Jay Patel, insurance analyst at Timetric’s Insurance Intelligence Center (IIC), analyses the importance and implications of passporting for the UK's insurance industry.
In the event of the UK losing financial passporting rights, Patel explains there are some measures and agreements that could partially mitigate the disruption for insurers, such as third party equivalence.
The passport that provides the UK with access to the market for financial services within the EU has been the subject of many post-referendum discussions regarding the impact of Brexit on the UK’s financial services industry.
When deconstructing and closely examining its implications, Timetric's IIC team judges that its salience in these discussions overstates its overall importance to the UK’s insurance industry.
Why is passporting so important?
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There are two types of passport for insurers: freedom of service and freedom of establishment. Freedom of service enables an insurer based in the UK to provide insurance to a client anywhere within the EU.
Freedom of establishment enables a UK insurer to set up a subsidiary or branch anywhere in the EU and sell insurance to clients from that local base. Both freedoms are very important for the UK’s insurance industry.
Losing the freedom of service to operate within the European insurance market will affect insurers that sell insurance to EU on a cross-border basis. This freedom tends to be of greater importance to commercial insurers and reinsurers than retail insurers.
Without the passport, certain lines of business would be unprofitable to conduct from London. Therefore, a subsidiary would have to be established in the European Economic Area (EEA) to enjoy full access to the single market.
This would incur short to medium-term restructuring costs and in some cases require insurers to split their headquarters between two locations in Europe. This would be an operationally inefficient outcome compared to the status quo. In the long-term these increased inefficiencies could lead to higher than expected expense ratios than would have been the case in the absence of Brexit.
However, it must be noted that London-based insurers could enjoy greater tax efficiencies from using Dublin as its EEA hub. Ireland’s 12.5% corporation tax rate could help to offset operational inefficiencies for some insurers in the future.
Meanwhile, without the freedom of establishment, UK insurers would have to convert their EU branches into subsidiaries.
This would require more capital to be held in that branch than is required under the current trading arrangements. As a result, firms will assess which areas of business will deliver a rate of return that would be at least equal to the cost of that capital and this to could lead to the retrenchment of certain operations.
Jonathan Howe, UK insurance leader at PwC speaking to Insurance Day magazine said that, “Before the introduction of Solvency II, there was a large-scale restructuring process, where many firms converted their companies across Europe into branches, with [the] provided liquidity benefits under the regime.” Restructuring these branches back into companies will be a time and expensive process for insurers.
'Life insurers, less vulnerable'
Life insurers based in the UK are not as vulnerable to the loss of passporting rights. This is because larger life insurers tend to have independently capitalized European subsidiaries. Therefore, if the UK does lose passporting rights they will not need to make significant changes to the geographical distribution of capital within their business.
Lloyd’s business with the EEA accounts for 11% (£2.9 billion) of the company’s total premiums. However, only £800 million is at risk from Brexit according to Lloyd’s. This accounts for about 4% of premiums and is non-marine, aviation and transport business that is written on a cross-border basis and is most likely to be affected by UK withdrawal from the single market. Multiyear policies will be binding regardless of whether the UK formally leaves the EU.
QBE, the Sydney-based insurer in a statement made in late June said, “The referendum outcome may require a revised approach in relation to approximately £500 million of insurance and reinsurance premium that QBE currently sources from EU member countries that is written via branches of UK regulated entities under current EU passporting rules.”
Although, premiums at risk do not translate directly into premiums lost, there is a significant chance that London will lose a noticeable portion of insurance business.
Sense of perspective
Despite all the disadvantages of losing the financial services passport, it is important to keep a sense of perspective on the magnitude of the impact that Brexit will have on London.
According to a recent legal update from Mayer Brown, the law firm, ‘the loss of the EU passport will likely not significantly impact pure reinsurance business.’ Furthermore, it says the insurance sector is ‘far less reliant’ on EU passporting than other financial services as it relies more on non-EEA trade. A large portion of UK insurers’ cross-border business is done with Canada, the US and Bermuda. In this sense the London market’s global capabilities are not wholly dependent on the UK’s future relationship with the EU.
Nevertheless, for the majority of executives in the City of London, a form of Brexit which involves the UK keeping its financial passporting rights is the most ideal solution. Therefore, the options above that include free trade in goods but not access to the single market are seen as quite similar in terms of what it would mean for any possible restructuring plans.
In the event of the UK losing financial passporting rights, there are some measures and agreements that could partially mitigate the disruption for insurers.
Third party equivalence with the EU’s financial services regulatory regime is seen as the most feasible way for the UK to retain some access to the single market whilst leaving the EEA. Since the UK must implement all EU rules and directives until the day it leaves, it will have identical financial services regulation.
As it pertains to Solvency II, equivalence in reinsurance means EEA regulators cannot impose additional requirements on insurers from the country that is equivalent, for example requiring a UK based reinsurer to post extra collateral. Equivalence in group supervision means that EEA regulators can rely on the group supervision exercised by the third country regulator so that the insurance group is not regulated by two separate entities.
Equivalence is something ironically that the UK pushed the EU to incorporate into many of its regulatory frameworks to ensure the bloc did not become too closed off from the rest of the world. It is recognition from the EU that the regulatory regime in another country is equivalent in the robustness of its legal framework and competency of the regulator.
Bermuda and Switzerland examples
Bermuda and Switzerland have achieved full equivalence with the EU’s Solvency II regime. Full equivalence is determined across three parameters: reinsurance, solvency calculation and group supervision. Provisional equivalence (the status that Canada and the US have achieved) relates only to group solvency calculation, while temporary equivalence can be granted for reinsurance activities or group supervision.
When Timetric asked the Bermuda Monetary Authority (BMA) about the benefits of equivalence, a spokesperson for the regulator replied, “The principal benefit of Solvency II equivalence is that Bermuda’s commercial (re)insurers and insurance groups will not be disadvantaged when competing for underwriting business in Europe.” Clearly Bermuda and the UK have different perspectives on the benefits of equivalence as they have different relationships with Europe (and the UK is not as reliant on insurance) but it should provide some comfort to insurers that an insurance hub such as Bermuda was so enthused about equivalence and its potential benefits.
It must be noted that equivalence does not give financial services firms the same depth of access to the single market that the UK currently enjoys. Furthermore, despite the UK having exactly the same regulations as the EU upon exit, the granting of equivalence is completely at the discretion of the European Commission (EC) and it can take up to a year for equivalence to be granted.
Furthermore, Solvency II consists of such a detailed set of regulations that the equivalence criteria do not cover all areas of it. Theoretically, the UK could drop some of the ‘less’ useful Solvency II rules which it does not agree with.
An example being the risk margin applied to longevity risk held by life insurers (a measure that has been publicly questioned by the PRA in the past). This could be used by the UK as a counter balance for losing full access to the single market but it would by no means be a close substitute for a large number of insurers.
Another problem that firms may have even if the UK achieves full equivalence, is that it does not bind the UK to copy changes in EU law. Therefore, if in the future EU regulation changed in a way which the UK did not agree with, it could choose not to implement the change and consequently could lose equivalence. The lack of absolute certainty regarding future equivalence could push insurers to relocate operations to EEA countries.
There is also a limit to the amount of deregulation that the UK could undertake whilst keeping equivalence. Any ‘bonfire’ of regulations would not only be questionable in terms of its economic impact but it would also be almost impossible to keep any form of a relationship with the EU regarding market access.
How might regulation change in the UK?
London was one of the epicentres of the global financial crisis. In the aftermath of the crisis, the ‘tripartite’ system of financial regulation set up by the then Prime Minister Gordon Brown which split responsibilities between the Financial Services Authority (FSA), Bank of England and the Treasury was widely criticised. A common criticism of the FSA is that it succumbed to lobbying by banks to not introduce or enforce stricter regulations; being convinced that doing so would harm London’s competitiveness.
As a result when the Prudential Regulatory Authority (PRA) was created, its brief did not include a requirement to consider the implications for competitiveness when originating and applying regulations. The insurance industry having not played as big a role in the financial crisis, have been unhappy with this state of affairs for a number of years and felt the less market focused attitude of the PRA harmed their prospects relative to their international competitors. There is now hope that in any possible reform of the regulator post-Brexit, there will be awareness within Government that it will be more important than ever that its regulators have a strong focus on competitiveness.
Negotiating bilateral deals with emerging economies will become ever more important for the UK, post-Brexit. This will require increased effort, coordination and intelligence with regards to attracting foreign companies to operate and invest in the UK.
In order for this strategy to be a success, UK regulators would have to become more proactive in being alert to business decisions made around the world. For example, the Monetary Authority of Singapore (MAS) has permanent staff based in the largest financial centres around the world to increase awareness of the jurisdiction and make the process of setting up operations there easier for companies. This may be a strategy the UK may have to pursue in a post-Brexit world.
Clare Swirski, Corporate Partner in the financial institutions group and global insurance group at Clifford Chance speaking at a recent webinar held by Insurance Day magazine, mentioned the importance of there being an agreed set of transitional provisions.
If at the end of negotiations the UK was going to lose its financial passporting rights it would be important to have some transitional provisions in place to allow an orderly transition from the old trading relationship to the new one.
These provisions would be required not only to give firms time to adjust their operational structures but also on a more practical level in terms of policies.
So where insurers based in the UK have ongoing policies with EU clients it is important that it is made clear to the industry that transitional provisions states that such policies can continue until runoff, otherwise there would be a great amount of disruption caused to the sector.
The provisions could also assist in any in-between period lasting from actual exit from the single market to the enactment and recognition of equivalence or a similar trading or service agreement.
Insurers should be prepared for the lobbying boom
While the pace of the UK’s exit from the EU is likely to be more drawn out than businesses on both sides of the Channel would prefer; it does open up a huge opportunity for the industry to shape the economic environment of the UK to their benefit.
In the absence of remaining in the EEA, the insurance industry must lobby the government strongly so that it can influence the financial standards and rules that will now be devised in London instead of Brussels. It is an unprecedented chance for the industry to contribute to the creation of a regulatory environment that will compensate it for the loss of access to the single market.
To access more market insight, data and forecasts from Timetric's Insurance Intelligence Center, visit www.insurance-ic.com