FCA clarifies what good looks like for assessing liquidity for orderly wind down

Who is this blog for?

This blog is of particular interest to CROs, CFOs, and their respective functions at FCA solo-regulated firms.

What’s new?

The FCA’s financial resilience requirements are not new to General Insurance brokers and other solo-FCA regulated firms. Firms are very conscious of the ongoing requirement to maintain “adequate” financial (and non-financial) resources, in line with various aspects of the FCA handbook, including MIPRU, Threshold Condition 2.4 (“TC2.4”), and the FCA’s Principle 4.

However, many FCA regulated firms are seeing a shift in the FCA’s expectations. The accepted approach to modelling cash flows under an orderly wind-down is being challenged, with firms being expected to be more granular, more prudent and risk-based. In line with this, the FCA performed a multi-firm review involving 10 General Insurance brokers to obtain insights into their approach to assessing liquidity for orderly wind-down.

On 23 September, the high-level results of this review were published by the FCA, providing feedback on what they consider as good and poor practice from their sample population.

What is the FCA expecting?

Based on the findings shared by the FCA and good practice we have seen in the market, the key messages for firms are:

• Robust risk management – The importance for firms to ensure they are appropriately and accurately assessing the most pertinent risks to their business. This involves firms having clearly identified the internal and external macro-economic risks posed to their business model, and regularly re-assessing their critical and emerging risks through deep dives.  Additionally, firms should monitor their most significant risks against an agreed appetite risk, both on a retrospective and forward-looking basis to enable firms to make informed decisions and prevent pertinent risks from crystalising.  
• Formal and well-structured stress testing frameworks – There is an expectation that firms’ stress testing frameworks are clearly documented and robust. Stress testing should not be a one-off exercise. The FCA are increasingly challenging whether firms’ suite of scenarios are appropriately broad and adequately severe;
• A clear circle between the risk register, stress testing / reverse stress testing and risk appetite – Firms need to be able to demonstrate the linkage between the risk register and results of (reverse) stress testing undertaken and then consider how the results can inform the identification of risks and setting of tolerances, and more widely linking back to setting strategy;
• Detail and rigour – Increasing the level of detail in cashflow modelling, as well as re-assessing whether assumptions are sufficiently prudent and doing sensitivity testing to show the impacts of key assumptions not playing out as initially expected;
• Producing an operational wind-down plan – and then keeping this up to date (with opportunity to learn from other sectors to establish what good looks like); and
• Considering the optimal approach when operating within a complex structure or large group – Firms with complex group structures should ensure there is adequate governance, risk management and wind-down planning arrangements in place across its regulated entity portfolio to both understand the risks posed to individual firms, and the wider group. This will enable firms to monitor and mitigate those risks. Firms should also adequately understand the pertinence of group exposures when assessing risks. This should include financial considerations, such as debt guarantees as well as operational dependencies, such as through shared functions.

Following the publication of the outcome of their multi-firm review, the FCA are expecting firms to act on their findings to ensure that business leaders have sufficient comfort that their modelling of minimum liquidity is appropriate, credible and operable. An effective and robust wind down plan will minimise the risk of firms entering a disorderly wind down and the possibility of any resulting consumer, market or market participant harm that may arise.

What are the key implications for firms?

The FCA’s report is likely to raise a number of action points for firms it regulates, no matter their size, complexity or maturity.

Across the market, and in our experience, many firms are only considering their capital resource requirements under MIPRU, and are yet to conduct a formal TC2.4 exercise, or have prepared a wind down plan. For these firms, change programmes are likely going to be required to enhance their risk frameworks, identify their financial and non-financial resource requirements, and develop their wind down arrangements.

Following a formal TC2.4 exercise, and / or (reverse) stress testing for wind down planning, some firms may uncover their capital and liquidity requirements are substantially higher than they may have expected. This is more likely as firms develop more severe and plausible scenarios to stress test, which may shed further light on vulnerabilities associated to key risks. This will have implications for firms in a variety of ways, particularly as Senior Management will likely need to make good on any capital and liquidity deficit in the short term to ensure their financial resource buffers are adequate.

Next Steps

As an immediate next step, we encourage General Insurance brokers and other FCA solo-regulated firms to examine the full findings from the multi-firm review and perform a detailed gap analysis of their current stress testing and wind-down planning frameworks relative to the FCA’s expectations of good practice. In this gap analysis, firms should also consider the guidance in other relevant FCA publications, as listed below.

In the medium term, Senior Management, notably those who hold Senior Management Function (“SMF”) 3, or SMF 4 (for enhanced firms) under the Senior Managers & Certification Regime, should expect to be called upon to attest, and potentially evidence, that their liquidity assessments for wind-down, and their wind-down planning, are adequately robust. Assurance (external or through Internal Audit) should be considered to support this.

In conclusion, firms’ financial resilience is a continued priority for the FCA and this multi-firm review shows a significant shift in its expectations of General Insurance brokers.

FCA’s finalised guidance on assessing adequate financial resources (FG20/1);

FCA’s Wind-Down Planning Guidance; and