Written evidence submitted by the Prudential Regulation Authority (SOL0051)

This letter provides the additional evidence requested by the Treasury Committee at the hearing on 22 February.

With respect to Solvency II, my view is that the fundamental regime is sensible and has many similarities with the previous ICAS regime in the UK. Solvency II allows firms to use internal models for their capital requirements, reflecting the fact that a standardised approach is unlikely to meet all the needs of the diverse UK industry. The regime takes into account the values of assets and liabilities, as they are today and consistent with the market. This reflects what we learned from previous experience, and in particular the problems with Equitable Life. Additional features built into the regime include the Matching Adjustment (as the replacement for the Illiquidity Premium under ICAS) which, together with other features of the regime, has reinforced incentives for long-term investment.

Although the fundamental regime is sound, there are nevertheless adjustments that need to be made to address issues in important areas, with the most obvious being that the design of the Risk Margin is excessively volatile due to its sensitivity to risk-free interest rates.

I took away from the session two points where the Committee wanted further evidence: our views in relation to the ABI's 23 areas recommended for reform; and our plans to consider further the costs and benefits of reporting requirements. These issues will of course have to be considered fully by the Prudential Regulation Committee (PRC) and they will be as soon as possible. However, given the timetable of the Committee's Solvency II inquiry I thought it might be useful to the Committee for me to set out my preliminary view on these matters here.

I plan to conduct a review of our implementation of Solvency II reporting requirements, with a view to identifying ways in which we might reduce insurers' reporting burdens while fully meeting our statutory objectives, including our secondary competition objective. We are constrained in many respects by the Solvency II Directive, but this does leave us some flexibility - especially on quarterly reporting burdens -which we have already taken advantage of to some extent. We remain open to discussions with the ABI and other stakeholders and will survey a sample of insurers to gather information on the impact of reporting through the firm. We will also review the ongoing usefulness of the data collected in supporting the PRA's supervisory functions, and the extent to which the information collected helps the PRA to meet and balance its objectives. I intend to progress this work as a matter of priority and will provide a response to the Treasury Committee on the outcomes of the review.

In relation to the 23 areas of concern the ABI identified, I set my views on each in the appendix. You also asked me to identify which of those I considered would not be within our gift to address. The areas where we are constrained include assessments against the Matching Adjustment eligibility criteria, where the PRA is legally required to consider each application against the MA eligibility criteria in Solvency 2 (Art 77b of the Directive, as transposed in Regulation 42 of the Solvency 2 Regulations 2015 SI 2015/575). However, set against this requirement, we have been flexible within its limits, for example by allowing firms to restructure illiquid assets so that they can qualify. In other areas we are constrained in our ability to provide definitive domestic guidance on the directly-applicable EU Solvency II Delegated Regulation, which means for example that we are unable to provide more clarity on the treatment of some US securitisations than the Regulation provides. In other areas, particularly reporting, there are some very clear constraints, but there also exists some opportunity to apply proportionality and I will explore this further as set out above.

I hope that my thoughts on these topics will assist the Committee in its deliberations.

Yours sincerely

Sam Woods

Deputy Governor and CEO, Prudential Regulation Authority

Appendix: ABI's 23 areas recommended for reform

Areas where I am open to reform and will explore options with the ABI - these issues will need to be fully considered by the PRC in due course

Internal model change process

The PRA will continue to review the ongoing appropriateness of model approval processes and ensure they do not impose an excessive burden, whilst respecting the constraints of the Solvency II regime. We are currently reviewing a large number of internal model and other approvals and acknowledge the resource-intensive nature of the regime. We are actively looking at ways to reduce the burden on supervisors, firms and boards. It should be noted that although, under the relevant Solvency II provisions, the PRA has six months from the date of application to provide a decision on major model changes, our experience so far has shown we have taken considerably less than six months to provide decisions.

Recalculation of the transitional measures on technical provisions

The transitional measure on technical provisions (TMTP) is an integral part of the Solvency II regime and is intended to ensure a smooth transition to Solvency II by gradually phasing in the impact - principally, of the Risk Margin - on existing business written and priced before Solvency II commenced. It is important that the TMTP reflect the economic position of firms with a reasonable degree of accuracy and also that this should be balanced with the need to avoid excessive burden for firms and the PRA within the constraints of the Solvency II regime.

In May 2016, following consultation, the PRA set out a simplified process for firms to apply to recalculate the TMTP in response to changes in their risk profiles, including in response to changes in the market environment. The PRA has set out its expectation in a way that is simple and consistent for all insurers. The PRA is also currently consulting on its policy towards updating the Individual Capital Assessment (ICA) assumptions used in future recalculations, closing on 15 March 2017.[1] Following publication of its final policy in this area, the PRA will also communicate to firms its expectations around the 24-monthly routine recalculations of the TMTP, the first of which will take place at year end 2017. The PRA welcomes views, particularly in the context of that consultation, on ways in which we could simplify further the TMTP recalculation process.

External audit of the Solvency Financial Condition Report

The Solvency and Financial Condition Report (SFCR) is the key public disclosure required by Solvency II. The external audit of the SFCR is intended to give users of the SFCR, including investors, policyholders and the PRA, greater confidence in the quality of the disclosure. Market participants have historically relied on insurers' published disclosures for undertaking analysis and some of these disclosures have historically been audited in the UK. The audit requirement is also consistent with ElOPA's view that external audit can be a 'powerful tool'. Nevertheless, the PRA will ensure the external audit requirements remain proportionate. The PRA will assess the costs of external audit to firms relative to the benefit that external audit provides to investors, policyholders and the PRA, and consider whether the external audit requirement remains appropriate for all firms. However, this assessment can only commence after having received and fully considered the first set of audited SFCRs this year.

Longevity transfer and hedge arrangements

I should be clear that there is no PRA approval process for these transactions. Longevity transfer and hedge arrangements can represent very significant changes to firms' risk profiles, so in order to monitor the growing market, the PRA does expect to be notified of longevity risk transfer and hedge arrangements and the firm's proposed approach to risk management well in advance of completing such a transaction.[2] This expectation applies where a firm is buying or selling longevity protection. As well as allowing us to gain a fuller picture of the market, this would also allow us to understand the potential build-up of risk concentrations as a result of these transactions. This will enable supervisors to consider whether the risks of the proposed transaction are being appropriately managed and that the transaction has an underpinning rationale that is consistent with good risk management principles. However, we would be happy to work with the industry to determine whether some of the information currently provided by firms in their notifications could be omitted so as to reduce any undue burden. Going forward, we plan to conduct a series of deep dives into firms' counterparty risk management. Once this is completed, we intend to take stock of the current requirements and may review the current notification arrangements.

Legal entity identifiers

The PRA will continually assess the appropriateness of its application of the Solvency II reporting regime to ensure it remains practical and proportionate. ElOPA Guidelines on the use of Legal Entity Identifiers (LEIs) state that LEI codes should be requested for all institutions under the PRA's supervisory remit.[3] Therefore, the PRA requested that all entities within groups obtain an LEI code, including holding and dormant companies. The PRA acknowledges that this may prove burdensome for some firms, although there are important advantages of using LEI codes for regulatory reporting across borders and the financial industry. We would be happy to work with the industry to determine areas where any excessive burden can be reduced in this area.

Areas where I share some concerns but do not necessarily agree with the ABI's prescription

Risk Margin

We agree with the ABI's view that the Risk Margin needs major reform and we consider that the best course of action is to seek lasting reform of the risk margin at its source, in the Solvency II regime itself. The Commission has asked ElOPA to assess a range of issues in the Level 2 Delegated Regulations covering the full breadth of the standard formula, the risk margin and the quality of capital and in December 2016, ElOPA released a discussion paper, which it will use to inform its first batch of advice to the Commission. We encouraged UK industry to submit a constructive response to the ElOPA discussion paper and to turn its mind to potential redesigns of the risk margin that are realistically achievable and that deliver the desired outcomes of reducing both size (versus its level at current interest rates) and sensitivity to the level of market interest rates. The Commission's review is due by end 2018, on the basis of ElOPA's advice, which will be given towards the end of 2017.

The PRA has engaged with various proposals to reform the risk margin under the current regime. In particular, the industry proposed a mechanism through which firms would adopt a hypothetical future management action that would only take place in very specific circumstances. The effect of this would be to reduce the risk margin without any actual change in the level of risk. The PRA Board expressed concern with the industry's proposals, both because such future actions would be binding, even in circumstances where the result would be imprudent, but in particular, as firms might then seek to apply a similar approach in adopting further hypothetical management actions in other areas of the Solvency II framework, notably in relation to capital requirements and technical provisions. Furthermore, the PRA

Board decided to prioritise work to reform the risk margin in Europe and has concerns about actions being taken unilaterally that might potentially jeopardise the outcome.

Dynamic Volatility Adjustment

The PRA's view is that the Volatility Adjustment (VA) is intended to provide relief from 'artificial' volatility in the Solvency II balance sheet, on an ongoing basis, but particularly in times when bond prices are temporarily but sharply depressed. Anticipating future increases in the VA when modelling, for example, future bond price falls, has the effect of reducing the capital that firms hold against credit spread risk. In the PRA's view this was not one of the intended effects of the VA, and would likely reduce its effectiveness as a tool to reduce pro-cyclical behaviour during times of market stress.

The PRA's view is that modelling of a 'dynamic' volatility adjustment is not consistent with or intended by the Solvency II Directive, although we are aware of the range of views on this amongst Member States as well as between insurers and regulators. The PRA is currently working with ElOPA and the other Member States to achieve a European-wide solution.

As further background, in contrast with other EU insurers, UK insurers make much more extensive use of the Matching Adjustment (MA) the in preference to the VA. By way of illustration, UK firms have received aggregate benefit of £59 billion from MA versus only £1bn from VA. For firms using the MA, 'dynamic' modelling of the MA in stressed conditions is permitted and UK firms already benefit significantly from this.

Quantitative indicators

The Quantitative Indicator (Ql) framework is important to the PRA as it ensures the consistency of calibration between firms' capital requirements. So, while we do not intend to move away from this approach, the PRA recognises the need to keep its Qls under regular review. The Ql framework has been a very useful tool in helping to ensure that similar risks are assessed consistently across firms, and made model reviews more efficient and fair. The PRA has been open in how it uses quantitative analysis as part of model approval, and has sent a number of letters to firms on this topic.[4]

Reinsurance counterparty risk

The PRA already takes a principles-based approach in respect of reinsurance counterparty risk. The PRA expects firms to have a risk management system covering reinsurance counterparty default risk (including concentration risk).[5] This includes all risk exposures with a loss potential that is large enough to threaten the firm's solvency or financial position, which I do not consider to be unreasonable. Firms are expected to mitigate reinsurance counterparty default risk concentrations by demonstrating prudent risk management and compliance with other relevant requirements within the PRA Rulebook. Mitigation may take various forms (examples include, but are not limited to, funds withheld and collateral agreements), and our supervisory statement is clear that these will often be uniquely tailored to a firm's specific business, the counterparty's credit profile and the particular form of reinsurance. We have also been clear that we intend to take a proportionate approach, and that for smaller firms the consideration of the trade-off of different component aspects contributing to the credit risk might be materially different to those for larger firms.

US securitisations

The uncertainty over the current treatment of US securitisations in Solvency II primarily stems from directly applicable regulations, rather than from the parts of the regime that the UK has had to transpose into its legal framework. Furthermore, I see the harmonisation of securitisation regulation across various sectors within the EU via the Simple, Transparent and Standardised (STS) Securitisation Regulation as sensible and appropriate.[6]

Availability of own funds at group level

The approach to assessing fungibility of capital at group level is currently being discussed with other EU insurance supervisory authorities and ElOPA with a view to harmonising the interpretation of Solvency II provisions. In principle, the diversification of risks is allowed for under the Solvency II regime. However in practice, the movement of capital from subsidiaries to elsewhere in a group is often constrained by local capital requirements. On a point of detail, the 'arbitrary restriction' of 9 months cited by the ABI is a requirement imposed by the Solvency II Delegated Regulation.[7]

Look-through for asset reporting reguirements

The PRA has sought to implement the look-through requirements in a proportionate way and, through its published guidance, has encouraged firms to apply materiality in making reasonable approximations. The PRA intends to review more generally the reporting burden placed on insurers.

National Specific Templates

National Specific Templates (NSTs) were developed to address important gaps in the Solvency II reporting regime relating to specificities in the UK insurance industry that are necessary for supervision. The PRA intends to review more generally the reporting burden placed on insurers.

Eguitv release mortgages and other illiouid assets

Solvency II sets out very specific eligibility criteria for both assets and liabilities in the context of the MA and requires prior supervisory approval to determine whether those criteria are met.[8] The Solvency II criteria do not allow for a principles-based approach. ERMs do not have fixed cash-flows and therefore do not, in raw form, meet the MA asset eligibility criteria.[9]

The MA is mainly used in the UK market and the current MA benefit is in the order of £59 billion. It has helped to enhance strong incentives for UK life firms to invest in long-term illiquid assets, such as commercial property financing, equity release mortgages and infrastructure financing. It should be noted that whilst the eligibility criteria are tighter than under the previous ICAS regime, the MA is more generous than the Illiquidity Premium under ICAS and therefore strengthens these incentives. The PRA has taken a flexible approach within the limits of the Solvency II regime, for example by allowing firms to restructure illiquid assets such as ERMs so that they qualify for the MA.

On 15 December 2016, the PRA released a Consultation Paper and draft Supervisory Statement which set out its proposed expectations in respect of firms investing in illiquid, unrated assets (including restructured ERMs) within their MA portfolios.[10]1 The consultation period is ongoing and closes on 14 March 2017. The PRA plans to monitor the level of MA benefit claimed by firms investing in illiquid and unrated assets and gain assurance that the level of MA benefit obtained by firms remains appropriate.

Matching Adjustment approval and change process

Firms can, in principle, invest in the full range of major fixed income assets for MA purposes, where those assets qualify as being eligible. However, the Solvency II Directive explicitly subjects application of the MA benefit to prior supervisory approval and HMT's Solvency 2 Regulations provides for firms wishing to apply for this to submit an application to the PRA. The application must demonstrate that each of the Directive's eligibility criteria will be met, as the PRA cannot otherwise approve use of the MA and cannot waive the eligibility criteria for particular asset classes. There are therefore some inevitable constraints around the MA approval process. The same is true of changes to an approved MA portfolio: the PRA must require a new approval in respect of future assets/liabilities that do not have the 'same features' as assets/liabilities in the approved MA portfolio.[11]

Additionally, the requirement for firms immediately to report MA breaches to the PRA (and the period within which breaches must be remedied) is derived from the Directive.[12]

Areas with which I disagree

Treatment of deferred tax assets

Deferred tax assets are often material to the calculation of a firm's capital position. Their calculation is by its nature highly complex and involves inherently uncertain projections. Accordingly, the use of such assets is limited under Solvency II. The PRA's expectations of firms in this regard are proportionate.

Having calculated the value of deferred tax assets, Solvency II requires firms to demonstrate that those assets can likely be used before the benefit of them can be recognised as capital resources. The PRA has set out the level of credibility of projections that it expects firms to reach in order to demonstrate a likely ability to use the assets.[13] It is not for the PRA to comment on the level of credibility other regulatory authorities require of the information provided to them by their firms.

Staff pensions

Under both ICAS and Solvency II, firms are required to hold capital for the risks arising from defined benefit (DB) pension schemes and the UK experience has shown that these risks are very real. The PRA considers it important that firms hold an adequate level of capital to cover such risks. It should be noted that the level of capital held for pensions risk has generally been lower under Solvency II than ICAS.

Future reinsurance premiums

The PRA has addressed this matter in its Director's letter of July 2015.[14] Solvency II takes a cash flow-approach to constructing an insurer's balance sheet where contractual commitments are recognised. The ABI proposes that firms should instead recognise future reinsurance premiums with corresponding recognition of future recoverables, which would require a cedant to include some expected future new business within technical provisions. Solvency II is clear that technical provisions should not include future new business.

Ring-fenced funds

There are two separate issues within ABI's submission: the first relates to ring-fenced funds generally and the second relates to calculation of surplus funds.

Ring-fenced funds

The PRA has issued rules and a supervisory statement pertaining to with-profits business. In its supervisory statement[15] the PRA set the expectation that in general, each UK with-profits fund should be treated as a ring-fenced fund for the purposes of Solvency II. To do otherwise may overstate the own funds position of a firm by including amounts that are not in fact available to absorb losses outside the with-profits fund. The PRA considers that ElOPA's guidelines on this matter are appropriate.

Surplus funds

The PRA issued rules and a supervisory statement to prescribe a method for firms to calculate 'surplus funds' applying to individual with-profits funds. The calculation basis for surplus funds is heavily based on the previous FSA rules. By making the calculation mandatory (rather than optional) for all with-profits firms, we aim to achieve comparability between with-profits funds and firms regarding amounts that have not been made available for distribution.

Sovereign debt in internal models

Solvency II requires firms to include all material risks within the scope of their internal model. On the basis of clear evidence from the last ten years, the PRA considers credit and market risks associated with sovereign debt, including gilt-swap spread risk, to be material risks that should be modelled in firms' internal models.

Model drift monitoring

Model drift is the risk that capital requirements calculated using an internal model may drift over time. Monitoring model drift is one tool that the PRA uses to help ensure that capital requirements under Solvency II remain reflective of the risks to which firms are exposed, ensuring that the safety and soundness of firms is promoted and the appropriate degree of protection for policyholders is not weakened over time. This is especially important in the UK market: the PRA has approved more internal models than any other EU country.[16]

The PRA's approach includes the monitoring of the internal model Solvency Capital Requirement (SCR) against certain objective measures of risk that include, but are not limited to, the standard formula SCR (where an estimated approach is allowed), the pre-corridor Minimum Capital Requirement (MCR), the net written premium and the best estimate of liabilities. The need to maintain the ability to calculate the Standard Formula SCR to a reporting standard is particularly important in the event a firm's model approval is revoked.

Reguirement for Gl firms to model risk to the ultimate time horizon

The PRA expects insurers to recognise all of the risks that they are exposed to. The Pillar 1 framework calculates the SCR over a 1 year time horizon, and the Risk Margin is an additional liability intended broadly to cover the cost of transferring the business of a failed insurer to a competitor. But Solvency II is clear that other risks, including how long-tailed Gl risks might develop over time, should be reflected in firms' ORSAs.

Senior Insurance Managers Regime

The SIMR is designed to ensure the individual accountability of senior managers and directors of insurers for their own conduct, for overseeing the business conduct of the key individuals reporting to them, and for the ongoing safety and soundness of their firms and the protection of their policyholders. The SIMR is fully consistent with the provisions of the Bank of England and Financial Services Act 2016 (the "2016 Act") that was passed last year. Furthermore, the PRA has implemented a streamlined and simpler SIMR regime for small non-directive firms.