On 30 May 2014, the PRA held a roundtable discussion for insurance sector trade bodies. The purpose of the roundtable was to:
- draw attention to the “very important” Consultation Paper (CP) and draft Supervisory Statement (SS) published 3½ hours before; and
- explain the proposals in the CP and SS, as well as the reasons for them.
This Client Briefing summarises the roundtable discussion, CP and SS. It is likely to be of interest to:
- every PRA-authorised insurer; and
- those who invest in subordinated debt, if the debt has been issued by a company in the same group as, and it has been guaranteed by, a PRA-authorised insurer.
The roundtable discussion
In November 2013, the PRA carried out “a small, almost ad hoc, survey” to see whether firms are complying with the PRA’s existing connected transaction rules and, if not, what impact these failures might be having on their regulatory capital position. Having done so, the PRA believes that “probably less than 20 insurers” have entered into subordinated guarantees without discounting the value of their regulatory capital in accordance with the rules, although “there might be others we don’t know about”. The PRA has therefore issued a CP, which includes a draft SS. If the SS is made in its current form, it will require every insurer in category 1, 2, or 3, and some insurers in category 4 or 5, to take steps that will enable the PRA to:
- develop a more informed view about the insurance market’s compliance with the connected transaction rules;
- understand the true regulatory capital position of those insurers that have, or may have, breached the connected transaction rules; and
- encourage or require non-compliant firms to “come into line” with the PRA’s requirements in an orderly way.
In most cases, the PRA expects to find that any rule breaches that do exist have developed “inadvertently” over “a long-period of time”, as groups have merged and restructured. The PRA therefore describes the proposed SS, and the actions it is proposing to require, as more of a “forward looking” “tidying up” exercise, than anything else. However, it is not offering “a formal amnesty” for firms that come forward now. Regulatory action of some kind cannot therefore be ruled out, if circumstances require it.
The PRA is expecting that some firms will need to change their contractual arrangements and/or their regulatory capital structure. The timetable of actions set out in the draft SS is intended to create “a framework that will enable firms to get there in a managed way”.
Auditors “should be concerned about the possibility that firms have two sets of liabilities, but they are only reporting one”. Certainly, the PRA has seen examples of this.
The PRA will be looking closely at third-country branches, especially if “there is something that undermines the branch, or gives the branch an advantage over subsidiaries”.
CP9/14: Subordinated guarantees and the quality of capital for insurers
The CP includes an SS, and the SS is concerned with the application of, and insurers’ compliance with:
- the PRA’s connected transaction rules (GENPRU 2.2.65R and GENPRU 2.2.169R); and
- the rules that will implement article 93 of the Solvency II Directive (Characteristics and features used to classify own funds into tiers) when they come into force.
The connected transactions rules prevent an insurer from taking a capital instrument into account as tier 1 or tier 2 regulatory capital “if the issue of that item of capital … is connected with one or more other transactions which, when taken together … could result in that item of capital no longer displaying all of the characteristics set out in” the rules that specify the qualifying characteristics for tier 1 and tier 2 capital instruments.
The draft SS gives two relevant connected transaction examples:
- “Type 1”: where a holding company (HoldCo):
- owns the whole of the equity in an insurance company subsidiary; and
- issues a £100m tier 2 subordinated debt instrument to investors, which includes a guarantee from the insurer that, if HoldCo fails to meet its coupon and other obligations, the insurer will meet them instead.
Under these arrangements, the insurer is potentially liable for the repayment of HoldCo’s debt, and the quality of its capital has therefore been undermined. As a result, the connected capital rules require the insurer to disqualify £100m of the tier 1 equity investment it has received from HoldCo when it reports its regulatory capital to the PRA on a solo basis.
(In this example, it seems to be impliedly assumed that the only capital instrument relationships between HoldCo and the insurer are that: (i) HoldCo owns the whole of the insurer’s issued share capital; and (ii) the insurer has guaranteed HoldCo’s subordinated debt obligations.
- “Type 2”: where the facts are the same, except that the insurer has also issued a £100m tier 2 instrument for the benefit of HoldCo, which is capable of producing the coupons HoldCo will need to pay the coupons on the external subordinated debt. In this case, if the intra-group debt instrument provides that, if the insurer meets HoldCo’s coupon obligations the insurer’s obligations to HoldCo will be extinguished, the insurer would not be obliged to disqualify £100m of its tier 1 capital, if other tests were also met.
The PRA wants to ensure that insurer issued subordinated guarantees do not undermine the quality of the capital they hold to meet their regulatory capital obligations. It therefore wants to ensure that, if an insurer accepts a potential liability, and that liability would have to be met from its capital resources, that fact is properly taken into account.
To help it achieve these outcomes, the PRA is proposing to assess subordinated guarantee arrangements to ascertain whether they are consistent with one of the following “situations”, and whether they display the characteristics described in the paragraph that follows:
- “Situation 1”: “From the perspective of the guarantor firm, if a subordinated guarantee is called upon, the guarantee should effectively extinguish or replace an existing subordinated liability. Otherwise the guarantee represents an additional potential liability that has not been reflected in, and would have to be met from, the guarantor’s capital resources. The subordinated guarantee should possess the same, or better, features regarding quality of capital (eg loss absorbency and subordination) as the subordinated liability it is replacing.”
- “Situation 2”: “Where a subordinated guarantee does not extinguish or replace an existing subordinated liability, the firm should acknowledge the existence of the guarantee by disqualifying the guaranteed amount from the guarantor’s Tier 1 capital. The amount may still count towards a lower tier of capital if the terms of the subordinated guarantee meet all of the relevant criteria — in effect a relegation. Whether the relegated amount can count towards total capital will also depend on the capital gearing rules, which constrain the amount of lower quality capital that can count as capital resources.”
- “The characteristics”: “In either case, any capital instrument that is guaranteed should still fulfil its regulatory purpose. The subordinated guarantee should not override the loss-absorbing features of a capital instrument and investors in a capital instrument should not avoid bearing losses when it is appropriate for them to do so.”
The draft SS was published for consultation on 30 May 2014. The consultation is open until 11 July 2014.
(Subject to the outcome of the consultation exercise) the PRA expects to publish the final SS on or about 11 August 2014.
- Within a calendar month of publication, insurers will be expected to:
- “inform their usual supervisory contact … if their capital structures involve the use of subordinated guarantees, and whether they have made any adjustment to the tiering of their capital resources to reflect that…”;
- confirm to the PRA, if the insurer is:
- in category 1, 2 or 3, and if it is the case; or
- in category 4 or 5, it is asked for a confirmation, and if it is the case,
that they “do not have these capital structures in place, and are not considering using them”;
- By 31 December 2014, insurers should give the PRA a copy of the terms of the subordinated guarantee and any related capital instruments, together with:
- (if an adjustment to capital resources has been, or will be, made in the firm’s regulatory returns), a note which explains where the adjustment has been, or will be, made;
- (if no adjustment has been made, the insurer is not proposing to make one, and it is not proposing restructuring or changes to contractual terms to change the impact of its subordinated guarantees), an independent legal opinion which addresses the economic substance of the structure as well as its legal form, and assesses whether the capital instrument that is guaranteed is fulfilling its regulatory purpose;
- (if no adjustment has been made, but the insurer is proposing a restructuring or changes to contractual terms to address the issue), a detailed plan of the proposed restructuring or changes to the contractual terms, which includes a deadline for implementing the plan, and a justification for the selected implementation date.
The PRA will assess the information it receives, and may challenge or disagree with it.
If a firm proposes a restructuring or changes to contractual terms and fails to implement them to a standard that meets the PRA’s expectations by 31 December 2015, the PRA will expect it to make adjustments to its capital resources reports for year-end 2015.
The PRA is especially keen to receive feedback “about any unintended consequences” its proposals may have. It is “looking for a way that will allow us to work together to resolve the issues in a pragmatic way on a sensible timetable. That’s the spirit the CP’s been issued in. So feedback that helps achieve that would be welcome”. Firms are therefore “encouraged to respond to the CP”, if they have something to say. The e-mail address for responses is: CP9_14@bankofengland.co.uk.