According to the IRRD, critical functions mean activities, services, or operations performed by an insurance or reinsurance company for the benefit of third parties which cannot be replaced within a reasonable time or at a reasonable cost, and where the inability of the insurance or reinsurance company to perform those activities, services, or operations could have a significant impact on the financial system and the real economy in one or more Member States of the European Union, including by affecting the social well-being of a large number of policyholders, beneficiaries, or injured parties, or causing systemic disruption or the undermining of overall confidence in the provision of insurance services.
Ensuring the continuity of critical functions is one of the objectives of resolution. Critical functions can be identified from different assessment perspectives — e.g., at the EU, national, or regional level.
The concept of critical functions was used in the key guidelines issued in 2011 by the Financial Stability Board (FSB) entitled Key Attributes of Effective Resolution Regimes for Financial Institutions (the so-called Key Attributes), which were extended in 2014 with annexes for sectors of the financial system other than the banking sector, including the insurance sector.
In 2013. the FSB issued a document entitled Recovery and Resolution Planning for Systemically Important Financial Institutions: Guidance on Identification of Critical Functions and Critical Shared Services clarifying what critical functions are and how they should be identified.
https://www.fsb.org/2013/07/r_130716a/
It indicates that entities can provide certain economic functions (a broader concept than critical functions) that are so elementary that it is necessary to sustain them under all circumstances. A critical function is, therefore, an economic function whose continuation must be sustained. The FSB notes that a critical function is that of an entity which is characterized by two elements; namely,
- It is provided by the entity to non-affiliated third parties.
- The abrupt discontinuation of which could have a material adverse effect on those entities, cause contagion, or undermine overall confidence in market participants.
A similar conceptual understanding of critical functions is adopted by the International Association of Insurance Supervision (IAIS). Critical functions are defined by the IAIS, for example, in the 2019 document Holistic Framework for Systemic Risk in the Insurance Sector. They are understood there as those functions for which a disruption in their performance can have a systemic impact.
https://www.iaisweb.org/uploads/2022/01/191114-Holistic-Framework-for-Systemic-Risk.pdf
Two characteristics of critical functions are identified there:
- The activity of the company in the area of the function is important for the operation of the financial sector and the real economy.
- There are few, if any, readily available substitutes for that function. (This is the situation when there are few insurers or a monopoly in a given market.)
The ‘economic functions that should be pursued to achieve resolution objectives’ (i.e., critical functions) are also referred to in the 2021 IAIS paper Application Paper on Resolution Powers and Planning.
Those functions should be identified considering the following elements:
- the nature and scope of the business and the impact on the business of others, taking into account the volume and number of transactions, the number of customers, etc.
- the materiality of the company’s operations, which can be assessed on the basis of its size, market share, links, complexity, and international activities
- the nature of its customers (retail, corporate, public entities)
- the potential impact of the cessation of its functions on markets, the financial market infrastructure, customers, and public services.
Identification of critical functions in insurance and reinsurance companies
