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PRA may relieve run-off firms of external audit requirements

UK run-off companies could find themselves exempt from new Solvency II-related external audit requirements under new proposals by the Prudential Regulation Authority (PRA).

A consultation paper published by the PRA in April proposes to amend the rule that requires the external audit of parts of the Solvency and Financial Condition Report (SFCR).

The proposal comes after the regulator determined that the cost of an external audit may be disproportionately onerous for smaller insurance companies.

The PRA estimates that the proposed amendments would remove the SFCR external audit requirement from the end of 2018 for more than 150 smaller UK Solvency II firms.

However, the calculation used to determine which firms would be classified as a “smaller firm” could mean that even some of the largest run-off companies would find themselves exempt from the rule.

The PRA has proposed a risk scoring system which uses written premium and best-estimate liabilities to determine whether an insurance firm falls into this category. A risk score of more than 100 means the firm will require an external audit of their SFCR.

However, for run-off companies the written premium is virtually zero, as they have stopped writing new business. Therefore, that element of the formula would contribute very little to the risk score, explained Stuart Wilson, UK financial services audit partner at EY.

“In order to get to a score of 100 on the test of best-estimate liabilities alone, you would actually need as much as £2.5bn ($3.44bn) in insurance liabilities to be within scope of an audit,” he said.

One area that will not be audited in the GAAP financials is the calculation of the capital requirement under Solvency II, in terms of the amount of capital that needs to be held by the entity, Wilson continued.

“To be fair, for run-off companies there is a different dynamic – as they are not introducing new business all the time, you would hope the liabilities are much more stable, and are being run off in an orderly manner,” he said.

But this does mean that, without an audit, a quite large run-off company might be reporting a capital requirement higher or lower than is required under Solvency II and the auditor would not look at this, he added.

Wilson continued: “This isn’t necessarily an oversight by the PRA but I think some in the market are surprised by this rule. Of course it is a consultation paper and they may choose to look at the proposed rule again if a number of responses say the risk scoring rules out quite a few of the largest run-off companies.”

If the proposal is approved, all insurance firms will still be subject to an external audit of all their other publicly disclosed financial statements. Any concerns held by the regulator could also be scrutinised further via a Section 166 investigation.

Legacy sources canvassed by The Insurance Insider expressed some relief at lesser regulatory reporting requirements for their firm. External audits, particularly for smaller run-off companies, can be extremely costly for the size of the business, some said.

One source also noted that many EU regulators already conduct annual reviews of run-off companies, and this SFCR external audit would cause unnecessary additional cost and resource.

Ken Randall, chairman of Randall & Quilter, said his firm would likely still be subject to the external audit requirements due to its progam underwriting business.

However, he said that some regulation for legacy companies did not seem fit for purpose.

Randall said that even for acquired companies with very small amounts of residual liabilities R&Q would have to report on a number of areas for regulatory reasons.

“All the work we have to do on that seems to be completely disproportionate to the risk that those entities carry,” he said.

“Of course, legacy portfolios are not without uncertainties but it’s not on the same scale as some insurance classes, such as catastrophe business or cyber, for example,” he added.

“I would like to see more regulatory focus on those big areas of exposure rather than analysing every which way a £2mn portfolio can go.”

Responses to the consultation paper are requested by 11 July.

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