The PRA has published a consultation paper setting out the proposed rules for the new PRA Rulebook in respect of certain transitional provisions regarding risk-free rates and technical provisions (CP3/15). In addition, the consultation paper includes two draft supervisory statements: the first on the PRA’s expectations regarding these transitional measures; and the second on the internal model treatment of participations for the purposes of calculating the solvency capital requirement at solo level. This newsletter considers the proposals relating to transitional measures.

Key points

  • The PRA is consulting on draft rules to implement Solvency II transitional measures for risk-free interest rates and technical provisions as well as a draft supervisory statement on this matter. 
  • The transitional measures aim to avoid market disruption associated with the move to a new regulatory regime and to limit interference with the existing availability of insurance products. 
  • The proposed rules are designed to ensure a smooth transition towards the full requirements of the Solvency II regime. There are two transitional measures:
    • Risk-free interest rate transitional measure (Article 308c of the Solvency II Directive): this provides for a temporary upwards adjustment to the relevant risk-free interest rate term structure used to discount admissible insurance obligations. The adjustment is calculated as a portion of the difference between the rate that applies under the current regime and the Solvency II discount rate.
    • Technical provisions transitional measure (Article 308d of the Solvency II Directive): this provides for a temporary reduction in technical provisions which is calculated as a deduction from the amount of Solvency II technical provisions. The deduction is calculated as the difference between current technical provisions and Solvency II technical provisions.
  • A firm may not apply both transitional measures.
  • Both transitional measures apply for 16 years. The amount of the benefit is reduced on a linear basis. Firms will need to apply to the PRA for approval to rely on the transitional measures. 
  • The PRA is also consulting on a supervisory statement clarifying the internal model treatment of participations for the purpose of calculating the solvency capital requirement (SCR) at the solo level (Appendix 2.2).
  • As a result of the transitional measures, the PRA does not expect any firm to recalculate or restate the technical provisions it uses for regulatory purposes as a result of the proposed transitional measures.

Transitional measures on risk-free interest rates

Article 308c of the Solvency II Directive allows insurance and reinsurance undertakings to apply a transitional adjustment to the relevant risk-free interest rate term structure with respect to admissible insurance and reinsurance obligations. This is subject to prior regulatory approval and firms will be able to apply to the PRA for approval to transition from their current discount rate requirements under the existing INSPRU regime to the corresponding Solvency II requirements. 

The risk-free interest rate underpins the calculation of liabilities by (re)insurers and, as a default approach, the risk-free interest rate is primarily derived from the rates at which two parties are prepared to swap fixed and floating interest rate obligations. In the absence of financial swap markets, or where information on such transactions is not sufficiently reliable, the risk-free interest rate is based on government bond rates. The risk-free interest rates are:

  • calculated for different time periods, reflecting that the liabilities of (re)insurers stretch years and decades into the future;
  • calculated in respect of the most important currencies for the EU insurance market;
  • adjusted to reflect that a portion of the interest rate in a swap transaction (or a government bond) will reflect the risk of default of the counterparty and hence without adjustment would not be risk-free; and
  • based on data available from financial markets.

The risk-free rates will be published by EIOPA. In determining the amount of technical provisions, the risk-free interest rate may be adjusted by (i) a volatility adjustment, (ii) a matching adjustment or (iii) the risk-free interest rate transitional measures. The interaction of these measures and the technical provisions transitional measures is complex. 

An adjustment (the volatility adjustment) is made to the liquid part of the risk-free interest rate in order to reduce the impact of short term market volatility on the balance sheet of undertakings. 

A different adjustment (the matching adjustment) is made in respect of predictable portfolios of liabilities. An insurer can assign eligible portfolios of assets with fixed cash flows that it intends to hold to maturity. 

Under the transitional measures on the risk-free interest rate, a (re)insurer is required to calculate the adjustment to the risk-free interest rate for each currency as a portion of the difference between (i) the interest rate as determined by the (re)insurer in accordance with INSPRU 3.1.28R to INSPRU 3.1.47R and (ii) the annual effective rate, calculated as the single discount rate that, where applied to the cash-flows of the portfolio of admissible insurance and reinsurance obligations, results in a value that is equal to the value of the best estimate of the portfolio of admissible insurance and reinsurance obligations where the time value is taken into account using the relevant risk-free interest rate term structure.

If a matching adjustment is used with respect to liabilities, neither the risk-free interest rate transitional measures nor a volatility adjustment may be used (but the technical provision transitional measure could be applied).

Where a firm applies the volatility adjustment in accordance with the rules on technical provisions, the relevant risk-free interest rate term structure referred to above must be based on the risk-free interest rates adjusted with the volatility adjustment. Where the risk-free interest rate transitional measure is applied, a (re)insurer:

  1. cannot include the admissible insurance and reinsurance obligations in the calculation of the volatility adjustment;
  2. cannot apply the technical provisions transitional measure; and
  3. as part of its SFCR, must publically disclose that it applies the risk-free interest rate transitional measure and the quantification of the impact of not applying the risk-free interest rate transitional measure on its financial position.

Transitional measures on technical provisions

Article 308d of the Solvency II Directive allows insurance and reinsurance undertakings to apply a transitional adjustment in respect of technical provisions. This is subject to prior regulatory approval and firms will be able to apply to the PRA for approval to transition from their current discount rate requirements under the existing INSPRU regime to the corresponding Solvency II requirements. 

Under the current regime, firms are expected to calculate their insurance liabilities on both a Pillar 1 (INSPRU 1) and a Pillar 2 (INSPRU 7) basis.  There are two possibilities under the transitional measures, firstly relating to circumstances where the current INSPRU 7 technical provisions amount (i.e. an amount equal to the value of the insurance liabilities after deduction of reinsurance recoverables under INSPRU) is greater than the current INSPRU 1 technical provisions amount (i.e. an amount equal to the technical provisions after deduction of reinsurance recoverables under INSPRU), and second, relating to circumstances where the INSPRU 7 technical amount is less than the INSPRU 1 technical amount. 

Where a (re)insurer’s INSPRU 7 technical provisions amount is greater than the INSPRU 1 technical provisions amount, it must use the INSPRU 7 technical provisions amount as the basis for the calculation without any adjustment. When calculating the INSPRU 7 technical provisions amount, a (re)insurer should use methodologies, assumptions and input data that are consistent with its most recent INSPRU 7 technical provisions submission, including any margins held (e.g. implicit within unearned premium reserves, management margins), or amounts held following guidance given by the PRA or its predecessor, the Financial Services Authority.

Where the INSPRU 7 technical provisions amount is lower than the INSPRU 1 technical provisions amount, firms have two options for calculating the transitional deduction. The first option is to use the INSPRU 1 technical provisions as the basis. The second option is to make a comparison of the INSPRU 7 amount with the existing regime technical provisions requirements and to make an adjustment to the INSPRU 7 amount if necessary.

If a firm chooses to use an adjusted INSPRU 7 amount, it should make its own assessment of whether their INSPRU 7 technical provisions are at least as great as the existing minimum amount and submit the conclusions of this assessment within the relevant application to the PRA.

What next?

The transitional measures aim to avoid market disruption and allow firms much-needed time to meet the full Solvency II requirements.

Comments can be made on CP3/15 until 20 February 2015. The consultation period is short to enable the PRA to publish the final rules and supervisory statements before the Solvency II transposition deadline of 31 March 2015. The PRA plans to publish a policy statement, together with the final rules and supervisory statements, as part of a wider policy statement providing feedback and final rules to implement Solvency II in March 2015.

Firms wishing to use the transitional measures on the risk-free interest rate or on technical provisions may submit an application to the PRA from 1 April 2015. Firms are also requested to think about the interdependencies between all applications being submitted in respect of Solvency II approvals. Of particular interest is where firms apply for the transitional deduction at the same time as applying for the matching adjustment. In this scenario, the PRA asks that firms provide sensitivity tests showing the impact on the transitional deduction if the matching adjustment application were to be rejected.