The Prudential Regulation Authority (PRA) has published a draft supervisory statement setting out its expectations of insurers in relation to existing rules on the valuation of financial assets.

The draft statement, published for consultation on 30 May 2014, reminds insurers to review their compliance with  the valuation rules set out in Chapter 1 of the General Prudential sourcebook (GENPRU) and makes it clear that insurers are expected to have robust procedures in place to manage valuation risk.

What is valuation risk?

Valuation risk is the financial risk that an asset is overvalued and is worth less than its reported value when it matures or is sold. This risk is most often associated with portfolios of structured products and illiquid securities,  but it can also apply to large portfolios of conventional investments where a firm holds concentrated positions  that it may not be able to unwind at reported fair value.

Managing valuation risk requires an assessment of valuation uncertainty of each asset or portfolio of assets (i.e. the range of plausible values of the asset or portfolio at the valuation date).

What are the current rules?

The existing rules require insurers to comply with applicable national and international accounting rules and set out certain additional accounting requirements. They also impose various further regulatory requirements in relation to control and governance of valuation procedures:

  • Insurers are required to establish and maintain systems and controls sufficient to provide prudent and reliable valuation estimates; including:
    • Documented policies and procedures for the process of valuation
    • Reporting lines that are clear, independent of the front office, and ultimately lead to a main board executive director
  • Wherever possible, insurers must use “mark-to-market” valuation (i.e. current market prices obtained from independent sources). Where mark-to-market is not possible, insurers must use valuation models that have been independently assessed and tested. Insurers must ensure that their senior management are aware of positions valued in this way and understand how the uncertainty and risk inherent in such valuations might affect reporting of business performance
  • Insurers must always perform independent price verification regardless of the valuation method used

What’s new?

The draft statement does not represent a change in policy by the PRA but rather reinforces the existing rules set out in GENPRU. In particular, the draft statement emphasises that an insurer’s assessment and quantification of valuation uncertainty and associated risk must be underpinned by adequate standards of financial asset valuation governance and control. This includes:

  • Sufficient independence in valuing assets
  • Adequate documentation of policies and procedures
  • Adequate understanding of and control over valuation models
  • Adequate management information
  • Consistent governance between internally and externally managed funds

Client-supplied pricing

One particular concern around governance and control singled out by the PRA in the draft statement is the use of client-supplied pricing. This is where an insurer receives valuations from an external valuation provider but the valuations are based on prices or pricing inputs provided by the insurer itself or the insurer’s investment managers and are therefore not truly independent.

The PRA observes that this lack of independence might allow performance to be manipulated by investment managers and makes it clear that the PRA expects insurers to:

  • Monitor and limit their use of client-supplied pricing
  • Have clear visibility of the price sources used and to identify where client-supplied prices are used in their valuations
  • Where the use of client-supplied pricing is unavoidable, have robust controls, including independent price verification and reporting to senior management

Comment

The publication of the draft statement follows recent comments by the Governor of the Bank of England, Mark Carney, on the PRA’s approach to insurance regulation (reported in last month’s edition of this newsletter). In his article in The Times on 22 May 2014, Mr Carney acknowledged that the current economic and regulatory landscape is putting pressure on insurers to look towards less traditional investment types and he asserted that the PRA would be vigilant to the risks in any such move. The less traditional investment types referred to by Mr Carney are likely to include complex structured products that carry a higher degree of valuation risk.

Furthermore, it is apparent from the wording of the draft statement that the PRA has identified that insurers have not been complying with all of their current obligations under GENPRU. In particular, the emphasis placed in the draft statement on independent price verification and reporting to senior management suggests that there is  need for improvement in these areas. With the approaching implementation of Solvency II in January 2016, it appears that the PRA is now stepping up its efforts to improve risk valuation governance: the draft statement serves as a notice to insurers that they can expect greater scrutiny of their governance procedures in the future.