In this issue of insurance and reinsurance news we review recent developments under the Solvency II regime in relation to the long-term guarantees package (LTGP) and some of the steps that insurers are contemplating in respect of long-dated portfolios of assets. We provide an overview of some of the issues that the Prudential Regulation Authority (PRA) requires firms to consider when applying for the matching adjustment. We also include a timeline setting out both the EU measures and the UK implementing measures anticipated between now and 1 January 2016.

Background

The legislative process for the Omnibus II Directive was finally completed when the Directive was adopted on 11 March 2014. The agreement included a final timetable for implementation, with a deadline for transposition set for 31 March 2015 and full implementation of the new regime from 1 January 2016.

The agreement on the Omnibus II Directive has enabled the Commission to proceed with finalising the level 2 technical rules to Solvency II. The level 2 technical rules take the form of delegated acts, implementing acts and binding technical standards (both regulatory technical standards and implementing technical standards).  The final delegated acts were published by the European Commission on 10 October 2014 and are subject to approval by the European Parliament and Council. Over the summer months, the European Insurance and Occupational Pensions Authority (EIOPA) and the PRA have published a number of consultation papers, draft guidelines, draft supervisory statements and other communications, which have given further insight into the final Solvency II requirements.

HM Treasury explained in its August 2014 consultation paper on transposing Solvency II that the most significant area of change effected by the Omnibus II Directive was the development of the LTGP, which sets out the quantitative rules for the treatment of long-term insurance products.

This newsletter considers some of the developments that have taken place in relation to the LTGP since the adoption of the Omnibus II Directive and some of the issues that remain outstanding.

Matching adjustment and volatility adjustment 

The Solvency II Directive requires firms to hold technical provisions to cover all of their expected future insurance or reinsurance contractual liabilities, the value of which should be equal to the sum of a best estimate (which corresponds to the probability-weighted average of future cash-flows relating to the insurance or reinsurance obligations of the firm, taking account of the expected present value of future cash-flows using the relevant risk-free interest rate term structure) and an additional risk margin (which is the cost of holding regulatory capital in respect of the firm's (re)insurance obligations).

Articles 77b to 77d of the Directive set out the requirements relating to the calculation and use of the matching adjustment and volatility adjustment. The matching adjustment is subject to supervisory approval and, to the extent that such approval is granted, the matching adjustment may be applied to the relevant risk-free interest rate term structure to calculate the best estimate. The volatility adjustment covers insurance products that would not be eligible for the matching adjustment.  The LTGP measures are intended to take account of the long-term nature of certain types of insurance business (e.g. annuities, which are held by insurers for long periods of time) and mean that insurers do not have to recognise the full extent of short-term volatility in asset prices.

A key Solvency II issue for insurance companies is therefore whether the assets they hold meet the necessary criteria set out in article 77b to benefit from the matching adjustment. This has been recognised by the PRA who first sent a letter to directors of life and general insurance firms on 13 June 2014 explaining that the matching adjustment will be an important measure for many firms under Solvency II. On 15 October 2014, the PRA provided feedback on its trial matching adjustment submission, which took place over the summer. The feedback provided by the PRA should be taken into account by firms when preparing either their pre-application matching adjustment submission (which can be submitted between 1 December 2014 and 6 January 2015) or their formal application (which can be submitted from 1 April 2015). The PRA has expressed its awareness of firms' questions relating to the interpretation of the matching adjustment eligibility criteria, in particular those relating to the assigned portfolio of assets.

Cash flows 

One of the issues that a number of insurers are considering at the moment relates to the cash flow characteristics of the assigned portfolio of assets. The PRA has stated that it is not enough for the cash flows to be "very predictable" but that they must be fixed. The behavioural features of the asset determine eligibility not the notional class to which an asset (or a group of assets) belongs.

When demonstrating asset eligibility, the PRA has stated that it considers that:

  • the requirement for the portfolio to consist of "bonds or other assets with similar cash-flow characteristics" could also potentially be satisfied by considering relevant pairings or groupings of assets;
  • assets that produce both fixed and non-fixed cash flows would not necessarily be excluded under the eligibility criteria in Article 77b of the Solvency II Directive in cases where only the fixed cash flows are taken into account for the purpose of demonstrating cash-flow matching;
  • firms may be able to demonstrate that the cash flows from callable bonds up to the first call date are fixed, therefore allowing them to be partially recognised in the demonstration of cash-flow matching (provided that the asset also meets the other eligibility criteria);
  • where a cash flow is directly dependent on the realisable value of property, such uncertain cash flows cannot be regarded as fixed (irrespective of whether a firm proposes only to recognise a prudent estimate of the cash flow's value);
  • the requirement in Article 77b(1)(h) that "the cash flows of the assigned portfolio of assets are fixed and cannot be changed by the issuers of the assets or any third parties" does not necessarily disqualify all assets that are subject to early redemption/termination rights at the option of the issuer or a third party;
  • where assets have cash flows that may be changed at the request of the issuer or a third party, a derogation from Article 77b(1)(h) allows these assets to be eligible if firms are able to demonstrate clearly that the compensation they would receive in the event of a change in the cash flows would be sufficient to negate any reinvestment risk. However, there is no guidance as to what a sufficient level of compensation would be, just that a high degree of certainty must be provided.  The PRA has suggested that an adequate "Spens" clause (which provides that, on an early termination of a bond, the investor receives compensation that allows it to obtain the same cash flows by re-investing in risk free gilts) might satisfy the PRA;
  • the requirement in Article 77b(1)(h) will not necessarily disqualify reinsurance assets, provided that firms can demonstrate certain specific criteria;
  • where a firm proposes to include holdings in collective investment schemes or mutual funds within the assigned portfolio of assets, the firm should 'look through' to the underlying assets and demonstrate that these meet all of the eligibility criteria; and
  • it may be possible for firms to demonstrate that cash items are compatible with the eligibility criteria in Article 77b, provided that the inclusion of cash in the portfolio facilitates efficient portfolio management, including risk management.

Securitisations and restructuring asset portfolios 

Recently, we have seen insurers consider a number of options to address the situation where cash flows of an asset are not fixed but are susceptible to change by a third party (which might include the borrower itself).  Such options include restructuring those asset classes either within or outside of the insurers' group, disposing of the assets or relying on Solvency II transitional measures.

The PRA recognises that firms may be planning to undertake certain risk transformation transactions in order to benefit from the matching adjustment. To the extent that any such restructuring takes place within the same group as the insurance company, consideration will also need to be given to how any intra-group transactions are treated at the group level, as there remains the possibility that the matching adjustment relief sought at the solo level would be unwound at the group level. In addition, the PRA also draws firms' attention to the need to carefully assess and demonstrate compliance with (i) the risk management provisions in the Solvency II Directive and (ii) the Prudent Person Principle.

Risk management 

As part of their risk management systems, a firm's own risk and solvency assessment (ORSA) must include, amongst other things, an assessment of its compliance, on a continuous basis, with the Solvency II capital requirements (both with and without considering the use of any matching adjustment, volatility adjustment or transitional measures).

If a matching adjustment, a volatility adjustment or transitional measures have been relied on, the PRA has the power to impose a "capital add-on" on the firm under Article 37 of the Solvency II Directive if it considers that the firm's risk profile deviates significantly from the assumptions underlying the adjustments and transitional measures. This power is only supposed to be exercised in "exceptional circumstances" but it is not yet clear whether this provides an extra fetter on the PRA's power or whether any deviation deemed significant will mean that the circumstances are exceptional.

Prudent Person Principle

Firms are required to consider the prudence of any transactions or arrangements they enter into for the purposes of applying to use the matching adjustment, including their behaviour under stress and whether the associated risks have been understood and have been managed. The PRA has stated that "firms should have also considered any new risks generated by risk transformation arrangements, such as counterparty exposure, and how to account for these. In all considerations about asset eligibility, the key question the PRA expects firms to consider is whether they are exposed to the risk of changing spreads on the underlying asset, contrary to the fundamental rationale for the matching adjustment". We are expecting the PRA to share further details of the matching adjustment process with firms at the industry conference in November 2014. 

Conclusion 

The PRA has stated its intention to review asset portfolios on a case-by-case basis as part of the approval process and has made it clear that it will not prescribe a "closed list" of acceptable asset types. Instead, firms are expected to determine compliance with the matching adjustment criteria themselves. 

Firms should notify their normal supervisory contact by 30 November 2014 if they wish to participate in the matching adjustment pre-application process.

Timeline of activity 

EU Measures 

Click here to view the table.

UK Implementing Measures 

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