Regulatory Consultation Paper Round-up

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1 Regulatory Consultation Paper Round-up Both the PRA and EIOPA have issued consultation papers in Q some of the changes may have a significant impact for firms if they are implemented as currently drafted. Executive Summary Over the past few months the PRA and EIOPA have issued a number of consultation papers: PRA CP21/17 Solvency II Matching Adjustment PRA CP22/17 Solvency II: Supervisory approval for the volatility adjustment PRA CP24/17 Solvency II: Internal models modelling the matching adjustment EIOPA-CP : Consultation paper on EIOPA s second set of Advice to the European Commission on specific items in the Solvency II Delegated Regulation These consultations are the next step in formalising existing advisory guidance and they introduce some changes that could have an impact on firms. We encourage firms that are affected by the changes to provide consultation responses to the PRA or EIOPA, and PwC are able to help draft responses and provide our insight for clients submissions. We note that the draft Supervisory Statements included in the PRA consultation papers may cover all of the changes recommended in the Treasury Select Committee Report on EU insurance regulation. We think it is reasonable for firms to expect further guidance on key topics in coming months as the PRA seeks to react to feedback on these recent consultation papers, the Treasury Committee s expectations and the evolving view on the UK s regulatory relations with the EU, following Brexit. The sections below take each consultation paper in turn and outline: Important parts of recent consultations, particularly where there are changes to existing standards; Which firms are likely to be affected by each consultation; The impact on firms if the proposed changes are implemented as presented; How PwC can help to assist clients looking to draft responses to consultations, or implement the suggested changes into their existing processes. Contacts Shazia Azim William Gibbons Daryl Boxall Patricia Wan T: +44 (0) T: +44 (0) T: +44 (0) T: +44 (0) E: shazia.azim@pwc.com E: william.gibbons@pwc.com E: daryl.boxall@pwc.com E: patricia.wan.yan.keong@pwc.com This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers LLP, its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it PricewaterhouseCoopers LLP. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers LLP (a limited liability partnership in the United Kingdom), which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity KD-OS

2 CP21/17 Solvency II: Matching Adjustment Topics Covered Who should pay attention Issue Date 25 th October 2017 Response Deadline 31 st January 2018 Asset eligibility, liability eligibility, calculation of MA, liquidity plans, ongoing management of MA portfolio All firms currently using or considering using the Matching Adjustment. Likely to affect any firms looking to revised MA application within the next year Much of the guidance on MA portfolios to date, is contained in various Director s and Executive Director s letters issued by the PRA between 1 April 2013 and 15 February CP21/17 consolidates this into one draft Supervisory Statement - we highlight below only the areas that are new or add clarity to existing guidance. The new guidance in the draft Supervisory Statement is likely to affect a number of Firms over the next year, especially those who are considering to add additional assets to the MA portfolio or adapt the MA to a revised business strategy post solvency II implementation. Asset eligibility The PRA has reiterated that it does not have a closed list of MA eligible assets rather that Regulation 42 outlines the features that assets must have in order to be considered eligible and each asset is reviewed on a case-by-case basis. CP21/17 sets out that asset cash flows for which the timing is uncertain, but bounded, can be regarded as fixed for the purpose of demonstrating cash flow matching, provided other MA criteria are satisfied 1. This could widen MA eligibility criteria to include certain assets which firms have found difficult to demonstrate eligibility in the past (e.g. some infrastructure loans with a construction phase ). Firms may now be able to benefit from the MA on these assets from the point of investment, instead of holding them outside the MA portfolio until the timing of repayments has been confirmed. Many firms would welcome some relaxation of MA asset eligibility criteria, but this clarification may not go as far as they would have hoped. Its application is limited to a fairly small opportunity set and may not have a significant impact on MA portfolios as a result. Firms should consider providing feedback to the PRA around other assets that they believe reasonably satisfy the MA principles but are currently not eligible and might warrant further consideration by the PRA. Trading in the MA portfolio The PRA recognises that some trading in the MA portfolio may be required to facilitate a change in firms overall risk and investment strategy for example, to de-risk or re-risk the MA portfolio in line with a change in the overall risk policy 2. Where it is specifically for the purposes of good risk management, the PRA have provided guidance that trading an asset for one with the same yield but lower risk, or a higher-yielding asset with the same risk, is not necessarily precluded - as long as Firms can demonstrate robust risk management and governance processes around the trading policy. 1 CP21/17: paragraph CP21/17: paragraph 7.14 &

3 We expect firms may wish to revisit their MA portfolio trading rules and consider adding flexibility to the trading policy in light of this clarification. Changes to the MA portfolio The PRA expects that any material change to MA portfolios after approval has been granted will require a new application 3. We note that the PRA s definition of material changes include: Addition of new asset or liability types into the MA portfolio; Entering into new risk transfer arrangements, or making changes to existing ones; Restructurings and M&A activity; We expect a number of firms will be therefore be required to make new applications in 2018, due to changes in either their asset or liabilities in the MA portfolio. In particular, firms consider adding new liabilities to their MA portfolios may find it beneficial to engage with their regulatory teams at an early stage to avoid any potential delay to the application process which may occur if a number of firms seek to make changes at the same time. PwC view and further support At first glance, this consultation paper appears to do little more than consolidate previous guidance into a single draft Supervisory Statement. We expect that any firm making changes to their MA portfolios in the coming year will be required to consider how the draft supervisory statement impacts their MA application. Given the number of firms looking to add new assets classes and liabilities to their business, this will likely apply to a significant number of firms. Having supported a large number of firms with their Solvency II applications, PwC has deep experience supporting clients with all aspects of an MA application, including trading and liquidity policies. If you would like to discuss any part of this consultation paper, we would be more than happy to discuss these topics with you. 3 CP21/17: paragraph

4 CP22/17 Solvency II: Supervisory approval for the volatility adjustment Topics Covered Who Should Pay Attention Purpose of the VA, Financial Guarantees, ORSA, Earning VA in practice All VA firms Issue Date 3 rd November 2017 Response Deadline 9 th February 2018 The last significant statement on the volatility adjustment was SS23/15 published in June 2015, and the draft Supervisory Statement contained in CP22/17 is intended to update certain parts of this - we highlight below only the areas that are new or add clarity to existing guidance. We believe that, in the short term, the PRA may not enforce the changes on to firms that already have approval to use the volatility adjustment. However, any new or pending applications may be affected and it might be possible that firms are asked to revisit the appropriateness of how they apply the VA in their ORSA. Intended purpose of VA The PRA has reinforced the principle that the purpose of the VA is intended to mitigate Firms exposure to artificial short-term balance sheet volatility, and using the VA in a different way could give rise to undue capital relief 4. We expect that the PRA will ask Firms to provide a qualitative and quantitative rationale for the appropriateness of different blocks of business included in VA application This might be of particular concern to some blocks of business where this might be difficult to justify the use of the VA. Regardless, it may still be appropriate to use the VA for assessing these blocks if firms can demonstrate that they have sufficient liquidity to avoid having to liquidate assets at depressed prices to meet claims. Under-valuation of financial guarantees CP22/17 raises the critical point of firms using the VA to calculate the cost of providing financial guarantees 5. This is particularly important for Firms that issue products with financial guarantees. Reserves for financial guarantees should be based on the value of options strategies that replicate the product features if these options are valued including the VA it may result in under-valuing the guarantees. Holding reserves for financial guarantees based on the VA may significantly undervalue the cost of purchasing those guarantees in the market, and may not reflect the true risk of providing these guarantees. The PRA are clear that they expert firms to identify, manage monitor and report risks associated with using the VA 6, and this is one particular area where Firms may wish to review their existing processes. 4 CP22/17: paragraph CP22/17: Appendix Proposed amendments to Supervisory Statement 23/15 Solvency II: supervisory approval for the volatility adjustment Paragraph 3.8A1 6 CP22/17: Appendix Proposed amendments to Supervisory Statement 23/15 Solvency II: supervisory approval for the volatility adjustment Paragraph 3.8A2 4

5 Earning the VA in practice CP22/17 also outlines that the PRA expect firms to demonstrate that they can earn the VA in practice 7. Firms should review achieved yields on assets backing VA business, and consider the level of reliance on assets with uncertain yields and how this may impact the ability to earn the VA in the future. The VA, in principle is a long-term yield measure and it is not clear over what time period is reasonable for the PRA to expect Firms to demonstrate compliance. Firms which rely heavily on uncertain returns, or would require management actions to earn the VA should consider how they will justify their approach to the PRA if challenged. Depending on how vigorously the PRA intend to test this, it could potentially result in some changes to investment and risk management processes in VA business, or even a change in eligibility for some books if firms are unable to demonstrate the ability to generate sufficient returns. PwC view and further support The additional guidance outlined in CP22/17 is not definitive is some areas, and remains open to interpretation. We think that firms should use this consultation paper as an opportunity to provide the PRA with feedback before the PRA have crystalized their views. Firms that have new or pending VA applications may particularly be affected by the draft Supervisory Statement, and we expect that firms will be asked to reflect on the points raised in their ORSA. PwC would be happy to discuss how the draft changes may affect their business. 7 5

6 CP24/17 Solvency II: Internal models modelling the matching adjustment Topics Covered Who Should Pay Attention MA in the SCR, Framework for determining MA in SCR, MA compliance under stress, validation All MA Firms Issue Date 10 th November 2017 Response Deadline 9 th March 2018 The PRA recognises that the MA requirements were finalised later than other elements of the Solvency II Directive and this presented challenges for firms looking to reflect the MA on day one. The purpose of CP24/17 is to support firms looking to make changes to their models by providing clarity on the PRA s expectations for the modelling of the MA within the SCR calculation. Once the guidance in the new Supervisory Statement has been put in place, it is likely that Firms will be asked to consider how the guidance in the draft Supervisory Statement is reflected in any new model change applications. We think that this is likely to affect a number of Firms in the next year, and would encourage Firms to consider how they will be affected and provide feedback to the PRA. This consultation paper draws together guidance previously shared by the PRA, previous Supervisory Statements and also expands on the PRA s expectations in a number of areas. We focus only the areas that are new or add clarity to existing guidance. Validation of the matching adjustment model To date, Firms will have validated their matching adjustment calculation using different methods. In this consultation paper, the PRA has provided specific areas they expect to see addressed in the validation of the MA calculation. In a number of places in the paper, the PRA have made it clear that they expect firms with illiquid assets in the MA portfolio to adopt a bespoke approach for assessing the MA under stress for these assets 8. For example, in regards to corporate bonds, a comparison should be made using the Firm s fundamental spread stress at the 50 th percentile level and the EIOPA FS methodology 9. In the event results are not similar, firms need to assess what impact this has on the SCR. When considering the impact of defaults and downgrades, the PRA makes clear that it expects Firms to validate the stressed transition matrices against historic stress events. 10 In particular, the 1-in-200 transition matrix should be assessed against experience post 1930 s Great Depression (particularly 1932 and 1933). The MA benefit firms achieve needs to be validated using a method which is independent to that used to calibrate the stressed FS 11. An example of this might be the use of historical data to validate stressed a stress MA where the calibration method is heavily reliant on expert judgement. 8 CP24/17: paragraph 4.19, CP24/17: paragraph CP24/17: paragraph CP24/17: paragraph 6.8 6

7 We expect that Firms will have to make some changes to their model validation process to include these specific assessments particularly Firms that make use of illiquid assets in the MA portfolio. Granularity of modelling The PRA expects firms to be able to determine the credit rating of each asset under the modelled stress 12. Similarly, the starting point for appropriate granularity for FS and MA modelling is to match the current EIOPA FS tables 13 - to the extent that stressed FS and MA are calculated at a lower level of granularity, Firms will need to justify their approach. In addition, Firms with material exposure outside of corporate bonds (e.g. Illiquid assets), will also require their own calibration for these assets individually, in terms of having an appropriate methodology to assign a credit rating and an appropriate FS for these asset classes. We are aware that some firms currently do not model the credit rating of individual assets under stress and adopt an average credit rating or median rating approach. We therefore expect that some Firms will need to significantly develop their existing modelling sophistication to meet these criteria. Completeness of risks The PRA make clear their expectations that Firms carefully consider all quantifiable risks, and whether these risks are retained by the Firms in a stressed scenario. At the very least, Firms should consider: 1) downgrade and default risk 2) basis risk 3) concentration risk. More in-depth considerations will be required for Firms with material exposures to illiquid assets which have more sources of risk. With regards to concentration risk, this should be assessed using a number of different approaches 14 including: 1. Analysing current portfolio concentrations by sector, single name exposures and also considering any concentration limits specified in investment mandates. 2. Assess using quantitative measures (e.g. Herfindahl index is suggested) 3. Stress and scenario testing to understand potential concentration risk under stress. We anticipate most Firms will have assessed concentration risk for their current MA portfolio. However, we expect many will need to extend this analysis to include quantitative measures and stress and scenario testing. Firms should also explicitly consider the impact of underwriting risk stresses 15 (e.g. longevity) on the MA portfolio liabilities, and any risks arising from additional long-dated assets. 12 CP 24/17: paragraph CP 24/17: paragraph CP24/17: paragraph 4.13, CP24/17: paragraph 6.4 7

8 We are aware that a number of Firms do not currently assess how changes in longevity impact the MA under stress, and will need to make potentially significant changes to their modelling in order to account for longevity risk. Maintaining MA Compliance in Stress Conditions In most cases Firms will need to take management actions to restore the MA portfolio to compliance following a stress event. Firms should be able to demonstrate how the actions they propose to take to re-establish matching reflect the source, nature and the severity of the stress event 16 (e.g. a credit default, migration, longevity). Firms that intend to inject assets into the MA as part of the rebalancing process should ensure that they have performed a detailed assessment of the asset concentration and correlation following the rebalancing actions 17. In addition, Firms should also assess the impact of not being able to purchase the required assets in a stress scenario, and perform sensitivity tests to show, for example, the impact on MA benefit if gilts were bought instead of higher yielding assets 18. We understand that in the past, several Firms have demonstrated MA compliance post-stress, by assuming that they will be able to source replacement assets of a similar yield to their current portfolio. Firms may wish to re-interpret their approach in light of the new Supervisory Statement. Firms are expected to hold capital to allow for expected transaction costs for rebalancing trades 19. This approach might require firms to revise the modelling of their expected rebalancing trades and associated trading costs in a stress event to account for this requirement. We anticipate that this approach will need further consideration in the future, and that the requirements for demonstrating compliance post-stress are likely to be more quantifiable in the future. PwC view and further support The additional guidance outlined in CP24/17 could result in material changes to models and processes for a number of firms if the Supervisory Statement is implemented as drafted. Given the importance of the MA offset in SCR calculations, we expect that firms will want to understand the impact of these changes promptly, and where they may have a different perspective to the PRA, we would encourage them to respond to the consultation. PwC has deep experience in model build and validation, and has helped a number of Firms to establish MA portfolio investment guidelines and policies, and would be well-placed to assist Firms looking to assess how the draft Supervisory Statement may affect their future applications. 16 CP24/17: paragraph CP24/17: paragraph CP24/17: paragraph CP24/17: paragraph

9 EIOPA Consultation Title Topics Covered Who Should Pay Attention Issue Date 6 th November 2017 Response Deadline 5 th January 2018 EIOPA-CP : Consultation paper on EIOPA s second set of Advice to the European Commission on specific items in the Solvency II Delegated Regulation Interest Rate Risk, Market Risk Concentration, Currency Risk, Unrated Debt, Unlisted Equity, Counterparty Risk, Defaults, Look-through, Risk Margin All Solvency II firms, but mainly Standard Formula firms The second set of advice includes all items arising from the calls for technical advice not yet covered in the first set of Advice. The changes are mainly relevant to Standard Formula firms, but it could also impact Internal Model firms, to the extent that models now deviate significantly from the revised Standard Formula approach. We think this would be most relevant for firms which don t currently allow for negative interest rates in their internal models, as they will clearly be behind the EIOPA standards. In the sections below, we focus on the relevant changes within the Market Risk module that are likely to be of interest to Firms. Interest rate risk EIOPA views the current approach to interest rate shocks (calculated as a percentage of the current interest rate) as persistently underestimating interest rate risk. Two approaches are being considered: Approach A ( Minimum shock approach with a static floor ) A floor to the relative shock will be introduced whereby a minimum absolute shock of 200bps will apply for durations of up to 20 years, decreasing linearly to 0bps for durations of 90 years and above. The assumed minimum interest rate will be -2% for a duration of 1 year decreasing linearly to -1% for durations of 20 years and above. Approach B ( Combined approach ) Under which Approach A will apply in high and moderate yield environments and an affine stress will apply in low interest rate environments (which will lead to lower shocks than under approach A). Firms should think about the revised interest rate shocks and assess the impact on their SCR calibrations (under standard formula or internal model), including how it would affect their MA under stress. Market risk concentration EIOPA proposes to apply an average risk factor approach to exposure to groups that include insurers or credit or financial institutions so that the insurer s solvency position would be taken into account in respect of group exposures. For Firms with large exposures to companies within financial groups, it will be important to think about how the proposed change will affect the market risk SCR. We expect Firms may wish to clarify how the average risk factor approach will be applied. Currency risk at group level 9

10 Groups will be permitted to select a local currency other than the one used for consolidated accounts based on objective criteria such as currency in which material amounts of own funds or technical provisions are denominated. Firms will therefore have the flexibility to hold capital in currencies other than their reporting currency, where they have significant exposure in terms of own funds or technical provisions. Firms may also wish to revise their hedging strategy after the proposed change as well where appropriate (hedge at solo level or group level). Finding an appropriate measure is key and can vary from firm to firm. Unrated debt Proposed changes to the approach taken for unrated debt could be significant as it may be possible to be assign unrated debt (where both the debt and the internal credit assessment process meet certain conditions) to CQS2. This is a significant change to the existing treatment of unrated bonds. Where an insurer co-invests in unrated debt with a bank which has an approved internal model, where certain conditions are met the insurer may assigned a credit quality step to the debt based on the output of the banks internal model. The sum of the amounts included under both approaches above may not exceed 5% of the insurer s investments. We anticipate that this will be attractive for firms, but the 5% cap may introduce a practical limit where the relief is not worth the implementation cost for smaller firms. Unlisted equity Portfolios of EU/EEA unlisted equities (either directly held or through funds on a look-through basis) meeting certain risk and diversification conditions may qualify as Type 1 equities. The possible approaches that EIOPA is considering cover different possibilities for insurers to invest in unlisted equities: direct investment, private equity ( PE ) fund and PE fund of funds. We expect Firms with significant EEA unlisted equity holdings to respond to EIOPA in terms of the proposed change in equity risk charge and get further clarification on the expansion of the definition of Type 1 equities. Simplification of the counterparty default risk EIOPA s advice is to clearly define a risk-mitigating derivative. An amended definition of financial risk mitigating technique has been proposed to capture the economic effect of hedging strategies. It also proposes that all derivatives to be treated as Type 1 exposures irrespective of whether they are riskmitigating or not. New simplifications are also proposed regarding the below: the calculation of the capital requirement for Type 1 exposures (to reduce volatility where the standard deviation is around 7% of the sum of the losses given default); and the calculation of the risk-mitigating effect of reinsurance contracts which affect only one line of business We expect that firms will welcome clarity around the treatment of derivatives included in the counterparty risk module, especially under EMIR where there are more requirements around reporting, collateral, grouping of exposures. 10

11 We expect Firms will need to consider how the proposed changes would affect the way they classify and report their derivatives. Firms might need to review their current reporting packs and also adjust their SCR calculation based on the new treatment of derivatives. Treatment of exposures to CCPs and changes resulting from EMIR Two options are being considered to separately calculate the probability of default and recovery rate in the counterparty default risk module for derivatives meeting the requirements set out in Articles 305(2) or 305(3) of the Capital Requirements Regulation. Consideration is also being given to a change in the calculation of loss given default. We anticipate that this approach will need further consideration in the future, and that firms might need to adjust their credit risk models and ultimately their SCR calibrations to account for the potential change in the calculation of loss given default. Simplification of the look-through approach Currently an approach to look-through using data groupings for target asset allocations is limited to 20% of the assets of the insurer. It is proposed to carve-out assets for linked products from this threshold provided they either do not significantly contribute to SCR or do not significantly impact available own funds. Where look-through cannot be applied, an ability to use the last reported asset allocation of the fund will be introduced, as will an additional qualitative condition for the application of a simplified look-through. We anticipate that this simplification will provide Firms with additional flexibility around the look-through approach, although firms will need to consider whether their approach is insufficient and would need to meet a qualitative assessment instead. Risk margin No change has been proposed in terms of the risk margin. We expect that some firms may not be satisfied with this, given the Treasury Committee has mentioned that this is an area where change is needed in its recent Treasury Select Committee Report on EU insurance regulation. Firms may wish to respond to the PRA with regards to this. PwC view and further support The changes outlined in the EIOPA consultation are numerous; there are some key elements that may impact all firms, but specifically Standard Formula firms, or Internal Model firms that do not currently allow for negative interest rates. In addition, in terms of the proposition that the risk margin will not change, this might lead to further discussions with the PRA. PwC also has deep experience in both standard formula and internal model build and can help firms to implement the changes mentioned in the consultation when the time is right to do so. 11