182.Information about the Government’s approach to Brexit has emerged gradually over the last year or so. Written evidence was gathered by the previous Treasury Committee between 13 September 2016 and 11 November 2016, and it held oral evidence sessions in January and February, either side of the publication of the Government’s White Paper on Brexit. The triggering of Article 50 on 29 March 2017 was a significant milestone, but does not materially change the relevance of the evidence of the conclusions of the Committee when considering it.
183.A UK insurer can currently passport into any EU country by applying either ‘freedom to provide services’ or ‘freedom of establishment’ mechanisms. If the outcome of the UK’s negotiations to leave the EU is that a UK insurer will not be able to passport into the EU directly from the UK, then it can instead use an existing subsidiary in any EU member state, or establish a new EU subsidiary, and passport across the EU from this entity. The principal regulator for the insurer’s EU operations would then be the regulator in the country where it had established its EU subsidiary. The PRA would be responsible for the regulation of any entity above this subsidiary, alongside all its other non-EU operations. Given the time take to establish EU subsidiaries, many UK headquartered insurers already appear to be taking steps to do so, thus pre-empting the outcome of Brexit negotiations.
184.The Solvency II Directive “recognises the fact that the insurance industry is a global industry”. As such, “to avoid unnecessary duplication of regulation, the European Commission may decide about the equivalence of a third country’s solvency and prudential regime”. The assessment of a regime to be equivalent is “mutually beneficial” to both the EEA and third countries, and they “promote open international insurance markets, while simultaneously ensuring that policy holders are adequately protected globally”. The subject of ‘Equivalence’ featured in numerous submissions and was discussed in oral evidence. A popular theme to emerge was that “equivalent does not mean identical, as Switzerland and Bermuda demonstrate”. For this reason, Phil Smart of KPMG noted in oral evidence that other regimes “have gained equivalence but do not have the same level of disclosure currently required by Pillar III. This is an area that could be quite safely amended”.
185.Some written submissions to the previous Treasury Committee and other publications put weight onto the importance of gaining and maintaining equivalence, while others explained that equivalence was not a general grant, but instead is granted for specific areas such as group supervision or reinsurance. PwC stated that equivalence should be sought “at least” for group supervision under Article 260. This led PwC to conclude that any change to UK insurance legislation post-Brexit “should be weighed against the risk of the UK losing equivalent status with the EU.” However, in oral evidence the Committee heard that:
“equivalence as a notion has had a bit too much put on its back in terms of what it can bear. […] As you know, equivalence does not guarantee market access anyway. It is a framework by which regulators can work with each other in order to enable trade across borders, but it does not guarantee that trade itself. You still have to have some sort of agreement around the trading relationship.”
186.Huw Evans of the ABI went on to note the politicisation of equivalence:
“Equivalence is currently a political process, which can be withdrawn very quickly. […] It is not something that can, under its current form or its accepted usage, bear the weight of expectation that is being placed on it”.
187.Julian Adams of Prudential supported this view stating that equivalence “allows too much discretion to Europe” and can be “unwound very quickly”. For this reason, the ABI advocated a “bespoke treaty” between the UK and European Union to “ensure the full range of access and regulatory co-operation […] to make that relationship a success”. Huw Evans suggested that, given the high degree of convergence of the regulatory frameworks, it “should not be beyond the wit of humanity to devise a route that ensures ongoing market access while ensuring the best of the regulatory regimes” for both the UK and the EU 27.
188.Sam Woods noted in oral evidence to the previous Committee in July 2016, that even were the UK to seek equivalence, “it does not necessarily follow that to have equivalence, you have to have the same thing”, citing the equivalence granted to the US regime, which is “quite different” from Solvency II. While it might be logical that the UK regulatory regime is comparable with that of the EU, it is more important, for the sake of the industry and policyholders, that UK insurers “have unimpeded access to the EU market” and vice versa.
189.Several complications were highlighted by oral and written evidence to the previous Committee. In the absence of a more comprehensive agreement, Brexit will require business re-structuring as insurers seek to set up their preferred structure for a post-Brexit world. These actions will have an impact on UK regulators (PRA and FCA) and European regulators in terms of assessing and scrutinising business model restructuring, which may include the creation of new subsidiaries, and redomestication (both in the UK and Europe). Numerous suggestions have been made to alleviate the pressure on both regulators and the insurance industry. As noted by PwC, these include grandfathering agreements, which have been employed at several times previously to avoid relicensing queues as regulatory regimes change.
190.Clearly the ideal solution would be some form of reciprocal agreement between the UK and EU whereby neither UK or EU firms had to restructure their operations and the current status quo was effectively maintained. As a contingency, the PRA has asked firms to prepare plans for a full range of outcomes, including that there is no reciprocal arrangement. Firms are going ahead on this basis and many are already working with EU regulators to set up subsidiaries from which they can branch throughout Europe. Other firms may open third country branches in the EU but this is much more restrictive and cannot be opened while the UK is a member of the EU. EU firms are in a comparable position in that they need to decide how to operate in the UK.
191.However even if UK firms do establish EU subsidiaries, there is another technical issue relating to pre-Brexit contracts. Insurance contracts which are written pre-Brexit either in EU branches of UK firms or written directly into the EU will be outwith the firm’s authorisation unless further action is taken. It may therefore be difficult to pay claims or receive premiums, and there is a risk of a reduction in competition and a loss of jobs, as well as detriment to policyholders. One idea would be to transfer pre-Brexit business into a firm’s new EU subsidiary by a ‘Part VII’, but in practice this would seem to be unachievable at industry level, because each firm would have to obtain its own Court approval, and there would be insufficient specialist resource (PRA, independent experts, legal expertise, etc) to support such a programme.
192.Agreement on a pragmatic approach to pre-Brexit contracts is vital. In the absence of this, or a comprehensive reciprocal arrangement which addresses the problem of the loss of passporting, there will be substantial additional work for firms and regulators in both the EU and UK, especially the PRA. Wherever possible the PRA should adopt pragmatic approaches such as granting provisional recognition to EU branches prior to Brexit.
193.Further complications arise because, while the Solvency II Directive has equivalence provisions, two other directives relating to insurance (the Insurance Mediation Directive, and its proposed successor the Insurance Distribution Directive) do not include such provisions. This means that “business models of many insurers might become unworkable”. However, as PwC explained, “this can be overcome by thinking ahead about the links between the different directives insurers and brokers use to sell insurance products in the EU market”.
194.Lloyd’s of London is a unique organisation, and as such, Brexit presents it with some unique complications. Lloyd’s of London was set up by Act of Parliament, and is in effect a franchise operation for its various member syndicates (as opposed to being an insurance company in its own right). It currently operates across the EU because Solvency II incorporated specific legislation to allow for its unique role.
195.When the UK leaves the EU the specific legislation would no longer apply and Lloyd’s would be unable to operate in its current form across the EU. Until now, apart from a venture in China, Lloyd’s has provided the framework for syndicates to write their own business, rather than write business in its own name. This issue was discussed with the previous Treasury Committee in oral evidence. John Parry explained that:
“Our priority is to maintain mutual market access to the EU postBrexit. […] That may not happen, and certainly we are not expecting to get certainty on that any time soon. We want to be able to service our clients as seamlessly as we can, by establishing it before transition arrangements are clear.
The two alternatives are to set up branches in Europe, where you would operate as a third-party country, or via a subsidiary option in the EU, owned by the corporation of Lloyd’s”.
John Parry went on to explain the implications of such arrangements:
“The branches carry a lot of issues. A lot of capital would need to be put up, and for insurance, putting up capital in each different place that you trade is very inefficient. If I insured everybody’s house in this room, but I had to hold the capital in case your house burned down just for you, I would hold an awful lot of capital. It is not going to be very efficient. Branches are out, so setting up a subsidiary is not the preferred option but we will need to progress it to offer that certainty to clients in advance of any decision on either transition arrangements or single market access”.
He then explained their expectation to keep activity in London:
“One of the considerations is how much of that could be kept in London, around the Lloyd’s building and the other different businesses. The more frictional cost you add to it, the less attractive our platform will look. We are competing for capital and talent globally, so international groups could set up their own. We want to offer an attractive proposition, and obviously we need to do that at an efficient cost”.
He concluded that they were undertaking work to ensure they had a “realistic plan” to offer their market participants in the event that they do not secure single market access post-Brexit: “This is the price of uncertainty”. Subsequently, Lloyd’s has announced that it will set up a new subsidiary in Brussels, from which it can passport across the EU.
196.93% of Lloyd’s business is done without EU passports into the European Union; the United States is its largest market, at 40%. John Parry explained that it was about Lloyd’s of London’s “ability to offer a global service to clients” that made EU access important.
197.While Brexit does bring complications, the insurance industry and the PRA must seek to exploit its opportunities.
198.One opportunity is borne from the UK’s increased flexibility in its policymaking. For example, the IFoA noted that “in the event that the UK leaves the EU this presumably results in EIOPA having no UK-specific role which may then be an opportunity for the PRA to apply discretion”. This would also increase the PRA’s ability to “operate in the international space”.
199.Another potential opportunity was highlighted in oral evidence when the previous Committee heard about the Covered Agreement Notifications relating to reinsurance entered between the United States and European Union on 13 January 2017. This lowers the legal and capital barriers to business, and may present an “opportunity for the UK to arrange something similar” with the US, a point made strongly by the London Market Group in evidence to the International Trade Select Committee in March.
200.It should be noted that the EU/US covered agreement took many years to agree and is limited to the abolition of the requirement to post reinsurance collateral. Furthermore, the Swiss have an agreement with the EU which recognises the equivalence of Swiss supervision and capital calculations, but this, too, has its limitations as it does not offer the full reciprocal rights that the UK currently has in the EU. Nevertheless these two agreements have been cited as models which could provide useful precedents for a UK/EU agreement to reduce or remove non-tariff barriers for insurance.
201.The insurance industry should be regarded as a priority sector during the Article 50 negotiations. The Government should consider bespoke reciprocal agreement with the EU, similar to, but far more comprehensive than, the agreements that the EU has with Switzerland and more recently with the United States. Such an agreement could provide a solution for other parts of the financial services sector. At the very least, if the Government wants to meet its objective of a “smooth and orderly exit” from the EU, then it needs to address the urgent issue of pre-Brexit cross border contracts, perhaps through the mutual recognition of pre-Brexit insurance insurance contracts written in UK or EU member states.
232 SOL032, SOL026, SOL008, SOL023, SOL021, SOL017, SOL035,
241 Sam Woods giving oral evidence to the Committee on his appointment as Deputy Governor for Prudential Regulation and Chief Executive of the PRA, 19 July 2016, HC567 Q37
25 October 2017