Setting clear expectations

Peter Moore and Natanya Roelofse look at the PRA’s priority areas of focus for general insurers, and how firms can address them

On 5 November 2019, the Prudential Regulation Authority (PRA) sent out two letters – one to chief executives of general insurance (GI) firms regulated by the PRA, the other to chief actuaries of GI firms regulated in the UK. 

These set out PRA priorities for the GI sector, share insights from reviews of firms’ reserving during 2019, and provide general observations from supervision activity during the past year. 

What are the PRA key priorities, what can firms do to address the issues highlighted and what are the next steps?

Key priority areas

Firms can expect reserving adequacy, governance and controls to be important areas of supervisory focus.

Actuarial reserving reviews found evidence that could be indicative of:

• Bias in reserve assessment, including favourable development assumptions when recent experience arguably indicates otherwise (see Figure 1)
• Weakening of case reserving basis
• Inadequate claims inflation allowance
• Attritional loss deterioration
• A lack of transparency of key judgments and assumptions in management information (MI).

Underwriting conditions have been challenging during the past few years, and firms have struggled to push rate increases through. Some evidence suggests this has led to the potential underpricing of risks, leading some firms to struggle to achieve underwriting profitability.

A series of exposure management reviews have identified a number of areas for improvement, including overreliance on estimates of exposure that have been derived from complex models, and lack of assessment of the potential for changing and emerging catastrophe risks. 

Further questions have been raised around culture and support for control functions – are firms promoting a culture in which staff feel able to speak up about poor practices or unidentified risks, including issues relating to financial soundness?

Improving communication channels 

Our view is that the issues raised by the PRA are interconnected and need to be addressed as a whole. There are some quick wins, but also areas that may require deeper thought.

Firstly, most challenges can be addressed by setting up effective feedback loops across functions so emerging experience can be shared with relevant stakeholders in a timely manner. This could be achieved via formal regular meetings and supported by ad hoc meetings. The feedback loops should not only exist across functions (claims, pricing and underwriting, exposure management and reserving teams), but also ensure effective and timely communication channels to and from the board. 

The benefits of ensuring effective feedback loops across functions include:

• Better understanding of assumptions that drive bias in reserve estimates. For example, initial expected loss ratio (IELR) assumptions could include underwriting remediation activity. Direct and regular communication with underwriters and business plan owners will provide a better understanding of remediation activity, initial experience following remediation activity, and ultimately the achievability of the underwriting remediation activity in the business plan and IELRs.
• Improved articulation of how comfort of any claims inflation allowance in reserve assessments has been gained. Claims inflation assumptions can vary wildly between teams. It is important that teams understand their different views and how they have arrived at those views.
• Access to information, enabling firms to ensure reserves reflect emerging trends more quickly. Claims teams may be able to share insights on emerging claims trends that help the rest of the business react to emerging information in a timelier way. 
• A more thorough understanding of case estimates and any changes to case estimates. Sometimes claims diagnostics can share useful information about emerging trends. However, to fully understand output from claims diagnostics, closer links with claims teams are necessary. For example, higher paid-to-incurred ratios can indicate a weakening case estimate basis, but could also be indicative of improved claims handling procedures.
• The validation of pricing assumptions. The ultimate loss ratio and claims inflation are two of the most material assumptions in pricing. Effective feedback loops from different teams help validate these assumptions. Assumptions may not be the same in different parts of the business, but understanding these differences and the reasons for them is important.
• Improving the firm’s ability to understand its profitability. Sharing information across functions helps ensure a holistic view of the business. It will also support the development of new MI through leveraging information from different parts of the business, driving further efficiencies.

Improved communication channels to and from the board could address concerns around possible management challenge on actuarial judgments, particularly at times of heightened commercial pressures. These communication channels could be improved through mechanisms that provide control functions with access to non-executive directors outside board meetings.

Appropriate management information

Secondly, the business should provide relevant MI that can be shared across functions and with the board. Appropriate MI, at a sufficient level of granularity, will help support the firm’s understanding of profitability and address underwriting control weakness. More relevant MI may need to be created – for example, it’s good to look at quarter-by-quarter movements for emerging trends, but this should be supported by an overall longer-term view. 

In the same vein, the board requires sufficient MI that includes clearly identified key judgments made when setting reserves so that it can understand and challenge where reserves are being set within a reasonable range. This can be achieved by reporting that is sufficiently detailed to inform decision-making, but sufficiently concise to navigate and provide practical effective challenge. Key metrics that the board find useful should be agreed. This does not exclusively relate to reserving, and can be applied to other communication to the board.

Furthermore, any material findings following analysis or picked up in MI should be escalated to the board on an ad hoc basis, not just held for scheduled meetings. This allows boards to receive information in a timely manner.

Other actions to improve a firm’s reserving view include focusing on both upside and downside risks when setting reserves on a best estimate basis, understanding the social and cultural drivers of claims inflation, and considering whether loss development patterns and other material assumptions remain appropriate over time.

Pricing assumptions should also be continuously validated as the market changes, for example through back-testing. Firms should not only seek to include historical data in their pricing assumptions, but also make some allowance for a future that may be different to the past. 

On exposure management controls, firms with material natural catastrophe exposures should assess the potential for changing and emerging catastrophe risks. Flood and catastrophe models can be used to support this analysis. A forward-looking exposure-based assessment that challenges historical information should be included.

One consideration should be man-made catastrophe risk, given the changing nature of this risk. Some progress has already been made with firms that have started to develop action plans to address residual ‘silent’ or ‘non-affirmative’ cyber exposures. This needs to be further developed so the potential impact of cyber risk events within firms can be understood and risk mitigation strategies developed.

Lastly, firms should analyse how their strategy and growth plans are consistent with their risk appetite and reinsurance programme.

Peter Moore is a senior manager at BDO

Natanya Roelofse is a senior manager at BDO