PRA proposes reforms to Solvency II regime

This article was first published on Thomson Reuters Regulatory Intelligence.

The PRA has published the first of three consultation papers (CP21/17) on reforming the Solvency II regime.

The consultation reflects PRA experience of working with Solvency II since its introduction in January 2016, while covering some of the improvements proposed by the ABI and discussed earlier this year with the House of Commons Treasury Committee.

This first consultation paper contains some new guidance from the PRA on firms' use of the matching adjustment. It also consolidates earlier guidance, allowing firms to comment on the PRA's approach for the first time. The PRA's aim is not to change its existing guidance but to improve a firm's chance of making a successful MA application.Two further consultation papers in this series will cover:

• Model change process - December 2017
• Reporting - January 2018

The deadline for comments on CP21/17 is January 31, 2018. Firms should consider the draft guidance carefully and, in addition to raising any concerns, should adjust their internal processes as necessary to meet the standards set by the PRA.

Wider context to the proposals

In September 2016, the Treasury Committee launched an inquiry to look at the case for changing, or even replacing, Solvency II in a post-Brexit world. The inquiry was subsequently closed on May 3, 2017, when parliament was dissolved for the general election.

Nonetheless, evidence provided to the inquiry highlighted firms' dissatisfaction with how aspects of the Solvency II regime have been implemented in the UK. The Association of British Insurers (ABI) argued that the PRA's approach "goes beyond the requirements of Solvency II in a number of important areas" and "goes beyond what is necessary for financial stability".

Specifically on the matching adjustment, the ABI and others have argued that UK implementation of the directive has been unnecessarily restrictive and that the PRA's approach discourages firms from investing in certain types of asset that are particularly suited to a book of long-term liabilities.

The PRA argues, on the other hand, that it has taken a flexible approach to implementation of the regime but that its hands are tied by the level of prescription in the directive.

Proposed changes

The first objective of CP21/17 is to consolidate guidance contained in various publications (mostly in the form of directors' letters and executive director's letters) issued between April 1, 2013 and February 15, 2016 into a single supervisory statement. This is helpful.

It also means that firms will have an opportunity to comment on that guidance for the first time (it was originally issued without consultation) and with experience of operating within the boundaries of the current guidelines. This may provoke feedback that could not have been anticipated without that practical experience. The PRA also proposes to include additional guidance on the following issues.

Asset eligibility: demonstrating fixed cash flows

Assets held within a matching adjustment portfolio must have cash flows that are fixed in both timing and amount and which cannot be changed by the issuer or any third party (Article 77(1)(b) of the directive).

The PRA proposes to confirm that assets which contain cash flows the timing of which is uncertain, but bounded, can be brought into the matching adjustment portfolio, provided that those cash flows are recognised at the latest contractual date and that any additional amount contingent on the timing of cash flows (e.g. additional interest charges) is excluded.

This would cover, for example, bonds which provide for repayments to begin at an undetermined date but which have a fixed latest date for starting. This type of bond may be used on infrastructure projects where loans can have an initial "construction phase".

The insurance industry has argued for some time that an insurer with long-term predictable liabilities should be able to invest in well-matched long term assets, such as infrastructure projects.

Criteria for assessing 'sufficient compensation'

Where an asset's cash flows are fixed, but can be changed by the issuer or a third party, that asset can still be included in the matching adjustment portfolio if the insurer can demonstrate that it will receive "sufficient compensation" to cover the reinvestment risk of replacing those cash flows.

Proposed new guidance from the PRA is designed to allow firms to devise their own criteria for assessing "sufficient compensation" on the basis of the relevant matching adjustment liabilities being matched together with the ability to obtain an asset of at least as good quality as the original to replace these cash flows if they are changed by the issuer. The intention is that firms should be able to consider a wider range of assets than under existing guidance.

Changes to matching adjustment portfolio

The relevant EU legislation provides that a firm's ability to bring new assets (or liabilities) into its matching adjustment portfolio depends on whether they have the same features as assets (or liabilities) already within the portfolio and, therefore, within the scope of the firm's existing matching adjustment approval.

Updated guidance is intended to help firms carry out this assessment. For example, the PRA expects that a new application would be needed for:

• assets involving restructuring, pairing or grouping;
• infrastructure investments funding a materially different underlying project; and
• assets with a different form of compensation clause from those already included in the matching adjustment portfolio.

The PRA also expects new reinsurance agreements, which tend to be bespoke, to need supervisory approval before they can be included in a matching adjustment portfolio.

Firms should consider whether the PRA's expectations in this respect given them sufficient latitude. Whilst the relevant EU-level rule must be complied with, it must surely mean "the same relevant (i.e. relevant to the matching adjustment) features" rather than all the same features.

Consequences of breaching matching adjustment requirements

Where a firm's matching adjustment portfolio breaches the eligibility criteria set by the directive, compliance must be restored within two months. The PRA has previously issued guidance that firms should engage with the PRA as early as possible where there is a possibility that the criteria have been breached.

It now proposes that firms should establish appropriate processes to ensure that breaches will be detected on a timely basis. In addition, where a breach is "reasonably" only determined after the date it has occurred (i.e. identified by the firm or notified to the firm by the PRA), the PRA may consider the two month remediation period to have started from the point that a breach is detected or confirmed.

Restructuring asset cash flows using special purpose vehicles

In the lead-up to implementation of Solvency II, many firms were considering how they might restructure assets to fit the matching adjustment criteria prescribed by the directive. The PRA's guidance is intended to help firms decide, on a more informed basis than to date, whether restructuring proposals are likely to be acceptable.

In summary, while the PRA does not rule out the possibility that an intra-group restructuring could satisfy MA criteria (and more general prudential requirements relating to the group), the expectation is that intra-group structures will only be used in exceptional cases.

The paper indicates a general preference for structures which resemble as closely as possible an arm's-length transaction. In particular, the PRA expects consideration to be given to counterparty credit risk, in relation to elements of the transaction providing support to the fixed cash flow requirements of the matching adjustment portfolio (such as liquidity facilities and TRS).

Trading in the matching adjustments portfolio

Although the principle underlying the construction of a matching adjustment portfolio is that assets will be held to maturity, the directive acknowledges that some trading of assets may be needed to maintain the required degree of matching to liabilities. Proposed guidance to firms emphasises the limited amount of trading that is permitted within the matching adjustment portfolio.

Firms must be able to demonstrate that governance and controls are in place to ensure that any rebalancing of assets within the matching adjustment portfolio is strictly for the purposes of good risk management.

Future changes

Despite the early termination of the Solvency II inquiry, the Treasury Committee's report (which was published on October 27, 2017) recommends (among other things) that the PRA and industry continue to work together on further amendments of the Solvency II regime and on introducing increased proportionality into the regime.

In CP21/17, the PRA has already confirmed that it is looking at other possible improvements to the Solvency II regime, including in the following areas:

• recalculation of the Transitional Measure on Technical Provisions
• external audit of Solvency and Financial Condition Report.

In the lead-up to Brexit, the PRA will undoubtedly continue to argue that some of the changes to Solvency II being asked for by industry are design faults and not errors in implementation. Once the UK leaves the EU, the design versus implementation debate arguably becomes redundant as the UK will no longer be constrained by Solvency II.

In practice, the position is more complex, at least to the extent that the UK wishes to obtain an "equivalence" finding for Solvency II purposes.

Nonetheless, the ABI recognises that the PRA's proposals "are an important step forward" and it looks forward to other areas of concern being addressed.