Solvency II: An ERM reminder
16 Feb 2017 - Estimated reading time: 15 minutes
The PRA is continuing to increase its scrutiny of the use of equity release mortgages (ERMs) in Matching Adjustment (MA) portfolios. Having previously published a discussion paper on the topic in March 2016 – see our previous Newsflash – the PRA is currently consulting on a draft supervisory statement. This covers illiquid, unrated assets in general, with a particular focus on ERMs.
The draft supervisory statement focuses on how much MA benefit firms are deriving from illiquid, unrated assets, this being the difference between:
- the spread on the asset (i.e. the amount by which its yield exceeds the risk-free rate): noting that this is not directly observable from the market since the asset is illiquid; and
- the Fundamental Spread (FS): noting that, while assigning a FS is a relatively prescriptive process for assets with an external credit rating, more judgement is required if an external rating is not available.
The PRA intends to carry out selective in-depth reviews for those assets it judges to be most at risk of the MA benefit being misstated. Appropriate thresholds will be established to determine which firms to review, based on:
- the complexity of the asset: restructured assets are considered to be more complicated;
- whether the absolute amount of MA benefit is material to the firm in question; and
- whether the MA benefit (when expressed as a proportion of the spread) is high either in its own right or when compared to the benefit on a comparable reference instrument.
The paper provides a useful list of matters that it expects firms to consider in demonstrating an adequate level of assurance in respect of a firm’s practices. The supervisory statement reminds firms that each of the holders of the Senior Insurance Managers (SIM) roles (in particular Chief Actuary, Chief Risk Officer and Head of Internal Audit) should be satisfied that the allowance for the FS is appropriate.
One particular point is, when determining the FS in respect of an asset, the PRA expects firms to make adjustments to their internal credit assessments in order to take account of all the features of the asset. These can include qualitative factors such as a lack of data that have not already been allowed for within the internal credit assessment. These sorts of judgement would appear to be quite subjective, and firms may be vexed by the process of making them.
Focus on ERMs
The majority of the draft supervisory statement is given over to the specific case of restructured ERMs - and the quantitative and qualitative sources of risk that the PRA believes that firms should consider when carrying out internal credit assessments. Quantitative factors include the prepayment terms of the loan, the loan to value ratio and the condition of the property. Examples of qualitative factors include the terms and conditions of the legal agreement between the insurer and the special purpose vehicle (SPV) and the ability of the insurer to monitor the property and maintain knowledge of its exposure and risk.
While the previous discussion paper set out various concerns relating to these assets, the draft supervisory statement is particularly concerned with:
- the risk that the valuation and credit assessment of the MA-eligible notes issued by the SPV are not aligned with their true risk profile – which is acknowledged as being a risk present in any securitisation; and
- the risk that no negative equity guarantees (NNEGs) have not been allowed for appropriately.
In relation to NNEGs, the PRA has developed four principles for assessing the allowance firms have made for the underlying risk:
- Securitisations where a firm holds all the tranches do not result in a reduction of risk to the firm.
The PRA is looking to ensure that risks associated with NNEGs have been captured either in the value placed on the junior tranches that are held outside of the MA portfolio, or in the size of the FS assigned to the tranches held by the MA portfolio.
To help assess this, the PRA intends to use the concept of the “effective value” of the ERM, which was introduced in last year’s discussion paper and is defined as the sum of the value placed on the ERM assets and the reduction in the value of liabilities resulting from using some of these assets in an MA portfolio. By comparing this against the value of the cash flows delivered by the unrestructured ERMs, the PRA expects to be able to check that the costs associated the NNEGs have been excluded.
- The value of future ERM cash flows cannot be greater than either the value of an equivalent loan without a NNEG or the value of future possession of the property.
This follows from considering the cash flows that an investor receives from each of these investments. The loan without the NNEG pays an amount equal to the sum lent plus interest accrued over the term of the loan. A contract for future possession of the property at the end of the loan term pays the investor an amount equal to the value of the property at that time.
However, the cash flow delivered by an ERM is equal to the lower of these two cash flows. It therefore follows that the value of the ERM cannot exceed the value of either of these two contracts.
- The value of future possession of the property should be less than the value of immediate possession.
The PRA’s thought experiment considers an investor who could either purchase a property for immediate possession or could make a payment now to take possession of the property at some future point. These two contracts differ only in that latter does not provide any rental income – or other benefit from the use of the property – until the investor takes possession.
The PRA therefore argues that the value of future possession should be lower than the value of immediate possession, reflecting the economic utility (from rental income or other usage) of immediate possession.
- The compensation for the risks retained by a firm as a result of a NNEG must be more than the expected cost of the NNEG. This is to ensure that the time value of the option is reflected.
This follows from noting that, even if the NNEG is not expected to “bite”, it still has value to the borrower since it could still reduce their obligations if things do not work out as expected. The implication is that the NNEG is a liability for the lender even if it is not expected to be exercised. At this stage, the PRA has not expressed a view on the specific calibration of the adjustments that should be made for the time value of the NNEG. The draft supervisory statement mentions that, as part of the PRA’s reviews of restructured ERMs, firms will be asked how they have ensured that all risks relating to the NNEG have been allowed for.
Next steps for firms
Illiquid assets – and ERMs in particular – are an important part of the investment strategy for many annuity providers. It seems likely that these firms will see increased regulatory scrutiny of the way in which they allow for these assets on their balance sheets, both in terms of the value of the asset and the impact on the liability valuation. The proposed supervisory statement essentially sets out a framework for these reviews and so gives firms plenty of food for thought as they anticipate the questions that the PRA may ask.
Firms using internal credit ratings as a basis for deriving the FS will be concerned not only that the process is fit for purpose but that the assurance procedures adequately validate and document the position. Furthermore, the same concerns will apply to the restructured ERM assets. Firms, and the holders of SIM roles in particular, will need to ensure that they are comfortable with the approach taken in relation to these assets. If you would like to discuss this topic further, please contact us.
The PRA’s consultation ends on 14 March 2017.
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