DP2/23 – FSCS general insurance limit

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Responses are requested by Wednesday 24 January 2024

The PRA prefers responses to be sent via email to:[email protected].

Alternatively, please address any comments or enquiries to:
Capital and Compensation Standards Team
Prudential Regulation Authority
20 Moorgate
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EC2R 6DA

Executive summary

The Financial Services Compensation Scheme (FSCS) is designed to protect eligible customers when financial services firms fail. When an insurer fails, the FSCS will pay eligible policyholders, with a valid claim under an insurance policy, 90% or 100% of the claim value under that contract of insurance. Whether an eligible policy receives 90% or 100% protection depends on the type of insurance. Over the past 10 years an increasing variety of insurance areas have been moved to 100% coverage.

Following the publication of policy statement (PS) 21/20 - Extending policyholder protection for building guarantee policies in October 2020, which set out the Prudential Regulation Authority's (PRA) emergency rule change to increase the protection provided by the FSCS for eligible policyholders of buildings guarantee insurance from 90% to 100% of their claim, the PRA committed to review whether there are any other types of General Insurance (GI) policy for which increasing FSCS protection from 90 to 100% could be warranted on policyholder protection grounds.

This discussion paper (DP) sets out the PRA's analysis of those areas of GI where the PRA has identified additional FSCS coverage could be warranted to secure an appropriate degree of policyholder protection and possible options to remedy this.

In carrying out its analysis, the PRA identified that the current definition of 'small business' set out in the Policyholder Protection Part of the PRA Rulebook may no longer be appropriate. This DP outlines the issue with the current definition and a possible approach to changing that definition.

The PRA requests feedback on this DP from industry, the public and other stakeholders to help develop any potential policy proposals in a future consultation paper (CP).

1: Introduction

1.1 This Prudential Regulation Authority (PRA) discussion paper (DP) seeks feedback regarding whether it would be appropriate to increase FSCS limits for some or all the GI areas currently protected at 90%. The FSCS protects eligible customers when financial services firms fail. In the case of an insurer that fails, the FSCS will pay eligible policyholders, with a valid claim under an insurance policy, either 90% or 100% of the claim value under that contract of insurance. The level of FSCS protection depends on the type of insurance.

1.2 The PRA considers that an increase in coverage for some or all GI areas may be warranted to align FSCS protection for eligible policyholders more closely with the PRA's objective of securing an appropriate degree of policyholder protection. It would also support the PRA's objective of promoting the safety and soundness of firms.^{footnote [1]}

1.3 This DP seeks input from industry, the public, and other stakeholders to help in the PRA's assessment of whether, and for which specific types of GI, current FSCS protection levels may be insufficient, taking account of the potential benefits, costs and risks.

1.4 This DP also seeks feedback on whether the definition of small business in the Policyholder Protection Part remains appropriate. A small business is currently defined in the Policyholder Protection Part as a partnership, body corporate, unincorporated association, or mutual association with an annual turnover of less than £1 million (or its equivalent in any other currency at the relevant time). The PRA considers that the £1 million per annum threshold may no longer be appropriate as it limits the scope of FSCS protection in respect of certain GI policies to only the smallest businesses. Therefore, this DP also seeks input from industry, the public and other stakeholders, in determining an appropriate threshold.

1.5 This DP is relevant to:

• the FSCS as the scheme administrator of the PRA's Policyholder Protection Rules;
• insurers authorised by the PRA (including EEA insurers that establish a UK branch which has received PRA authorisation) and EEA insurers in the Supervised Run-off or Contractual Run-off regimes;
• firms that have assumed responsibility for liabilities from PRA-authorised insurers (successors); and
• policyholders.

Background

1.6 The PRA has two primary objectives:

• a general objective to promote the safety and soundness of all firms it regulates; and
• an objective specific to its regulation of insurers to contribute to the securing of an appropriate degree of protection for those who are, or may become, policyholders.

1.7 Safety and soundness and policyholder protection are complementary objectives. Action to promote the safety and soundness of an insurer will typically have the effect of protecting policyholders, by ensuring that the insurer's liabilities to them can be met both now and in the future. Additionally, current work by HM Treasury (HMT) and the PRA on developing an insurer resolution regime in conjunction with the PRA's strategic focus on ease of exit, is intended to reduce the impact of a disorderly exit of an insurer from the market on policyholders ie reducing the risk that continuity of cover will not be maintained, and policyholder claims will not be paid in full.

1.8 Notwithstanding the work mentioned in paragraph 1.7 above, the PRA is not a zero-failure regulator. There will be circumstances when an insurer authorised by the PRA with policyholders fails, where continuity of cover cannot be maintained, and eligible claimants cannot be paid. In this situation, the FSCS acts as a backstop, ensuring that valid claims under contracts of insurance by policyholders are met. However, not all policyholders have their claims protected by the FSCS. Only eligible policyholders benefit from FSCS protection and not all eligible policyholders have 100% of their claim protected.^{footnote [2]} Policyholder Protection Part 17.2 sets out that eligible policyholders are covered for 100% of any benefit under contracts for long-term insurance products,^{footnote [3]} as well as for GI products where the claim is in:

• respect of a liability subject to compulsory insurance;
• respect of a liability subject to professional indemnity insurance;
• respect of and arises from the death or incapacity of the policyholder due to injury, sickness, or infirmity; or
• respect of a liability subject to buildings guarantee insurance.

All other GI products are covered at 90% of the claim under the relevant contract of insurance.^{footnote [4]} This DP focusses on whether it is appropriate to increase the level of FSCS protection for eligible policyholders to 100% of the claim under a contract of insurance for some or all types of GI.

1.9 The current FSCS protection coverage limits for insurance are the result of a series of assessments and rule changes conducted by the PRA over the past 10 years. During this period, an increasing variety of insurance areas have been moved to 100% coverage.

1.10 Historically, FSCS protection was set at 100% cover for liabilities subject to certain compulsory insurance and 90% cover for all other insurance. Following a consultation in 2014, the PRA increased cover for long-term insurance to 100% coverage. This was based on an evaluation of the significance to policyholders of the risks insured by long-term products and the potential for significant adverse consequences for policyholders if cover was disrupted or obligations not paid.

1.11 Certain types of GI products were also included in the 2014 increase; however, the PRA decided to maintain FSCS protection at 90% for most GI policies on the basis that these GI policies were short term, did not feature any contractual lock-in, and there were no significant costs of exiting and switching cover to another provider. At that time, the PRA recognised that this would leave eligible policyholders to bear some residual financial cost, particularly those eligible policyholders with claims falling due.

1.12 That assessment was revisited in autumn 2020 in relation to buildings guarantee policies (BGP). For BGP, the context for the PRA's policyholder protection policy rationale had evolved significantly since it was set out in 2014, particularly in the aftermath of the Grenfell tragedy, subsequent changes to building regulations, and high-profile court cases. These events, in conjunction with the impending default of East West - an insurance firm with a book of BGP business - caused the PRA to urgently reassess the significance of the risks insured by BGP and the potential for significant adverse consequences if cover was disrupted or obligations arising under a BGP policy were not paid. Citing concerns that a shortfall in compensation for BGP policyholders could lead to problems remortgaging, selling and remediating property defects, the PRA made an emergency rule change to move FSCS cover of BGP from 90% to 100%.

1.13 As part of the policy statement setting out the emergency rule change, the PRA committed to review whether there were other categories of GI for which additional FSCS coverage could be warranted on policyholder protection grounds.

1.14 In light of that commitment, this DP seeks stakeholder feedback to build on the initial analysis carried out by PRA following the emergency rule change (see Chapters 2 and 3, below), to determine whether changes to the Policyholder Protection Part are appropriate, and if so, to identify and shape those changes.

1.15 In carrying out the analysis, the PRA became aware of an issue with the definition of small business in the Policyholder Protection Part. The current definition has remained unchanged since 2000 and only those partnerships, body corporates, unincorporated associations, or mutual associations with turnover of less than £1 million per annum meet the definition. The PRA is concerned that this may result in a number of companies being excluded from the scope of FSCS protection even though they are considered to be small for other purposes.^{footnote [5]}

1.16 The PRA considers that it would be beneficial to use this DP to seek input from industry, the public and other stakeholders in determining whether the existing definition of small business remains appropriate.

Discussion paper structure

1.17 Chapter 2 describes the analysis that the PRA has conducted regarding the potential for a material negative impact on policyholders' life circumstances (a 'life circumstances impact,' or 'LCI') if a GI insurer fails. It also requests feedback to inform the PRA's further consideration of that issue.

1.18 Chapter 3 describes possible courses of action that the PRA has identified, including various potential avenues to reduce LCI risk going forward. It requests feedback to aid the PRA in its assessment of the advantages and disadvantages of each approach.

1.19 Chapter 4 requests feedback on the question of whether the definition of small business remains appropriate.

Responses and next steps

1.20 This DP closes on Wednesday 24 January 2024. The PRA invites feedback on the topics discussed in this DP. Please address any comments or enquiries to [email protected].

1.21 Following the end of the discussion period on this DP, and as the PRA's work in this area evolves, a subsequent CP with draft rules may be published in 2024.

2: Life circumstances impact (LCI) assessment

2.1 The PRA conducted an initial review of the GI sector to determine whether, and for which specific types of insurance, current FSCS protection levels may be insufficient.

2.2 The PRA approached this review by considering the question of what might constitute an inappropriate degree of policyholder protection in the event of the failure of an insurance firm. The PRA considers that an inappropriate degree of policyholder protection may occur where an appreciable portion of policyholders would face a 'material negative impact on their quality of life including their financial and social circumstances'^{footnote [6]} (a life circumstances impact or LCI) if:

• they were compensated by the FSCS at 90%; or
• a replacement policy was secured by the FSCS for 90% of any future claims; or
• policyholders were unable to secure a replacement policy or unable to secure a replacement policy on equivalent terms.^{footnote [7]footnote [8]}

2.3 The PRA then assessed a range of GI products currently subject to 90% FSCS cover against that test. It found that in most categories of GI, there is potential for at least some policyholders to be severely impacted by the failure of an insurer. However, depending on their individual circumstances, policyholders may be affected very differently by the same scenario. Therefore, it is difficult to accurately predict whether a failure in an individual sector would lead to an appreciable portion of policyholders experiencing an LCI, demonstrating an inappropriate degree of policyholder protection.

2.4 Based on its assessment the PRA is concerned that there may be an inappropriate level of policyholder protection provided by the FSCS in the following areas:^{footnote [9]}

Areas of GI where there may be an inappropriate level of policyholder protection

Insurance area	Analysis
Insurance Backed Guarantees (IBGs)(a)	Some forms of IBG, such as policies covering major works to properties, would likely cause an appreciable portion of policyholders with claims falling due, or those that may claim in the future, to suffer an LCI similar in nature and extent to BGP policyholders in the event of a failure. For example: the residual 10% that a policyholder would have to contribute beyond the 90% FSCS compensation could amount to a significant amount of money which certain policyholders may struggle to find. it may be hard to obtain alternative cover if there has been a claim under the original policy and, even if alternative cover is available, it may be expensive. if the FSCS is able to secure continuity of cover for policyholders, the new policies will only provide 90% of the protection provided by the original policy. However, in cases where the policyholder has significant personal wealth or the claim is smaller, for example repairs under an extended warranty for a small household electrical item, a shortfall would not be expected to cause an LCI.
Home insurance - buildings and contents	Shortfalls under policies covering rebuilding a property or entirely replacing the contents of a property appear likely to impact policyholders in a similar way and to a similar degree to IBG policyholders. Therefore, there is a clear risk that an appreciable portion of policyholders may suffer an LCI. By contrast, many other claims, eg, for accidental damage to a mobile phone, would be likely to cause an LCI in many fewer cases and so may not be an inappropriate level of policyholder protection. A further portion eg boiler repairs, would lie somewhere in between, in that at least some policyholders could be severely impacted by a 10% shortfall, but the extent is hard to predict as it will depend to a large extent on the policyholder's financial circumstances.
Motor insurance (excluding third party)	A 10% shortfall in claims that cover repairs or replacements to a policyholder's vehicle may not be significant for many policyholders who have sufficient wealth to cover this, or have alternative means of transport available to them. Others may not have these options available to them and their activity may be greatly limited by such a shortfall. For example, that could be the case for a taxi driver or hospital staff who work unsociable hours whose car is essential to their job and who may struggle to cover the 10% shortfall and/or arrange a replacement policy on equivalent terms (particularly if they have already made a claim under the policy). Given the disproportionate impact on policyholders that require motor insurance for their employment the PRA considers that there a risk that an appreciable portion of policyholders may suffer an LCI, indicating an inappropriate level of policyholder protection.
Private health insurance	Most policyholders with private medical cover are likely to have the option of NHS treatment available to them in the event of the insurer's failure which reduces the risk of them suffering an LCI. However: there could be cases where the NHS may not be able to offer equivalent treatment on a timely basis. If the policyholder's health has deteriorated, they may be unable to purchase a replacement policy on equivalent terms, so be unable to continue with that treatment. depending on the nature of the treatment and a policyholder's financial position, a 10% shortfall in a claim for treatment already provided, or due to be provided in the near future, could prove to be a significant expense. The PRA considers that although it is not clear whether an appreciable number of policyholders would suffer an LCI, the impact of 90% FSCS protection in situations where the NHS cannot provide equivalent timely treatment is so severe that it could lead to an unacceptable outcome for the affected policyholders.
Travel insurance	Travel insurance covers a wide spectrum of claims from lost luggage and stolen passports to medical costs abroad. While many policyholders may be able to cover the balance arising from a 10% shortfall in a claim for lost luggage, the opposite is likely to be true in respect of claims for medical costs abroad and medical repatriation, where that shortfall is likely to amount to a significant amount of money. The PRA considers that claims associated with medical repatriation share similar characteristics to those related to private medical insurance where the NHS cannot provide equivalent care. As such the impact of the 90% coverage could be so severe that it leads to an unacceptable outcome for the affected policyholders.
Public liability insurance (PLI) (b)	Claims for accidents or injuries under PLI policies are made in respect of third parties (ie members of the public, clients, or customers who suffered the accident or injury), frequently in respect of serious circumstances giving rise to high value claims such as those related to bodily injury. An LCI may arise because: the company pays 100% of the claim to the third party but only receives 90% protection from the FSCS resulting in a 10% shortfall which may cause that company financial distress. if the company is insolvent, the third party seeks to recover directly against the company's PLI insurer but only receives 90% protection from the FSCS resulting in a 10% shortfall that may have a significant impact on that third party's life circumstances (c). Although PLI is not required by legislation, it is likely to be a necessary requirement imposed on companies and contractors by trade associations and prospective employers. The PRA considers that there is a real risk of an LCI if a policyholder is unable to purchase a replacement policy on equivalent terms, for example because: there has been a claim under the original policy resulting in increased premiums; or the refund of the remaining policy premium does not cover the cost of the new policy, Given this, the PRA is of the view that the test for an inappropriate level of policyholder protection is likely to be met.

^{(a) IBGs reinforce warranties on goods and services by means of the insurer taking on the risk of a business ceasing to trade and hence being unable to fulfil the warranty should customers have claims.}

^{(b) Public Liability Insurance covers the cost of claims made by members of the public for incidents that occur in connection with a firm's business activities.}

^{(c) The PRA interprets the definition of policyholders in a broader sense than simply the person who takes out the policy to include those who are beneficiaries of insurance contracts. See paragraph 20 of the PRA's approach to insurance supervision.}

2.5 While the table summarises those areas of GI identified by the PRA as susceptible to LCIs, it does not purport to give an exhaustive picture. The PRA acknowledges that there may be others either areas of GI susceptible to an LCI now or in the future.

Q1: What views do respondents have on when the PRA considers an inappropriate degree of policyholder protection to occur as described in paragraph 2.2?

Q2: Do respondents have any views on the PRA's analysis in the table in paragraph 2.4 and whether there are other areas of GI in addition to those considered in the table which might give rise to an inappropriate degree of policyholder protection?

3: Possible approaches going forward

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.

4: Small businesses and FSCS protection

4.1 The FSCS will only pay out GI claims where they relate to eligible claimants. The definition of eligible claimants is broad,^{footnote [12]} however, most businesses are excluded unless they are of a type that is listed in Policyholder Protection Part 7.2 or meet an exemption.^{footnote [13]} Small businesses are listed in Policyholder Protection Part 7.2 therefore, they are allowed to bring a claim under the FSCS.

4.2 The Policyholder Protection Part currently defines a small business as a partnership, body corporate, unincorporated association or mutual association with an annual turnover of less than £1 million (or its equivalent in any other currency at the relevant time). This definition has not been amended since it was first introduced into the policyholder protection rules in 2000. The PRA is concerned that the £1 million threshold contained in the definition may no longer be appropriate, as it limits the scope of FSCS protection in respect of GI insurance to only the smallest business. This is a particular issue in relation to PLI which, as set out in Chapter 2, can result in very high value claims. Businesses that fall just outside the definition of a small business may face severe adverse financial consequences if they are unable to get the full amount of a PLI claim should their insurer fail.

4.3 By contrast, section 382 of the Companies Act 2006 defines a small company as a company that satisfies two of the following three requirements:

• Turnover - not more than £10.2 million
• Balance Sheet total - not more than £5.1 million
• Number of employees - not more than 50

The PRA considers that it may be appropriate to amend the threshold in the Policyholder Protection Part definition to make it consistent with that set out in s.382 Companies Act 2006, and which is already used in the Policyholder Protection Part to define a large company. The PRA considers that this approach would have the benefit of simplifying FSCS eligibility criteria for policyholders and would be more administratively straightforward for the FSCS to deliver thus potentially reducing the FSCS' operational costs.

Q15: The PRA welcomes comments on whether the current definition of small business remains appropriate.

Q16: The PRA welcomes comments on whether the threshold for a small business in the Policyholder Protection Part should be aligned with that set out in s.382 Companies Act.

PRA objectives and have regards analysis

4.4 The PRA considers that aligning the definition of small business to that set out in s.382 Companies Act 2006 would ensure that the FSCS is viewed as an effective safety net for policyholders. This would lead to greater confidence in policyholders' dealings with insurance firms, benefiting all insurance firms and leading to a stronger financial system. Therefore, the PRA considers that aligning the definition of small business with the Companies Act 2006 is consistent with the general objective of promoting the safety and soundness of firms regulated by the PRA. In addition, it would also promote the PRA's objective to secure an appropriate degree of protection for those who are or may become policyholders (the policyholder protection objective) because it would increase the scope of FSCS by, for the first time, allowing those businesses with an annual turnover of £1 million or more to benefit from FSCS protection.

4.5 The PRA has assessed whether aligning the definition of small business to that set out in s.382 Companies Act 2006 would facilitate effective competition, the international competitiveness of the UK's economy and its growth in the medium to long term. The PRA considers that amending the definition may result in increased costs for insurance 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 that new definition which would promote competition and growth. The PRA does not consider that amending the definition of small business would have an impact on international competitiveness.

4.6 In considering its approach to the definition of small business 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): Amending the definition of small business would result in an expansion of FSCS coverage, producing a better outcome for those small companies that are currently excluded from FSCS protection in respect of claims under insurance policies.

Q17: Do respondents have any views on the potential for increased costs for insurance firms if the definition of small business was aligned with that under s.382 Companies Act?

Equality and diversity

4.7 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. The PRA does not consider that the approach mentioned above has an impact on equality of opportunity amongst policyholders and the other elements of the general duty in the Equality Act.

5: Questions

Life circumstances (LCI) assessment

Q1: What views do respondents have on when the PRA considers an inappropriate degree of policyholder protection to occur as described in paragraph 2.2?

Q2: Do respondents have any views on the PRA's analysis in the table in paragraph 2.4 and whether there are other areas of GI in addition to those considered in the table which might give rise to an inappropriate degree of policyholder protection?

Possible approaches going forward

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

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?

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?

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?

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?

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?

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?

Small businesses and FSCS protection

Q15: The PRA welcomes comments on whether the current definition of small business remains appropriate.

Q16: The PRA welcomes comments on whether the threshold for a small business in the Policyholder Protection Part should be aligned with that set out in s.382 Companies Act.

Q17: Do respondents have any views on the potential for increased costs for insurance firms if the definition of small business was aligned with that under s.382 Companies Act?