The director for insurance supervision at the Prudential Regulation Authority has told insurers to consider whether business factors have changed since their models were designed, following a combination of risks insurers currently face in the sector. 

Use of models was one of the three areas Shoib Khan highlighted during a speech at a webinar organised by Westminster Business Forum today, the other two being stress testing and ease of exit.

In light of several crises in 2022  – the continued impact of Covid-19, an unexpected war in Ukraine, a sudden repricing in UK government debt and rising interest rates in the UK – Khan said users of the model should understand that events in the future may not be reflected in historical experience. 

Using the repricing of long-term gilts as example, which required intervention of the Bank of England to reduce contagion risk, Khan argued models might be misleading in the midst of a crisis.

He said: “The fact that you have just witnessed a one-in-100 year rise in gilt yields does not necessarily mean that you would not see a similar rise the next week. Unprecedented events such as these remind us that the need for action – in this case, the provision of liquidity – can arise suddenly, unexpectedly, and assets may not perform as they traditionally have.”

In addition, users of a model must understand the intended use of the model and its outputs, Khan said. 

“Model use should focus beyond one biting scenario to understand how different combinations of stressed inputs can lead to modelled outputs that are just as severe,” he explained.

Stress testing was another area Khan focussed on, adding that insurers should be confident that management actions will be available if needed during times of stress. 

Using aviation as analogy, Khan said insurers carry out stress tests and check the viability of their management actions but added: “They are always ready to deviate from the flight plan and enact a range of management actions such as changing direction or altitude to avoid in-flight hazards.”

He said the Bank of England will run an exploratory system-wide exercise to investigate the behaviours of a range of sectors, including insurers, in response to a “severe but plausible stress” to financial markets. 

More detail will be available on the 29 March. 

“We will investigate how the type of behaviours and market dynamics we found in the insurance stress test can occur in other financial sectors and how they can all interact to amplify shocks in markets and potentially bring about risks to UK financial stability.”

For Khan’s third area of his speech  – ensuring that firms can achieve a safe and orderly exit – he said insurers understand the concept of recovery generally well. However, resolvability – when  the “only safe course of action is for the insurer to end the flight prematurely” – is often less well understood. 

He said: “Insurers should understand that there will be a point beyond which continuing to push for recovery will not only be fruitless but could make it more difficult for the insurer to exit the market in an orderly way and, in the process, harm policyholders.”

The government is currently consulting on the Insurance Resolution Regime, which would give UK authorities powers to manage an insurer that is failing or likely to fail. The consultation runs until 20 April.

Khan said: “We hope and expect that the regime would only be used rarely, but pressing forward with the IRR is an important priority for the PRA. Its existence will not only bring the UK into line with relevant international standards, but provide more confidence about the UK’s insurance market, which will make the UK a more attractive place for insurers – and those transacting with them – to do business.”