How do you formulate a Preparatory Crisis Plan?

How do you formulate a Preparatory Crisis Plan?

A new law for the winding up of insurance companies in financial distress states that all Dutch insurers with Solvency II approval are required to formulate a Preparatory Crisis Plan. This article explains the practical considerations that need to be taken into account when formulating this plan.

In early 2019, a new Dutch law went into effect regarding the winding up of insurers in financial distress. The ‘Insurers Recovery and Resolution Act’ (Wet herstel en afwikkeling verzekeraars) determines the actions to be taken in the event of the bankruptcy of an insurance company and provides for the possibility that the insurance company will be wound up by the central bank of the Netherlands, DNB, if this is more favorable for the policyholders and other interested parties than a bankruptcy.

The Dutch Insurers Recovery and Resolution Act is based on the same basic principles as the European legislation for banks (Bank Recovery and Resolution Directive, BRRD). Unlike in the banking world, insurance companies are not subject to European regulations for recovery and resolution. To date, no plans have been announced to include this topic in Solvency II legislation.

To prevent bankruptcy or a winding-up scenario, the new law also prescribes that all insurers with Solvency II approval must formulate a Preparatory Crisis Plan. The insurer prepares and updates this plan as part of regular business operations. The goal of the Preparatory Crisis Plan is to obtain insight into possible recovery measures beforehand in the event that the financial position of the insurance company deteriorates significantly.

Recovery measures

A Preparatory Crisis Plan is drawn up when the insurance company is in good financial health. The idea behind this plan is that the insurer defines recovery measures or even prepares them before the financial position deteriorates. The intended effect is twofold. On the one hand, the potential recovery measures are prepared when there is no financial distress. This is so that, in the event of an acute crisis, actions can be taken more quickly than if nothing had been anticipated beforehand. On the other hand, potential winding-up is facilitated because, under favorable financial conditions, business operations can be adapted structurally. This could be by dealing with operational interdependence or financial intra-group structures1 , for example.

In the event of an acute crisis, it is often important to act quickly. A good crisis plan not only provides an overview of possible recovery measures for various problems, but also determines how decisions are made regarding these measures and who is to carry them out. The usual decision-making and implementation processes are often not suitable for this or inadequately prepared for the far-reaching measures that must be taken in a short notice. This is why it is important that agreements be made beforehand regarding the conditions under which managers are to take certain measures. In the banking world, ‘dress rehearsals’ have been commonplace for many years now. These make clear the importance of having developed practical plans, among other things.

Formulating a Preparatory Crisis Plan

A Preparatory Crisis Plan is designed to provide the insurer with recovery plans in the event of financial distress, so that recovery measures can be implemented immediately. To make sure the plan is adequately prepared, it should deal with both the nature or content of the recovery measures and the manner in which they are carried out.

How do you formulate this kind of plan? Start by identifying potential scenarios that could put the insurance company into financial distress. Possible scenarios are those identified as part of the Risk Appetite Statements (RAS) (what can jeopardize my mission and vision?) or stress test scenarios in the Own Risk and Solvency Assessment (ORSA). Obviously, it is not possible to prepare a crisis plan for every imaginable scenario. But these scenarios should be sufficiently diverse and concrete to accurately assess the measures formulated in the Preparatory Crisis Plan. To promote such diversity, it is important to define scenarios related to systematic (system-wide) and idiosyncratic (institution-specific) risks and the timeframe (fast versus latent) in which a scenario arises.

Scenario thinking

In defining scenarios, ‘scenario thinking’ is a robust method that is a good place to start. It is widely applied when developing severe but plausible scenarios for identifying risks that are not captured in those generated by stochastic models or historic analyses. Famous historic situations in which scenario thinking was used are during the Cold War by the United States Department of Defense and by Shell prior to the oil crisis. The basis of the method is that trends and developments in the STEEP categories (social, technological, economic, environmental, and political) are examined and, after studying how they interrelate, are used as input for defining scenarios.

Financial trouble

Insurance companies can end up in financial trouble in two ways. First, a situation may arise in which the insurer is not sufficiently solvent, i.e. does not have enough money to meet all of its financial obligations in the long-term. Second, the insurer may have sufficient assets, but insufficient liquidity. An example of this would be a life insurance company whose policyholders want to redeem their policies en masse, while the insurer is unable to release the necessary capital quickly enough because it is largely invested in illiquid instruments like mortgages and direct real estate.

Establishing governance

The Preparatory Crisis Plan should contain both preventative measures to reduce capital and liquidity risks and recovery plans to improve the capital position and generate liquidity. Every measure should be assessed for operational, financial, and legal feasibility. In addition, it must be clear in every scenario what the impact of each measure will be on the financial situation of the insurer and any mutual dependencies of the potential measures must be identified.

The formulation of a Preparatory Crisis Plan is not limited to the contents of risk-reducing measures, but governance must also be established. It must be clearly stated, for instance, when the plan is to take effect and who is responsible for what. Depending on the measures determined, preparations will also have to be made to ensure that these measures can be carried out directly. This could include the operational preparation of (additional) hedging, selling portfolios or spinning off business units.

How can we help?

The importance of formulating a sound Preparatory Crisis Plan should not be underestimated. This plan will have to be supported by both the board of directors and the DNB. The roles and responsibilities in both its formulation and execution must be absolutely clear. In anticipation of measures, some aspects of the organization may have to be adapted in order, for example, to facilitate the immediate splitting of business units. In other words, this is an important process in which stakeholder management and bringing various disciplines within the insurance company closer together are important elements.

We can provide support in both formulating a Preparatory Crisis Plan and reviewing it. This entails assessing whether the plan adheres to the regulatory requirements and comparing the plan to those of peers or banks (who have had experience with this for some now time). Support can be offered on both the project management level and on the subject level in various focal areas. Here are a few examples of the support we can provide:

  • Gap analysis between required information for a Preparatory Crisis Plan and information already available from ORSA and the RAS.
  • Workshops for defining scenarios in accordance with the scenario thinking method.
  • Identifying (additional) risks that could result in a deterioration of the capital and liquidity position.
  • Designing and implementing triggers for the implementation of the Preparatory Crisis Plan.
  • Designing crisis measures.
  • Formulating an organizational chart to define roles and responsibilities for times when measures under the crisis plan need to be carried out.

[1] Proportionality is, of course, a consideration here. An insurance group must be able to take advantage of group benefits, for example.