DP2/23 – FSCS general insurance limit

3.1 This chapter describes several approaches that the PRA considers could remedy an inappropriate degree of policyholder protection with respect to GI. The PRA requests feedback on the approaches listed below to help it develop potential policy proposals for inclusion in a future CP. Respondents should bear in mind that the final policy proposal will need to balance the need for the PRA to meet its policyholder protection objective and avoid the burden and uncertainty of emergency rule changes against the potential cost to industry.

Option 1 - 100% coverage of all GI products

3.2 The first possible approach to remedy an inappropriate degree of policyholder protection would be to move all GI policy types which are currently covered by the FSCS at 90% to 100% coverage, without changing the rules on what insurance areas are in scope and who is eligible to claim under the FSCS.

Advantages

3.3 As mentioned in paragraph 2.3, it is very difficult to accurately predict whether a failure of an individual insurer would lead to an LCI. If the PRA is unable to identify the risk of an LCI for a particular line of GI in advance and is therefore unable to increase protection for that particular line of GI to 100%, issues with insufficient policyholder protection may still arise. This could result in the PRA having to make further emergency rule changes as in the case of East West. The key benefit of an approach to move all GI policy types to 100% coverage would be to reduce the risk that, should a GI insurer fail, eligible policyholders are exposed to an LCI.

3.4 Increasing the GI limit to 100% would result in eligible policyholders no longer suffering a shortfall in the amount of any claim under a contract of insurance paid out by the FSCS. Furthermore, it would facilitate orderly exit for eligible policyholders by enhancing the possibility of the FSCS securing continuity of cover for those policyholders. This could be achieved by the FSCS arranging for the transfer of policies to another firm at 100%, rather than the current position of 90%, of any future claims.

3.5 Increasing limits to 100% would be administratively more straightforward for the FSCS (potentially reducing operating costs which could partially offset the additional compensation cost) and would simplify the Policyholder Protection Part. In addition, by making coverage limits easier to understand, it would aid consumer understanding of the FSCS and consumer confidence in firms covered by the FSCS. In doing so it may potentially yield macroprudential dividends by enhancing trust in the FSCS as the backstop of the financial system in the UK.

3.6 For these reasons, the PRA considers that it could be appropriate to move the coverage of all GI products to 100% as one viable option for contributing to the PRA's policyholder protection objective, as well as providing further macroprudential and operational benefits.

Q3: Would moving to 100% coverage of all GI products a viable way to meet the PRA's objectives? Why, or why not?

Disadvantages

3.7 The PRA considers that the strongest argument against this approach would be the cost to industryof funding higher levies arising from higher protection levels. There are limits to firms' abilities to fund compensation without threatening their profitability or even viability. This may be a particular issue if a very large insurer were to fail, or if several medium-size firms were to fail concurrently. However, there are mechanisms to potentially smooth the impact of such an issue on insurers over time. For example, there are limits on what the FSCS can levy industry and, should costs exceed these limits, the FSCS may request to borrow additional funds from HMT including by borrowing from the National Loans Fund, with these additional borrowings repaid over a longer period of time by industry via future FSCS levies.

3.8 To help assess the potential materiality of this disadvantage, the PRA in conjunction with the FSCS reviewed data covering GI claims subject to 90% coverage paid for the five-year period from August 2018 to August 2023. From this, the PRA has identified that, if the FSCS had paid the claims protected at 90% at the higher 100% rate, this would have added approximately £39 million to the compensation costs paid in total over those five years. As can be seen from the table below, this would have increased the compensation element of the levy by around 4-9% per annum compared with maintaining the status quo. Taking the 2022/23 levy as an example, increasing coverage on GI claims from 90% to 100% would have meant that the levy would have been £7,288,024 more than it was, bringing the total levy to £197,517,103. This amounts to an average increase of £29,387 in the levy paid by each firm, although, in reality, the amount paid by each firm would depend on the level of FSCS protected business held by each firm.^{footnote [10]}

FSCS compensation spend on GI claims between August 2018 and August 2023

2018/19	2019/20	2020/21	2021/22	2022/23
Total cost at 90%	£148,918,481	£148,966,987	£120,812,966	£157,866,214	£190,229,079
Total cost at 100%	£154,483,727	£155,422,482	£127,207,050	£171,433,559	£197,517,103
Additional cost of moving to 100%	£5,565,246	£6,455,495	£6,394,084	£13,567,345	£7,288,024
Percentage increase	4%	4%	5%	9%	4%

3.9 On the one hand, based on the analysis in paragraph 3.8, the PRA considers that the costs of moving to 100% coverage of all GI products may not be significant for firms individually, and in aggregate, to cover, and could have the potential to be reduced further by the PRA's work on ease of exit and future work on an insurer resolution regime. On the other hand, the PRA recognises that the compensation levy has increased in recent years as a result of historical failures. Any increase in protection levels, no matter how modest, would further increase that levy and require going concern firms to pick up a higher bill for failed firms. This could potentially result in increased costs being passed on to policyholders.

Q4: Is the PRA's assessment of the impact of the potential increase to the levy accurate and complete?

Q5: Is the burden to firms of an increase to the levy proportionate to the benefit that would be derived from increasing coverage to 100%?

Q6: Are there potential consequences to moving to 100% coverage of all GI products that the PRA has not considered?

Option 2 - Targeted additional coverage

3.10 An alternative to moving to 100% coverage for GI products would be to attempt to target increased coverage more precisely to those GI products with an LCI potential. Despite its analysis of GI, the PRA has been unable to precisely identify those GI products where there is a clear causal link with the potential for an LCI. The PRA is asking industry for its views on whether there is a test that would enable such a determination to take place before an LCI occurs.

Advantages

3.11 Precisely targeting additional coverage to those areas of GI with LCI potential could reduce the risk of an LCI occurring while controlling potential increased costs to industry.

Disadvantages

3.12 The potential for an LCI to occur is highly dependent on both individual and broader economic circumstances. Therefore, the PRA is concerned that it is unlikely to be able to anticipate all potential areas of LCIs for existing GI products and future GI products that are currently being developed. This means that issues with insufficient policyholder protection may still arise, creating a risk that the PRA would need to make further emergency rule changes reactively in failures where unexpected LCIs emerge.

3.13 A targeted approach would also involve complex rulemaking as certain sectors of the GI market would benefit from 100% protection while others remaining at 90%. This is likely to result in confusion for some policyholders around their level of FSCS coverage. It would also require the rules to be frequently reviewed and updated as new insurance products are developed which have the potential to cause an LCI.

3.14 Additionally, although a targeted approach has the potential to control costs to industry, it would still lead to an increase in costs, particularly if most types of GI policy were moved to 100% cover.

3.15 Finally, such an approach may result in accidental mis-categorisation of insurance policies by either insurers or the FSCS. This may occur, for example, if it is not clear whether a new insurance product does in fact fall within one of the areas of targeted coverage. The PRA considers that this may increase the administrative burden on the FSCS, increase costs to industry and delay FSCS paying compensation or seeking continuity of cover.

Q7: Is there a viable approach that would allow the PRA to target increased coverage to specific areas of GI while still mitigating the risk of LCI's occurring? Could it be a viable way to meet the PRA's objectives?

Q8: Does the potential to control (but not eliminate) increased costs to industry justify the additional complexity and residual LCI risk associated with a targeted approach?

Option 3 - Rule-based discretion

3.16 The PRA could consider implementing a form of rule-based discretion, giving the FSCS the ability to pay out 100% compensation where an individual claim meets a specified set of criteria, related to the LCI. This would be broadly similar to the system now in place for temporary high balances under the Depositor Protection Part of the PRA Rulebook,^{footnote [11]} where high balances of more than £85,000 can be covered by FSCS protection in certain circumstances set out in the rulebook.

Advantages

3.17 This would allow the PRA to target increased coverage more precisely, providing 100% FSCS protection to a wider range of GI policyholders and reducing the chances of an LCI while controlling the increase in costs to industry.

Disadvantages

3.18 This could in theory provide increased compensation to some of those in need, however, the PRA considers that the relevant criteria are difficult to define in advance and may need to evolve, including as new GI products are developed. Ultimately this approach is likely to require a very high degree of subjective judgement by the FSCS. A rule allowing policyholders to apply for 100% coverage if they would otherwise suffer an LCI would require the FSCS to evaluate whether a particular policyholder would suffer a material negative impact on their life circumstances - for instance, on housing, health, or finances - which they are unlikely to be able to bear or would bear with great difficulty. For each such claim, the FSCS would need to conduct a detailed and fact-dependent assessment of the policyholder's personal circumstances to ensure the relevant criteria are met before issuing a decision. Furthermore, a public perception that FSCS decisions are subjective or arbitrary has the potential to undermine the reputation of the FSCS, and thereby, the PRA's statutory objective to promote the safety and soundness of the firms it regulates.

3.19 The PRA considers that savings to the compensation levy gained through this approach would be counterbalanced by increases to the management expenses levy (MELL). The type of decision-making required would call for significant FSCS resource in processing claims (or risk slowing down the pay-out timeline for all claimants). The resulting expansion of FSCS functions could increase the FSCS' costs, erasing any compensation levy savings as compared with the other possible approaches discussed in this DP and causing greater difficulties and uncertainty for claimants.

Q9: Could providing the FSCS with rule-based discretion be a viable way to mitigate the risks of LCI's occurring and meet the PRA's objectives? Are there arguments using this approach that the PRA has not considered?

Q10: What criteria could the PRA impose that would clearly and appropriately limit FSCS discretion, if the PRA was to take this approach?

Option 4 - FSCS excess

3.20 Another option would be to introduce an 'FSCS excess' which would deduct a specified amount from each claim paid out by the FSCS to fund the increased costs of moving all GI to 100% protection.

Advantages

3.21 As with option 1, this approach would reduce the risk that, should a GI insurer fail, eligible policyholders are exposed to an LCI. However, it could also balance out the increased costs to industry of 100% GI cover while still providing sufficient coverage for claims with high LCI potential.

Disadvantages

3.22 The FSCS has estimated that approximately £56 would have to be reduced from every claim it pays to make increasing the GI coverage limit cost neutral. While on its own this figure appears manageable, the FSCS pays many small claims, often for the return of unused premiums. The FSCS estimates that an excess of £56 would lead to a number of claims currently paid being moved to nil. This would radically alter the effects of the compensation scheme by excluding a significant percentage of policyholders from the benefits of the scheme, and consequently, may undermine the overall consumer faith in the safety of the financial system.

3.23 An FSCS excess could also be made proportionate to the value of a claim through the first £x of a claim being covered at 90%, with the remainder receiving 100% coverage. This could limit cost increases somewhat and reduce LCI potential from large claims, but at the expense of complexity and the appearance that large claims are being treated more favourably than small ones. It would also increase claims processing costs which would ultimately be passed on to firms.

Q11: Would an FSCS excess be a feasible option for limiting overall cost to industry while mitigating the risks LCI's occurring and meeting the PRA's objectives? If so, how should that excess be designed and applied?

Option 5 - Reverse deductible

3.24 The PRA could provide increased FSCS cover across all categories of GI while imposing a reverse deductible. This would entail 100% cover provided for a certain amount of a claim, then 90% cover for anything exceeding this. For example, the FSCS could provide 100% cover for the first £500 of a claim and then 90% cover for any amount above this.

Advantages

3.25 As with option 1, this approach would reduce the risk that, should a GI insurer fail, eligible policyholders are exposed to an LCI. It could also balance out some of the increased costs to industry while still providing sufficient coverage for claims with high LCI potential. Finally, it would represent a return to the position that the Financial Services Authority (FSA) put in place between 2001 and 2009, therefore policyholders may be more familiar with the concept.

Disadvantages

3.26 As mentioned above, implementation of a reverse deductible would represent a return to the approach in place between 2001 and 2009. This approach was replaced by the FSA to simplify and streamline claims processing. The PRA considers that reverting to it now could delay pay-out by the FSCS and increase processing costs. In particular, this approach would be operationally challenging for the FSCS because insurance claims often have more than one payment. To ensure that the reverse deductible was correctly applied, the FSCS would need to collect additional data to verify the position of claimants across multiple payments relating to a claim.

3.27 Additionally, while a reverse deductible may limit costs, it would not prevent the occurrence of an LCI in all cases, as a 10% reduction of a large amount would probably still be a large amount for many policyholders. Thus there remains a risk that the PRA would need to make further emergency rule changes reactively in failures where LCIs appear likely to emerge.

Q12: Would a reverse deductible enable the PRA to meet its objectives? Would it be a feasible option for limiting overall cost to industry while mitigating the risk of LCI's occurring? If so, how should that deductible be designed and applied?

Option 6 - Maintain protection at current level

3.28 A final alternative option would be to do nothing and maintain 90% protection where it is currently in place in GI.

Advantages

3.29 This approach has the benefit of maintaining current costs to industry and ensuring that losses are borne by policyholders of the firm in default, given they have a far closer link to the firm than other groups who may otherwise be liable, such as the customers of other firms who may ultimately bear compensation levy costs. The PRA is conscious that it is unsustainable to increase the level of coverage provided by the FSCS continuously, and that it may be difficult to withdraw increased protection once granted.

Disadvantages

3.30 The PRA considers that the long-term affordability of the FSCS for insurers is unlikely to be affected by increasing protection levels beyond 90%. As set out above, the increase in funding costs under even the most expansive of the options this DP explores - 100% coverage of all GI products - would be comparatively modest. The 'do nothing' approach therefore forfeits the potential benefits of reducing LCI outcomes for policyholders and facilitating ease of exit in order to avoid what would be relatively minor adjustments to the coverage limits.

3.31 Moreover, for any approach that involves a residual likelihood of LCI outcomes developing, there remains a risk that the PRA would need to make further emergency rule changes reactively in failures where LCIs appear likely to emerge. As was seen in the context of BGP, this is a resource-intensive backstop and, in general, a brake on insurer exit. Although this also holds true for some of the other options discussed above - for example, targeted additional coverage and reverse deductible - the risk would be at its highest if the PRA were to maintain protection at current levels.

Q13: Are there arguments for or against maintaining protection at current levels that the PRA has not considered? For example, do respondents consider that the PRA does not need to do anything because there are no insurance lines that would give rise to an LCI?

Q14: What other possible approaches should the PRA consider to reduce LCI risk going forward?

PRA objectives and have regards analysis

3.32 The PRA has a statutory general objective of promoting the safety and soundness of PRA-authorised persons and an insurance specific objective to secure an appropriate degree of protection for those who are or may become policyholders (the policyholder protection objective). An effective compensation scheme provides a safety net, offering protection to policyholders, which in turn leads to greater confidence in their dealings with financial services firms, benefiting all firms and leading to a stronger financial system. Therefore, the PRA considers that approaches 1-6 set out in this chapter are consistent with the general statutory objective and the insurance specific policyholder protection objective as they seek to minimise the adverse effect that the failure of a PRA-authorised insurer may have on policyholders, and in doing so help promote the stability of, and confidence in, the UK financial system.

3.33 The PRA has assessed whether the approaches in this chapter of the DP facilitate effective competition, the international competitiveness of the UK's economy and its growth in the medium to long term. The PRA considers that each of option 1-5 would result in an increase in costs to firms which, depending on the amount of that increase, could negatively impact effective competition and growth. However, this needs to be weighed against the increased stability of, and confidence in, the UK financial system gained as a result of implementing any of those approaches which would promote competition and growth. As option 6 maintains the status quo, the PRA does not consider that it would have an impact on effective competition. The PRA does not consider that the approaches would have an impact on international competitiveness.

3.34 In developing these approaches, the PRA has had regard to the FSMA regulatory principles, the aspects of the Government's economic policy set out in the HMT recommendation letter from 2022. The following factors, to which the PRA is required to have regard, were significant in the PRA's analysis of the approaches:

• better outcome for consumers (HMT Recommendation Letter) - increasing FSCS protection for all or some GI-eligible policyholders from 90% to 100% would produce a better outcome for policyholders by reducing the potential for them to suffer an LCI thus minimising the adverse effect that the failure of a PRA-authorised insurer may have on them.

Equality and diversity

3.35 In considering the approaches listed above, the PRA has had regard to the need under the Equality Act 2010 to promote equality of opportunity, eliminate discrimination and foster good relations between those with protected characteristics and others. Moving protection for all or certain groups of GI eligible policyholders from 90% to 100% would not affect those with protected characteristics differently in that they would change the compensation offered to all policyholders in a consistent way. The PRA considers that there may be overlap between certain protected characteristics, such as age, disability and pregnancy/maternity, and a heightened vulnerability to the kinds of harm the paper is trying to address, namely a LCI based on a 10% shortfall in compensation in an insurance failure. This is because people with certain protected characteristics may be affected more severely by and/or be less able to respond to a negative impact on their life circumstances. The PRA considers that options 1-5 seek to lessen such impacts, and so would have a positive effect on equality of opportunity amongst policyholders and the other elements of the general duty in the Equality Act.

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