“The Standard Formula” podcast continues its Back to Basics series — a deep dive into the Solvency II regime — discussing the regime’s provisions regarding third country branches and the cross-border provision of services. For this third instalment in the series, host Robert Chaplin is joined by colleague Meher Pahuja to discuss the significance of this subject for insurers and the focus on competitiveness and growth in the U.K. market.
This episode of “The Standard Formula” podcast is part three of the “Back to Basics” series, which takes a deep dive into the Solvency II regime. Skadden partner Rob Chaplin is joined by his colleague Meher Pahuja to discuss third-country branches and the cross-border provision of services.
Rob and Meher explore the significance of third-country branches and the cross-border provision of services, shedding light on the regulatory landscape before and after Brexit. They emphasize the importance of these topics, discussing “passporting” and pre-Brexit regulations. They also provide insights into the post-Brexit environment, explaining the Temporary Permissions Regime (TPR) and the Financial Services Contracts Regime (FSCR) in the U.K., in addition to briefly covering the contingency arrangements implemented by the EU.
Later in the episode, Rob and Meher analyze the Prudential Regulation Authority’s (PRA's) proposals to remove capital requirements for third-country branches, and highlight the PRA's efforts to encourage competition and protect customers in the U.K. insurance market.
- Brexit’s Impact on Third-Country Branches: Brexit has had a significant impact on the insurance industry, particularly regarding third-country branches and cross-border services. It’s important to be aware of the changes in regulations and the implications for conducting business in both the U.K. and the EU at this point in time.
- PRA’s Regulatory Reforms: The PRA in the U.K. is undergoing significant regulatory reforms, including proposals to remove capital requirements for third-country branches. The PRA is taking significant strides to encourage competitiveness and growth in the U.K. market while protecting customers.
- Diverse Regulatory Landscape Across EU Member States: There’s a lack of harmonization across EU member states regarding contingency arrangements for third-country branches. Those operating in multiple EU jurisdictions need to be aware of the varying rules and regulations in each country, as this can significantly impact their ability to provide cross-border services.
From Skadden, the Standard Formula is a Solvency II podcast for UK and European insurance professionals. Join us as Skadden partner, Robert Chaplin, leads conversations with industry practitioners and explores Solvency II developments that matter to you.
Rob Chaplin (00:18):
Welcome back to the Standard Formula podcast. If you’ve joined us before, you’ll know that we are now doing a Back to Basics series of which this is the third episode. We’ve been conducting a deep dive into the Solvency II regime and today we’ll continue this journey. The Back to Basics episodes will be compiled into a book that will be released chapter by chapter, so please sign up to our mailing list as we’ll be releasing chapters of the book to those on it.
Today, we’ll be talking about third-country branches and the cross-border provision of services. We’ll be taking a three-pronged approach to this, talking through what the Solvency II regime was, what it’s become post-Brexit, and the impact this has had on both the EU and UK regimes, as well as what insights the recent PRA consultation papers provide us with.
To help me discuss these issues, I’m pleased to be joined by my colleague Meher Pahuja, who will help us map out the intricacies around this topic. Meher, why don’t you start us off by talking about what we mean when we talk about third-country branches and the cross-border provision of services?
Meher Pahuja (01:33):
Thank you very much, Rob. It’s easy to overlook the importance of third-country branches and the cross-border provision of services. However, in 2022 under Solvency II, there were 21 third-country branches, over 6,500 notifications of freedom to provide services cross-border for branches and over 14,000 notifications of cross-border freedom to provide services. These numbers clearly indicate the importance of the subject.
To set the scene, the Solvency II regime allows insurance undertakings authorized in one European Economic Area, or EEA state, to provide insurance in another EE state on a freedom of services or a freedom of establishment or branch basis. This means either providing the services on a cross-border basis, meaning without having a permanent presence in that other EEA state, or by setting up a permanent establishment that is a branch in that other EEA state, which does not separately require local authorization.
This is otherwise known as passporting, with passports being available to both insurers and reinsurers. It’s helpful here to take a step back and look at what the law was before the UK’s exit from the EU and how the law in this area has changed. Over to Rob.
Rob Chaplin (02:54):
Thanks, Meher. An authorization from an insurers or reinsurers home member state is valid throughout the entire EEA, giving firms the freedom to provide services and the freedom of establishment both here and in other member states. Post-Brexit, this right ceased to apply to UK-authorized insurers who have had to undertake significant Brexit transition steps in order to continue to service EU-based customers.
This includes in certain circumstances setting up EEA-authorized insurers and migrating customers to locally authorized entities. We’ll still spend a couple of minutes summarizing the applicable rules for EEA insurers and EEA reinsurers, just bearing in mind that these are no longer applicable to the UK.
Under Article 147 of the Solvency II Directive, where an EEA insurer wishes to exercise their passporting rights without setting up a branch, the insurer has to notify the supervising authority of their home member state. Though there are no notification requirements for the passporting of reinsurers, Article 158 provides that reinsurers have to comply with the legal and regulatory requirements, which they would be subject to as reinsurers in the host member state.
Moving on, under Article 15(1), passporting insurers, this is of course assuming authorization in their home member state, can set up a branch in a non-home EEA state by exercising their right of establishment. This entails notifying the supervising authority in their home member state, including informing them of the details of the scheme of operations under Article 145.
The home state regulator will then notify the host state regulator. One of the reasons for this information requirement is that under Article 31, the supervisory authority from the home member state continues to remain responsible for supervising the passporting insurer party. Indeed, insurers carrying on business in another member state for a branch have to act in the interests of the general good. A somewhat vague but still helpful guiding principle that involves adherence to the Consumer Protection Code and Minimum Competency code 2017, amongst others.
That ends our whistle-stop tour of the establishment of branches and the law on the cross-border provision of services pre-Brexit. Why don’t we talk a little bit more about how a third-country branch can be established and their applicable capital requirements? Why don’t you start with talking about the EU requirements for authorization, Meher?
Meher Pahuja (05:44):
Of course. For an undertaking with its head office outside the EU to carry out direct insurance business in the EU, it must first obtain authorization. Analogously, generally for an undertaking with its head office outside the UK to carry out insurance business in the UK, it must also obtain authorization. Under Article 1622 to obtain authorization to operate in the EU, there are multiple conditions that an undertaking must fulfill.
We won’t go through each of them individually, but they range from designating a general representative to be approved by the supervisory authority to submitting a scheme of operations and are preconditions to the entity being granted permission. Brexit meant that insurers with EU operations and EU insurers with UK operations could no longer rely on their passporting rights. So, this means that the UK is now a third-country for Solvency II purposes with consequential impact for UK insurers and vice versa.
Let’s now break down what happened and where things now stand. I’ll start by talking about the contingency arrangements implemented by the UK government, then I’ll briefly cover the contingency arrangements implemented by the EU. The UK government has set in place two contingency arrangements. One, the Temporary Permissions Regime known as TPR, and two, the Financial Services Contracts Regime known as FSCR.
The TPR acts as a transition mechanism for EEA firms which operated in the UK on the basis of passporting rights to continue to do so whilst awaiting and applying for full UK authorization. In certain cases, this may require insurers that previously provided services in the UK on a branch basis to subsidiarize in the UK. This scheme ends on the 30th of December 2023, and the FCA expects any firms remaining in TPR that do not have active applications for full UK authorization either to apply to cancel their temporary permission or indicate that they expect to enter the FSCR.
The FSCR also acts as a transition mechanism for EEA firms. However, it instead allows for EEA firms to run off their existing regulated business in the UK. But different to the TPR, it does not allow for firms to write new businesses in the UK. Instead, it enables EEA firms that previously passported into the UK that did not enter the TPR or that lead the TPR without authorization or registration to wind down their UK business in an orderly fashion. The FSCR in itself also consists of two regimes, the Contractual Runoff Regime, or CRO, and the Supervised Runoff Regime, or SRO.
That’s a quick overview for the UK. This brings us to the EU. Unfortunately, there’s no easy answer here. There’s been a lack of harmonization across measures in the EU member states, with certain member states providing no runoff regime whatsoever. Each jurisdiction has its own rules and it’s up to insurers to see what contingency arrangements are in place for that state, which means that the ability of UK insurers to continue to provide cross-border services across the EU will vary across each member state.
It would be helpful at this point to discuss the new PRA consultation papers. Rob, what do these new publications tell us about the law surrounding this area?
Rob Chaplin (09:32):
Well, the PRA has been considering significant reforms for third-country branches. Consultation papers issued this year set out the PRA’s proposals. Most significantly, they’re looking to remove the need to calculate and report third-country branch capital requirements.
This includes rules that require insurers from countries other than the UK that operate here through a branch presence to be free of the obligation to account for a branch Solvency Capital requirement, or SCR, and a Branch Minimum Capital Requirement, or MCR. Why don’t you break down what this means, Meher?
Meher Pahuja (10:12):
Absolutely, Rob. Let me explain what we mean by these two calculations. The SCR is the amount of regulatory capital that an insurer is required to hold for it to be considered sufficiently protected against unexpected losses on a one in 200-year failure basis. This level of financial resources is calculated on the basis that policyholders and beneficiaries need reasonable insurance that they will receive payments as and when they are due, even if the business is facing any kind of difficulty.
The MCR is a smaller amount. It’s the threshold below which a firm’s financial resources should not fall without warranting supervisory intervention in the form of withdrawing authorization. The PRA is proposing to abolish the SCR localization requirement for third-country branches. That is, the requirement to hold assets in the UK to cover the branch SCR and the requirement to establish and report branch risk margins on balance sheets.
These proposals are set to apply to all third-country branch undertakings in the UK, and any insurers considering authorization in the UK as a branch. What do you think are the PRA’s intentions with these changes, Rob?
Rob Chaplin (11:31):
The PRA is reflecting the reality that a third-country branch can’t be seen as an independent entity completely disconnected from its wider legal enterprise. This doesn’t let entities off the hook, however. It perhaps means instead that the PRA will exercise greater scrutiny over entities holistically and their home regimes, which are looking up to set up or maintain a branch.
It’s clear that these measures do reflect efforts to encourage firms to enter the UK market, thereby fostering healthy competition between insurers and the development of the UK insurance market. The PRA is attempting to equalize different firms here by removing the branch capital and other requirements. Third-country branches don’t have to comply with both home state and UK rules, which alleviates them of double qualification requirements.
One potential drawback to these reforms is that policyholders may be at higher risk. This is especially if the branch capital requirements may have previously acted as a safeguard against less adequately capitalized firms operating in the market. At a macro level, however, these proposals may nonetheless further the PRA’s prudential framework. With arguably lower entrance requirements, the PRA expects there to be an increase in the number of insurance entities that set up third-country branches in the UK.
With this gravitation of firms to the UK, it’s likely that the range, variety and quality of options available for consumers market-wide will increase, allowing them more choice and flexibility and creating greater market-wide resilience. This isn’t to say that the PRA isn’t looking out for individual policyholders in proposing to implement these reforms. The PRA will still depend on home state authorities to check that these third-country insurance undertakings are properly regulated and overseen.
Moreover, the PRA will still require third-country firms to show that they maintain adequate worldwide financial resources. This isn’t the only guidance that the PRA has recently published on potential changes for third-country branches in the UK, though, is it, Meher?
Meher Pahuja (13:51):
It’s not. In September, the PRA published a consultation paper where they outlined potential changes to ring-fence bodies, also known as RFBs. Ring-fencing is the requirement for banks in the UK who are over the deposit threshold to essentially ring-fence their core activities. Ring-fencing here can be taken to mean creating separate legal entities for different types of activities and monitoring and supervising the interactions between these bodies.
There are two broad proposals that the PRA has suggested in respect of this. The first is introducing a provision where RFBs should ensure that there is no material risk presented by a third-country branch to the RFB’s provision of core services in the UK. The second, linking back to the first proposal, sets out some guidance criteria for what the PRA may take into account when deciding whether such a material risk is posed.
The PRA proposes to look at disclosure in firms individual capital adequacy assessment process for non-UK entities that are over a certain size, the establishment of non-UK entities in countries who could potentially pose risks to the RFB and the impact of non-UK entities on resolvability. While that’s a brief overview, what is clear from all these consultation papers is that the PRA is taking significant strides to encourage competitiveness and growth in the UK market while protecting customers.
Rob Chaplin (15:27):
That’s an excellent way to summarize what we’ve discussed and brings us to the end of what we have to say today. Thank you for joining us. We hope you will continue to tune in for future episodes.
(15:39):In case you missed it, our last episode covered reinsurance and risks transfer, and our next topic will be the difficult and complex subject of insurance groups. If you have any questions or comments on any of the topics we spoke about today, or Solvency II in general, please feel free to contact us. Thank you, and we hope you’ll join us next time.
Thank you for joining us on the Standard Formula. If you enjoyed this conversation, be sure to subscribe in your favorite podcast app so you don’t miss any future episodes. Additional information about Skadden can be found at skadden.com. The Standard Formula is a podcast by Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates and affiliates.
Skadden is recognized for its deep experience in representing insurance and reinsurance companies and their advisors on a wide variety of transactional and regulatory matters. This podcast is provided for educational and informational purposes only and is not intended and should not be construed as legal advice. This podcast is considered advertising under applicable state laws.