Solvency II: Regulatory roundup
17 Feb 2017 - Estimated reading time: 30 minutes
The last two months of 2016 saw a daunting flurry of publications from the PRA. To help you navigate your way through this we provide below a roundup of the relevant Solvency II related publications released in that period.
In terms of new policy, the two most significant developments in recent months have been consultation on a new supervisory statement on illiquid, unrated assets in Matching Adjustment portfolios and a consultation on a proposal to amend the supervisory statement on the recalculation of the transitional measure on technical provisions. We discussed these in separate articles, which can be found here and here.
However, the majority of the recent publications stem from the PRA’s review of the material it provided to firms in the various letters from its Directors and Executive Directors as Solvency II was being implemented. The PRA has pulled out the material relevant to its ongoing supervision and is transposing this material in a series of new supervisory statements and amendments to existing supervisory statements.
The PRA publications covered by this publication are:
- SS17/16: Internal models – assessment, model change and role of non-executive directors;
- SS18/16: Longevity risk transfer;
- SS19/16: ORSA;
- SS20/16: Reinsurance – counterparty credit risk;
- Updated SS2/14: Recognition of deferred tax;
- Updated SS5/15: The treatment of pension scheme risk;
- CP38/16: Group supervision;
- PS38/16: Reporting format of National Specific Templates and reporting clarifications; and
- PS37/16: PRA fees and FCSC levies for insurers.
SS17/16: Internal models – assessment, model change and role of non-executive directors
This supervisory statement brings together the internal model-related material from various past communications. Those most relevant to life insurers are:
- Internal model applications: covering what happens if a firm needs to change an internal model application after it has been submitted; the use of internal management loadings to mitigate weaknesses in a model; and the need for firms to have a contingency plan in the event that an application is not approved.
- The assessment of credit risk, which explains why it is important that firms do not adopt a mechanistic approach to calculating stressed fundamental spreads (FS) using the methods prescribed for calculating the unstressed FS used to calculate the technical provisions..
- The volatility adjustment (VA) in the modelling of market and credit risk, which states that the PRA expects firms to make no allowance for changes to the level of VA following a hypothetical market stress for the purpose of calculating the Solvency Capital Requirement (SCR);
- The role of non-executive directors (NEDs) in relation to the internal model: NEDs can expect to be interviewed to check that they understand the key strengths and limitations of the model as well as judgements used within the model and where these are most significant.
- Validation of models, which explains that model justification and model validation are two separate processes. Model justification essentially involves providing evidence to the PRA that the Statistical Quality Standards have been met – e.g. that the assumptions used are adequate. In contrast, validation is a regular and independent process which includes reviewing the model in terms of the appropriateness of its specifications, comparing its results against experience and its overall performance over time. The PRA expects firms to produce clear evidence showing how the board is influencing the design of validation processes;
- The PRA’s use of quantitative analysis in approving models, which includes the use of specific quantitative indicators for sufficiently homogeneous risks together with other internal tools in order to assess if the model meets the Directive tests and standards;
- Internal model change policy, which outlines that the policy should cover the scope, identification and classification of changes, including an assessment of the reason for the change and definitions for major model changes.
SS18/16: Longevity risk transfers
This is a very short supervisory statement reiterating the PRA’s previously-communicated concerns relating to longevity risk transfer. Exposure to significant counterparty risk through these deals is highlighted and the supervisory statement sets out an expectation that firms should have effective monitoring, management and mitigation processes for these concentration risks on top of holding solvency capital for them. Further, the PRA expects to be notified of any longevity risk transfers, along with the firm’s proposed risk management, well in advance of the completion of such transactions.
This supervisory statement builds on SS41/15 and other related documents on guidance for the Own Risk and Solvency Assessment (ORSA).It echoes the information in the prior documents with the additional benefit of the PRA’s ongoing practical experience of reviewing ORSAs. The following key messages are re-iterated:
- The ORSA must be forward looking, in line with the proposed business strategy;
- It should consider the risks to which the firm may be exposed in the future; and
- It should consider stress testing as a tool for assessing and quantifying risks.
The supervisory statement provides detail of the PRA’s expectations of what makes a good ORSA report, a good ORSA policy and the associated processes, such as consideration of business strategy and risks the firm is exposed to.
SS20/16: Reinsurance – counterparty credit risk
In SS20/16, the PRA sets out its expectations of firms regarding reinsurance and the management of counterparty default risk resulting from the use of reinsurance. The PRA expects boards to understand the risk transfer taking place, to ensure the economic impact is adequately reflected in business planning, capital and reserving and to appreciate the wider risks reinsurance gives rise to. As in SS18/16, the PRA highlights the issue of high concentrations of counterparty risk and the need for risk management systems, which may result in additional measures over the SCR being necessary.
SS2/14: Recognition of deferred tax
SS2/14 was published back in 2014, and initially updated in February 2015. It has now been updated again to reflect the additional PRA expectations communicated in the Directors’ letter of 13 March 2015.
In order to justify a reduction in the SCR through the loss absorbing capacity of deferred tax, firms need to demonstrate that – following the hypothetical shock - they will still be able to generate a significant level of taxable profits in the future. If this is the case then the tax charge otherwise due in respect of these profits would be reduced through offsetting the loss occurred at the time of the shock against these profits – which could justify the firm’s belief that it would be able to incorporate a deferred tax asset on its regulatory balance sheet immediately after the shock.
Firms therefore need to carry out projections of future taxable profits following the hypothetical shock. The update to the supervisory statement sets out the expectations that the capital resources needed to support the assumed level of business activity in a post-shock environment should be be consistent with a firm’s ORSA and that any assumptions and projections supporting availability and timing of capital replenishment should be credible.
The updated supervisory statement also sets out the expectation that where a firm calculates its SCR using an internal model, and does not routinely calculate the tax effect of the shock loss across the whole probability distribution, it will document clearly how it identifies which data points to exclude.
Finally, the update clarifies that the expectations in the supervisory statement apply equally to standard formula and internal model firms.
SS5/15: The treatment of pension scheme risk
SS5/15 has been updated to reflect the contents of the PRA’s 14 July 2015 Directors’ letter. This set out some additional considerations in terms of the calibration of internal models with regard to how pension scheme liabilities are assumed to change as credit spreads widen. In particular it highlights to firms that under stressed conditions:
- the market for some high quality corporate bonds may not be considered deep and therefore the yields on these bonds may not satisfy IAS19 requirements for deriving the discount rate for pension scheme liabilities; and
- a significant divergence between the IAS 19 deficit and scheme funding deficit increases the likelihood that the firm is required to pay additional contributions to the pension scheme.
The first of these arguments looks reasonable from a theoretical point of view. However, in practice, IAS19 discount rates continued to be based on AA-rated corporate bond yields even after the complete drying up of liquidity in the corporate bond market in 2008, with few if any objections from auditors.
CP38/16: Group Supervision
The final publication relating to the various Directors’ letters is a consultation on a proposal to update supervisory statement SS9/15 on group supervision, which was published in March 2015, to reflect material previously set out in the PRA’s letter “Solvency II: An update on implementation”.
The main addition being proposed to SS9/15 is a section relating to the availability of group own funds. This section outlines the PRAs expectation that firms will provide evidence of the absence of legal and regulatory restrictions on the transferability of own funds and that they can demonstrate that group own funds can be made available to the group within nine months.
PS38/16: Reporting format of National Specific Templates and reporting clarifications
As part of the Solvency II Pillar 3 framework, companies have to submit National Specific Templates (NSTs) to the PRA in addition to the set of Solvency II quantitative reporting templates (QRTs) and qualitative returns. This Policy Statement sets out the final rules to incorporate NSTs into the reporting part of the PRA rule book for 2016 and future year-ends. The policy statement includes the set of new Excel templates designed using eXtensible business Reporting Language (XBRL) principles and the accompanying log files containing definitions on how to complete the templates.
The NSTs that are most relevant for life insurers are:
- NS.00 – Basic information and content of submission
- NS.01 – With-profits value of bonus
- NS.02 – With-profits assets and liabilities
- NS.05 – Revenue account life
- NS.06 – Business model analysis (life)
- NS.09 – Best estimate assumptions for life insurance risks
PS37/16: PRA fees and FSCS levies for insurers
This policy statement sets out a transitional approach in the 2017/2018 PRA fees and FSCS levies. In the past, these fees and levies have been based on firms’ Solvency I reporting: with the PRA receiving the data between January and March and invoices being issued in July. However, the introduction of Solvency II – and its transitional measures on reporting – means that the PRA does not expect to receive the majority of regulatory returns relating to the 2016 year-end until 20 May 2017. Given that the PRA also requires additional time this year to analyse the impact that the transition from Solvency I to Solvency II will have on the proportion of the levy paid by each firm, it would not be possible to issue invoices in July if Solvency II data was used in the calculations.
Therefore calculations for the 2017/2018 fee and FSCS levy would be based on firms’ year-end 2015 Solvency I data with an adjustment required when a firm has carried out a Part VII transfer since the Solvency I disclosure. Firms also have the option to update Solvency I figures to year-end 2016 if they have gone into run-off since that Solvency I disclosure.
Hymans Robertson has a wealth of relevant life insurance experience, from risk and capital optimisation under Solvency II, through to broader areas such as model calibration and validation in the areas of longevity risk, credit risk, and dependency & aggregation.
Our experts would be delighted to support you. If you would like more information or advice, please get in touch.