.3.          There are criticisms from some insurers and industry observers of certain elements of Solvency II, particularly of its application to life insurance and the implications of its impact on investment decisions for the wider EU economy. Partly in response to such criticisms, the European Commission is reviewing certain elements of the way that insurers calculate the Solvency Capital Requirement (SCR) using the standard formula, and has asked EIOPA to provide technical advice on items identified by the Commission. EIOPA has, in turn, sought views from industry, intending to provide technical advice to the Commission by February 2018.

2.4.          Any desirable changes identified will be actioned through the EU’s legislative process with the consent of the European Council and Parliament. This will probably not be completed by March 2019. The approach, of assessing the way that the regime works in the light of experience and on the basis of technical advice, with stakeholder input and under the overall oversight of EU legislative bodies, appears pragmatic and sensible. We believe that the review will be positive for the development of the Solvency II regime.

2.5.          The major development for regulation of the selling of insurance is implementation of the IDD into national laws in February 2018. The EU is also considering changes to the European Supervisory Authorities, including EIOPA. A legislative package was released in September, 2017. 

2.6.          Therefore, we expect Solvency II to be fine-tuned but to continue in the longer term; we expect IDD will continue in the longer term, after it comes into effect in 2018; we expect an area of regulatory development in the longer term will be expanding international market access for EU firms through agreements between the EU and other states (e.g. the USA [Covered Agreement negotiated with Lloyd’s support!], Canada…); and we expect continuing efficiencies within the EU single market, benefitting EU firms, if members states make progress on aligning their consumer/SME protection and compulsory insurance regimes . 

3.      What are the key differences between financial regulation as agreed at the international, EU and UK levels, and where are the gaps? How important is it to maintain a level playing field for regulation?

Overview of international, EU and UK insurance regulation

3.1.          Overall, insurance regulation at international, EU and UK levels takes similar approaches. At the international level, insurance regulation is overseen by the International Association of Insurance supervisors (IAIS). The IAIS is a voluntary membership organisation of insurance supervisors from over 200 jurisdictions in nearly 140 countries. It is the international standard setting body responsible for developing material for the supervision of the insurance sector and assisting in its implementation. EU and, especially, UK supervisors are very active in the IAIS’s committee structure (the IAIS Executive Committee is chaired by Victoria Saporta of the PRA) and ensure that the IAIS’s views on regulation reflect experience in the EU.

3.2.          The IAIS’s key tool is its Insurance Core Principles (ICPs). These constitute a globally accepted framework for supervision of insurers, with which IAIS members are expected to comply. When the International Monetary Fund (IMF) carries out assessments of jurisdictions under its Financial Sector Assessment Program (FSAP), it compares local insurance regulation against ICPs, providing an incentive for ensuring regulatory alignment. Nevertheless, the IAIS is not a legislative body, and cannot oblige its members to comply with its models.

3.3.          This does not mean that there is a global system of insurance regulation. There are important differences in the way that different jurisdictions design and implement their regulatory systems and the ICPs are broad enough to encompass these. Essentially, there are two models of prudential insurance regulation:

(i)      Rule-based systems, with a focus on formulaic capital requirements; and

(ii)    Principle-based systems, focused on internal models and risk-based capital requirements.

3.4.          Solvency II sits in the second of these categories. It is an influential regulatory model for the IAIS’s ongoing work on capital standards.

Gaps in international insurance regulation

3.5.          The IAIS is prioritising work in two areas:

3.1.                       

3.2.                       

3.3.                       

3.4.                       

3.5.1. The supervision of internationally active insurance groups (IAIGs). IAIGs carry on business in different jurisdictions via subsidiary insurance companies. Each subsidiary is a separate legal entity, subject to the insurance laws and regulations of the country in which it is established. This can mean that, even though each individual subsidiary is adequately regulated, no single supervisor has a complete picture of the group as a whole and group risks can therefore be overlooked. The IAIS believes that there are over 50 IAIGs worldwide, many headquartered in the EU (including the UK).  

3.5.2.  The IAIS is therefore developing a Common Framework for the supervision of IAIGs (“ComFrame”). This is intended to be a framework for supervisors to efficiently and effectively cooperate and coordinate by providing a basis for comparability of IAIG regulation and supervisory processes. The IAIS intends to finalise ComFrame in 2019.

3.5.3.  A global insurance capital standard (ICS). Whereas banks have the Basel III framework laid down by the Basel Committee, there is no global capital standard for insurers at present. Bodies such as the Financial Stability Board and the G20 think that development of such a standard would be beneficial for global financial stability, as it is difficult at present to compare group capital standards in different jurisdictions.        

3.5.4.  IAIS is therefore developing a global ICS as part of ComFrame. It proposes that the ICS should apply to IAIGs and Global Systemically Important Insurers (G-SIIs) – i.e. not to individual insurance undertakings. IAIS is developing it through extended field testing and aims to implement it after 2019.

3.5.5.  The ICS has some similarities with Solvency II’s approach to regulatory capital but also some differences. Once the ICS is in place, questions will arise over whether the EU should modify Solvency II to align it with the ICS and whether there should be a unique regulatory capital standard for IAIGs or whether all insurance undertakings should comply with the ICS. Other jurisdictions worldwide, including the UK, will need to make similar decisions.

3.5.6.  This could create problems. Insurance undertakings which have adjusted to Solvency II will not welcome its fundamental re-ordering and there are some features of the ICS which could create difficulties for firms complying with existing jurisdictional regulatory models. 

The “level playing field”  

3.6.          In overall terms, the order of priority for Lloyd’s market participants is:

(1) Mutual market access internationally; and, a long way after this,

(2) Levelling the playing field in relation to prudential and conduct rules.  

3.7.          The EU’s arrangements for passporting, underpinned by the harmonised Solvency II regulations, are the optimal regulatory regime for an insurance undertaking such as Lloyd’s that carries on business internationally. This “level playing field” providing significant benefits, because it is a basis for cross-border market access which eliminates regulatory duplication at national level. 

3.8.          Nevertheless, the process of arriving at a level playing field can have disadvantages. Wide variations in regulatory approaches exist between jurisdictions and arriving at a consensual view on a single set of regulations means that supervisors must compromise and accept changes in their own models, requiring insurers to adjust to new regulatory approaches in their home jurisdictions. This may be a price worth paying, if in return they gain easier access to other markets and a reduced regulatory burden on cross-border business.

3.9.          However, if the process of levelling playing fields takes place in isolation from questions of market access, the consequent changes to regulation may not be worth it. Harmonising national regulatory regimes with a notional international standard can mean the loss of particular features which are well-adapted to local insurance entities. It can mean “levelling up” to the strictest regulatory standards contemplated, rather than designing a system to appropriate levels of regulatory prudence.    

4.      Are there any particular legal or practical challenges related to incorporating the existing body of EU financial services legislation into the UK’s domestic law, for example the PRA rulebook? 

4.1.          It is essential to domesticate the body of existing EU law into UK law. Without domestication there will be a legal vacuum and the Solvency II regime would not work, as it is a mixture of UK legislation and directly-applicable EU legislation. 

4.2.          The task of domestication is huge. There are more than 12,000 EU regulations and 7,900 statutory instruments[15]. Not only must the acquis be adopted and UK implementing law preserved, but consequential amendments must be made so that it functions appropriately after exit. The European Union (Withdrawal) Bill (“the Bill”) proposes to do this through delegated powers which will allow Ministers to make the necessary amendments by secondary legislation. The Government estimates that the necessary corrections will require between 800 and 1,000 statutory instruments: some lawyers think that this is a substantial underestimate. 

EU Directives

4.3.          UK financial services legislation, the PRA Rulebook and the FCA Handbook are all heavily reliant on EU legislation. The regulatory rulebooks, in particular, contain 1,000s of references to EU Directives and other EU legislative provisions, to the extent that substantial portions can only be understood in the context of the EU legislation that they are implementing.

4.4.          Unfortunately the Bill’s treatment of Directives is not straightforward. Clause 4 of the Bill says that some provisions of Directives capable of direct effect will be domesticated, although the Bill’s Explanatory Notes on Clause 4(2)(b) suggest that this will only be if a specific right has been judicially determined. Eventually, the multitude of references in UK regulatory rulebooks to Directives could therefore be to provisions whose legal status in the UK is unclear or which are explicitly intended to have no legal effect in the UK.

Future amendments to EU rules 

4.5.          We have reservations over how detailed regulatory provisions, such as those in the Solvency II delegated regulation and implementing technical standards (“Level 2 measures”) will be incorporated into the UK’s regulatory system and who can amend them subsequently.

4.6.          There are risks that, if Solvency II Level 2 measures are simply incorporated into the PRA and FCA rulebooks, and changes to them are viewed as lying purely within the ambit of the PRA and the FCA, important decisions over UK regulation will be made on narrow regulatory grounds, without consideration of wider issues, such as UK competitiveness. Neither the PRA nor the FCA has an objective relating to the competitiveness of the UK’s financial sector.   

4.7.          At present, UK regulators’ ability to make rule changes is constrained by the EU regulatory system in which they operate. For the most part the UK regulatory rulebook reflects EU legislation. EU legislative processes mean that the European Parliament and Council have considerable influence over financial services legislation, which therefore reflects wider society concerns over financial and economic policy and appropriate regulatory boundaries.

4.8.          We suggest that Parliament needs to consider three issues, to ensure that after Brexit UK financial regulatory policy develops on appropriate lines:    

4.1.           

4.2.           

4.3.           

4.4.           

4.5.           

4.6.           

4.7.           

4.8.           

4.8.1.  The objectives of the PRA and the FCA. We suggest that they are given an explicit competitiveness objective.

4.8.2.  The accountability of the PRA and the FCA to Parliament.

4.8.3.  Parliament’s oversight of regulatory policy. How can it ensure that it takes account of all relevant factors? 

Transition, equivalence and alignment 

5.      What would be the key priorities for a transitional arrangement, and how much continuity would you expect to see under such an arrangement? 

5.1.          For insurers, there are two separate issues to be addressed:

5.1.1.  Avoiding a “cliff edge” if the UK leaves the EU without a satisfactory agreement on market access. This could be done through a transitional arrangement.

5.1.2.  Dealing post-Brexit with cross-border insurance contracts arranged by passporting insurers pre-Brexit.        

A transitional arrangement

5.2.          A transitional arrangement is essential for the protection of EU and UK citizens and to avoid damage to the UK’s economy. As Andrew Bailey, FCA Chief Executive, said in July 2017:

“The big issue we face is a transitional one, whereby firms are put into a position where they maybe have to put their contingency plan in place before they know the outcome of the negotiations. That’s a difficult position to be in.

“That’s why implementation of a transitional arrangement to bridge that gap would be helpful.”  

5.3.          Under the Article 50 process, the UK will leave the EU on 29 March 2019 and there is insufficient time for the UK and the EU to negotiate and put in place a satisfactory agreement on their post-Brexit relationship within the time available. Without a transitional arrangement, 29 March 2019 will see Lloyd’s underwriters immediately losing their authorisation to carry on business in EEA countries on a services or an establishment basis.

5.4.          Lloyd’s and other UK businesses in this situation are seeking to protect their portfolios of EU business. They want a good outcome from the negotiations, but must plan on the assumption of a “hard Brexit” on 29 March 2019. As mentioned earlier, Lloyd’s is therefore establishing a subsidiary insurance company in the EU, through which Lloyd’s underwriters will be able to continue to write EU business. Other UK financial services firms have similar plans.

5.5.          A satisfactory transitional arrangement would reassure UK insurers and their EU clients that they do not need to act precipitately, reducing some of the damaging consequences of Brexit.

Key priorities for a transitional arrangement

5.5.1.  A transitional arrangement should retain the status quo, so far as possible, meaning a continuation of all the rights and obligations of the Single Market, in conformity with EU law.  This would entail the continuation of existing market access arrangements. A transitional arrangement on this basis would provide significant benefits to policyholders and UK and EU businesses.

5.5.2.  A transitional arrangement must avoid the expense and inconvenience of two sets of adaptation phases, as the UK moves into the transition period and into a subsequent long-term relationship with the EU. Again, this requires retention of the status quo.      

5.5.3.  There is insufficient time to negotiate a bespoke transitional arrangement, which could also be complex and impractical. It should take a pre-existing form accepted by the EU. 

5.5.4.  A transition arrangement should remain in force until the EU and the UK have agreed and put in place their new relationship.

5.5.5.  The UK and the EU must commit to a transition arrangement very soon: before the end of the year, if it is to be of full benefit to the UK. This does not mean that it will be worthless if entered into later. A UK insurer’s contingency plan is not something sitting on a shelf that a firm might trigger – to vary the metaphor, it is a ship that is already sailing to a destination, which the insurer may turn around, but with increasing difficulty as time passes.

Pre-Brexit passporting contracts

5.6.          UK insurance and reinsurance undertakings provide contracts to clients in other EU member states through passporting. EU insurance and reinsurance undertakings provide contracts to UK clients on the same basis. These insurers will lose passporting rights when the UK leaves the EU. Nevertheless, the contracts they have underwritten on a passporting basis will give rise to continuing contractual obligations:

5.6.1.  Some of the contracts will still be in force. This will apply particularly to life and pensions contracts, which are usually long-term contracts, in force for many years. Non-life contracts may also be of several years’ duration. Contracts in force for a year (the majority of non-life contracts) may commence less than 12 months before the Brexit date.    

5.6.2.  Contracts which have expired in terms of the insurance period covered are still a source of ongoing commitments, such as payment of outstanding claims (time-periods may be long, for example where a liability claim depends on a decision of a court in an EU member state).

5.7.          An insurer’s ability to service these contracts and to pay the valid claims of its clients will be constrained because the insurer will no longer have passporting rights, so will be unauthorised. In some countries, it is illegal for an unauthorised insurer to carry on business, which means that they cannot legally enter into insurance activity such as the payment of claims. In other words, insurers would have to break the law in order to fulfil their contractual obligations.

Key priorities for an agreement on pre-Brexit passporting contracts 

5.8.          An agreement to address this problem should cover the following:

5.8.1.  Recognition that the rights and obligations of the parties to insurance contracts written under passporting continue.

5.8.2.  Insurance contracts in force at the date that the Treaties cease to apply to the UK would continue in force until they expire in accordance with their contractual provisions and all obligations met.

5.8.3.  Legal obstacles to the ability of a party to an insurance contract to enforce a right or discharge a responsibility under the contract would not apply.

5.8.4.  Insurers who have appointed a legal representative under Article 145 or 152 of the Solvency II Directive would maintain a legal representative in the country concerned until the relevant national competent authority is satisfied that the business has been fully run off.

5.8.5.  Supervisory liaison to be ensured by establishing an EU27/UK committee.

5.8.6.  It needs to consider the question of contracts underwritten under delegated authority arrangements, whereby intermediaries (“coverholders”) may be appointed by underwriters to underwrite insurance business, issue certificates of cover and pay claims. Many coverholders are situated in EU member states and have long-standing relationships with Lloyd’s underwriters. 

5.9.          Because contracts can be in force for many years and can give rise to claims a long time in the future, this is not an issue that can be resolved purely through a transitional arrangement, which may only be in place for a short period. It needs to be considered as a separate issue.  

6.      In practical terms, how and when could a transitional arrangement be agreed and put in place? How long would such a transition need to last?                     

6.1.          We agree with the CBI, that the UK should remain in the single market and a customs union during any period of transition, until a deal is in force[16], giving sufficient time for business to adjust to the new arrangements. This is the only way in which sufficient continuity can be ensured to avoid material damage to UK businesses trading in the EU. A transitional arrangement must allow firms to make alternative arrangements in EU states to underwrite new business (e.g. setting up a subsidiary). An agreement to address the issue of pre-Brexit passporting contracts must exist for as long as necessary for meeting all obligations under contracts underwritten before Brexit.

6.2.          If, by early 2018, it looks unlikely that transitional arrangements will be put in place, UK companies are likely to have triggered their contingency plans on the assumption that the UK is leaving the EU in March 2019 without market access arrangements. Once such plans have been initiated, it will be difficult to reverse them, even if a satisfactory result is subsequently obtained. HM Government should seek to negotiate such an arrangement with the EU as soon as possible.

7.      What are the benefits and drawbacks of seeking equivalence? What conditions are likely to be attached by the EU to any equivalence decisions?

Background

7.1.          The International Regulatory Strategy Group (IRSG) has produced a report[17] assessing the EU’s third country regimes (TCRs) for financial services (most of which depend on equivalence) in detail. The report concludes that there is no comprehensive framework of TCRs and only a very small proportion of financial services which are currently covered by the passporting regime are the subject of TCRs. Given their limited coverage, compared to current rights of access, uncertainty of availability and lack of key safeguards, the TCRs (and therefore equivalence) do not provide an acceptable long-term, sustainable solution for the UK-based financial services industry to access EU markets.

7.2.          Nevertheless, positive equivalence decisions could provide benefits to particular market sectors. For the reasons given below, if the UK is unable to agree with the EU that UK-based undertakings can continue to provide reinsurance to EU-based undertakings on the basis of home state prudential regulation, Lloyd’s would welcome a determination of UK equivalence in relation to reinsurance under Article 172 of the Solvency II Directive.

Equivalence under Solvency II

7.3.          The Solvency II Directive has three equivalence tests for insurance and reinsurance:

7.3.1.  Reinsurance – assesses whether a third country’s solvency regime applied to reinsurance activities of undertakings with their head office in the third country is equivalent to Solvency II (Article 172). 

7.3.2.  Group solvency – assesses whether a third country’s solvency regime applied to the subsidiary of a group headquartered in the EU is equivalent to Solvency II (Article 227). 

7.3.3.  Group supervision - assesses whether an undertaking with a parent in a third country is subject to group supervision by the third country supervisor that is equivalent to Solvency II (Article 260). 

7.4.          Lloyd’s is not a group and would not benefit from the group equivalence provisions. 

7.5.          To date the EU has formally determined the reinsurance solvency regimes of Bermuda, Japan and Switzerland to be equivalent. 

Benefits of a formal determination of UK reinsurance equivalence

7.6.          EU member states would be required to treat reinsurance contracts with UK-based undertakings such as Lloyd’s in the same manner as reinsurance contracts concluded with EU-based undertakings (Solvency II Article 172(3)). Member states could not impose additional regulatory obligations on such contracts.

7.7.          EU member states would be unable to retain or introduce systems of gross reserving for reinsurance contracts with UK-based undertakings (Solvency II Article 173).   

7.8.          Within the EU, Germany, Poland and Portugal have restrictions or prohibitions on the ability of undertakings in non-equivalent third countries to provide reinsurance to undertakings established in their jurisdictions. Without either a satisfactory market access agreement or an equivalence determination, undertakings in the UK would therefore be at a disadvantage as providers of reinsurance to the EU.

Drawbacks of a formal determination of UK reinsurance equivalence   

7.9.          The process of making an equivalence determination is conducted under EU legislative provisions and can be lengthy. The third country concerned needs to ask for the determination and decisions are made on the basis of assessments carried out by EIOPA, which can take time. A determination of equivalence is ultimately made by a delegated act, which goes through the EU’s legislative process, including review by the European Council and Parliament. If the UK Government proposes to seek a determination of equivalence, it therefore needs to trigger the process in good time.

7.10.     An equivalence determination under Solvency II Article 172 covers reinsurance only. There are no comparable provisions relating to insurance.

Conditions attached to an equivalence decision

7.11.     A third country regime must meet the criteria set down in EU legislation. For a determination of reinsurance equivalence, detailed criteria are set out in the Solvency II Delegated Regulation (Regulation (EU) No. 2015/35). The European Commission can review equivalence determinations, to take account of any supervisory changes, in either the EU’s regime or that of the third country. 

8.      What alternatives may exist for maintaining alignment between the UK’s and EU’s regimes? What options could be considered for resolving disputes or arbitrating on such matters? What would be the barriers to a more bespoke arrangement?

8.1.          For insurance market access, the best outcome would be for the UK to retain membership of the EEA and therefore of the Single Insurance Market. This would mean that HM Government, the PRA and the FCA would have limited influence over the future direction of EU regulatory policy and the drafting of EU legislation. This would not be ideal, but is preferable to the alternative of reduced access.  

8.2.          If EEA membership is not an option, we want the Government to pursue three objectives:

         The most immediate priority is early agreement of transitional arrangements retaining existing passporting rights in full on a mutual basis. We cover this in more detail in our responses to questions 5 and 6.

         Agreement of a comprehensive UK – EU Free Trade Agreement, with a Financial Services Chapter.   It should preserve the principle of Home State prudential supervision and give UK-based insurers and reinsurers rights to accept business from the EU and a reciprocal right for EU27-based insurers and reinsurers to accept business from the UK.

         A formal determination of the UK’s reinsurance regulatory equivalence under Solvency II. We discuss this in detail in our response to question 7.

8.3.          All of these would be underpinned by the maintenance of regulatory alignment between the UK and the EU. As noted earlier, we believe that Solvency II is a broadly satisfactory regulatory regime, which it is worth the UK retaining in any case. Operating a Solvency II regime would not, of itself, give UK insurers, post Brexit, the right to passport across the EU. Rather, it is very unlikely that the UK could arrange reasonable access to EU insurance markets unless it had an insurance regulatory regime that the EU viewed as at least equivalent to Solvency II.      

The future environment

9.      What effect will the loss of the UK have on the development of the EU financial services framework and its capital markets?

9.1.          This question is more relevant for the banking sector, so we will not comment.

10.  Where is there scope for the UK to amend its regulatory regime? What precedents exist under current equivalence decisions for divergence to occur?

10.1.     We do not support the suggestion that the UK should move to an alternative insurance regulatory system. Moving to a different regulatory regime would be costly and its benefits would be doubtful.

10.2.     Lloyd’s and the London market have invested much time and financial resources in implementing Solvency II. It would be a mistake to create more upheaval and uncertainty by moving away from it, particularly in view of the volatile external environment.

10.3.     Our chief concern is retaining the ability of UK insurers and reinsurers to carry on business in EU member states, on terms as close as possible to those in place today. Amendments to the regulatory regime should be considered against that background and the likely need to retain regulatory alignment with the EU.   

11.  What challenges will expected innovations in financial markets, for instance in the FinTech sector, present in respect of regulation and supervision post-Brexit? How can these challenges be overcome? Can the UK maintain a competitive advantage while adapting to a new regime? If so, how?

11.1.     We believe that that the best way to support digital innovation at UK and EU level is to ensure that existing and future legislation is digital-friendly, technologically neutral and sufficiently future-proof.

11.2.     Digitalisation is changing the world, impacting the whole insurance value chain. It brings many benefits: better profiling of risks, more personalised products and services, improving insurers’ risk management capabilities. It allows exploring new segments, and innovating.  It also brings potential risks:

11.3.     Regulators around the world are thinking about how to address risks associated with FinTech, in particular the implications for consumers. In the UK, the FCA initiated an Innovation Hub in 2014, sometimes described as “regulatory sandbox testing”. This allows business to test innovative products, services and business products in a live environment. The FCA has co-operation agreements with some overseas regulators including Australia, Singapore and South Korea.

11.4.     The FCA’s regulatory sandbox approach creates space for insurance technology to be tested in a different regulatory regime from the traditional one.  This is an early stage and it will be important to ensure that there is ultimately a level playing field.

11.5.     Our view is that FinTech/InsurTech activities should not be regulated specifically. The same regulatory approach should apply to InsurTech as to other products. The end result is to do the right thing for consumers and a principles-based approach to regulation is important in order to focus on outcomes for policyholders. An InsurTech regulatory framework should balance support for innovation with maintaining standards of consumer protection. Consumers who are not computer or smartphone literate must still able to access suitable products.

11.6.     In the EU, the European Parliament strongly supports innovation in financial services, underlining the need for national competent authorities to allow for “controlled experimentation”, while ensuring a high level of consumer protection. It calls for rules covering FinTech operations to be future proof and technologically neutral, given the rapidly evolving markets. The European Commission is supportive of innovation in financial services and is undertaking a fact-finding exercise.

12.  Will leaving the EU affect the way that the UK represents itself in international fora?

12.1.     The UK is an active member of the IAIS and is also heavily involved in other international organisations relevant to insurance regulation, such as the OECD and the FSB. We expect this to continue after the UK leaves the EU. 

12.2.     In such international organisations, representatives from EU member states tend to be more closely identified with the countries from which they come than with the EU. Sometimes the EU, or EU organisations such as EIOPA, has its own representation. The insurance regulatory regimes of EU member states are based on EU models, such as Solvency II, so this forms the basis of UK representatives’ input to regulatory debates. We do not see this changing dramatically unless there is significant divergence between the regulatory regimes of the EU and the UK.        

Supervision

13.    The Commission is currently conducting a review of the European Supervisory Agencies. What, in your view, are the key areas where reform should be pursued and what might be the impact of such reform on UK supervision?                 

13.1.     We will restrict our comments to EIOPA.

13.2.     The UK’s priority should be to seek to retain regulatory cooperation with EIOPA after Brexit. The Regulation setting out EIOPA’s structure and powers does not make any provision for the supervisory authorities of non-EU member states to be members of EIOPA, so it is not a realistic aspiration for the UK to retain EIOPA membership. However, we think that it is desirable for the formation of a joint supervisory committee to oversee insurance regulatory relations between the UK and the EU.

13.3.     We believe that EIOPA has improved coordination between national competent authorities and raised standards of supervision across the EU. We do not think that it is necessary for EIOPA’s powers to be expanded and believe that it should focus on making better use of the powers it already has.

14.  How could an enhanced role for ESMA and the ECB in respect of euro-denominated clearing work? What are the options for the UK to retain euro clearing in the light of the European Commission’s recent proposals?

14.1.     This question is more relevant to the banking and securities sectors, so we will not comment.

15.  How would supervisory cooperation (as envisaged for CCPs) work in practice? Are there any precedents? What are the potential risks? 

15.1              This question relates to CCPs, so we will not comment. 

29 September 2017