EIOPA takes aim at brass plates and empty shells

February 2023

Who is this of interest to?

EIOPA's latest Supervisory Statement (SS) will be relevant to insurers and intermediaries operating in the EEA and a third country (particularly those EEA firms established following Brexit with a 'reverse branch' back to the UK).

What does EIOPA say?

On 3 February 2023, EIOPA released an SS on the use of governance arrangements in third countries. It sets expectations of national supervisors (and therefore, of the firms they supervise) that require that firms have appropriate substance in the EEA (corporate, staffing, decision-making etc), and sufficient governance over functions and activities performed by third country branches.

While EIOPA clearly has in mind firms whose operating models were set up following Brexit to enable access to the EU Single Market through the use of passporting rights whilst retaining access to expertise and capability remaining in London, the SS is also relevant to entities with branches in other third countries. Intermediaries are of particular interest.¹

EIOPA wants to ensure that insurers and intermediaries conduct their operations in a way that does not undermine how home state EU regulators supervise their activities. This means avoiding arrangements that display the characteristics of an empty shell and ensuring that firms do not perform disproportionate levels of functions or activities in the UK (or another third country).

The key consideration for firms and supervisors in reaching their assessment is whether the EEA firm is 'disproportionately dependent' on those operations that take place in a third country. 'Disproportionate dependence' is defined as being unable to demonstrate that its EEA entity can continue operating normally in the event of a sudden loss of its third country branch — a high threshold to meet, if applied literally.

In EIOPA's view, the purpose of a third country branch should be primarily to serve the market in which it is established — not to act as an offshore centre of expertise to serve EEA risks and policyholders. Supervisory authorities are encouraged to promote the relocation or secondment of staff from the third country branch to the EEA entity to address any concerns about insufficient technical expertise or specialist risk coverage in the EEA.

What are the implications for insurers and intermediaries?

The EIOPA publication is high level enough to accommodate a range of approaches by national supervisors. This is intentional, and EIOPA's Feedback Statement following the July 2022 consultation argues that its approach is flexible and proportionate enough to accommodate respondents' concerns that that certain activities — such as reinsurance, commercial risks and wholesale distribution — are inherently international.

We expect that European supervisors will increasingly refer to the expectations set out in the SS and might take different approaches around how to interpret them. We expect that insurers that have only limited substance in their EU head office and any operations across the EU will be asked to justify their current arrangements and develop plans to bolster their substance and governance where this is deemed insufficient by regulators.

Considerations for existing third country branches

The SS confirms an existing direction of travel for many firms responding to their local regulators' expectations. So, for firms with existing EU/UK arrangements and an approved business plan — whose structures are not outliers — it may amount to an incremental ratcheting up of local levels of management and staff.

Insurers and intermediaries should be ready for increased supervisory scrutiny, including onsite inspections. It would help to be prepared to explain corporate and governance structures and demonstrate the extent to which decision-makers and key function holders reside in the EEA.

Considerations for new third country branches

Those wishing to set up a new arrangement may need to meet higher supervisory expectations on substance from the outset. Going forward, there could be greater challenge in respect of:

• Can the home supervisor effectively supervise regulated activities in relation to EEA risks and/or policyholders? To what extent can they supervise directly, rather than rely on a third country?
• Can active supervision by UK regulators be relied on? EIOPA Feedback Statement suggests that the extent third country supervision can be relied on is rather limited.
• What is the primary function of the UK branch — is it to access UK policyholders and risks?
• Which regulated activities will be carried out from the UK branch in respect of EEA risks/policyholders?
• Where does decision-making take place and is this supported by adequate management information (MI) flows?
• Is there appropriate governance oversight, including by key control staff at head office?
• What is the split of expertise across the EEA entity and the UK branch in respect of underwriting, pricing and reserving?
• How will the firm comply with EEA regulatory requirements?

What about UK's approach to post-Brexit operations?

The UK's pronouncements on the UK/EU structures strike a markedly different tone. The PRA's 'Dear CEO' letter of January 2023 confirms its 'responsive openness' approach². The regulator is willing to place reliance on strong and cooperative Home State supervisors, provided this is commensurate to the risks the branch poses to its policyholder protection objective. The Solvency II reforms are expected to further reduce the capital and reporting burden³ — welcome news for around 130 entities that are expected to graduate from the Temporary Permissions Regime to becoming PRA-authorised branches.

This readiness for supervisory deference is not reciprocated by the EU, as further illustrated by the February 2023 (PDF 1.33 MB) study by the ECON committee of the European Parliament 'Recent trends in UK financial sector regulation and possible implications for the EU, including its approach to equivalence'. The report considers the prospect of exacerbated regulatory and supervisory divergence between the UK and the EU, and offers little hope for future equivalence findings or, indeed, closer supervisory ties.

It remains to be seen whether the more restrictive approach in the EU may encourage the PRA to follow suit. In an ideal world unobstructed by post-Brexit politics, policyholders would be best served by close cooperation to achieve effective cross-border supervision. In the meantime, market participants will be carefully observing the direction of travel on both sides.