Capital and Governance
Chaired by Fiona McBain, Scottish Friendly
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Andrew Bulley, Prudential Regulatory Authority Peter Hunt, Mutuo Scott Eason, Barnett Waddingham Robert Wharton, Keystone Law
AFM annual conference PRA Solvency II 12 October 2015
Topics Solvency II overview Transitionals Standard formula appropriateness Internal models ORSA
Andrew Bulley Director of Life Insurance
Solvency II overview: continuity and change •
The PRA is and will remain a judgement-led risk-based regulator – but internal models are far more complex, expert judgement is inherently subjective and PRA is now approving a model rather than giving individual capital guidance.
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UK regime has withstood shocks of last decade and PRA benefits from having a market consistent approach under the ICAS regime which has provided the UK with a solid foundation for Solvency II implementation – but whilst the “one in two hundred” calibration standard is the same Solvency II is different from the ICAS regime in a number of respects, most significantly the switch from ultimate and one year on the GI side and the introduction of the risk margin. For the risk margin a very comprehensive transitional regime is also being introduced and the PRA is firmly on the record that transitionals are fully qualifying capital.
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The existing regime expects regular reporting returns from the industry – but Solvency II will give the PRA a far greater quantity of data, at a more granular level than the current regime and much greater disclosure of key capital ratios.
Transitional measure on technical provisions •
PRA will give firms plenty of time to adjust to the new regime, and those firms who wish to make use of transitional measures will be allowed to do so subject to meeting transitional requirements.
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One of the main quantitative yardsticks the PRA will use to consider whether or not firms are in a position to pay dividends, is capital levels after the benefit of transitionals.
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For transitional measures to achieve their purpose there needs to be a shared understanding on some of the important practical details about how they will operate, including: – the application to Part VII transfers – the requirement on firms to be able to produce estimates of their solvency position on an ICAS basis for a period after the end of that regime
Standard formula appropriateness for life insurers Longevity: Firms with particular sector focus where their portfolio might be considered to have unusual concentrations e.g. deferred, enhanced or impaired annuities Some examples of potential indicators of inappropriateness: Risk areas that may form part of standard formula reviews
Equity: Firms pursuing an active investment strategy or with a concentrated equity portfolio Credit: Firms hold a variety of credit risky assets that may not be well represented by the average portfolio of corporate bonds assumed within the Standard Formula Operational: Firms with significant outsourcing arrangements and / or a range of legacy systems Pension risk
Standard formula appropriateness for general insurers Non-Life underwriting risk: Where deviations from underlying assumptions are significant
Potential indicators of inappropriateness:
PPOs: Should be modelled in the life underwriting sub-module (longevity risk). Long term solution may be to consider use of partial internal model – where proportionate to do so
Risk areas that may form part of a general insurer’s standard formula reviews
Cat Risk: Firms with non-standard portfolios with a large element of nonEuropean economic area (EEA) catastrophe risk or with large deductibles or complex outwards reinsurance programmes Credit Risk: Reinsurance counterparty risk Pension Risk
Options where the standard formula does not capture risk profile
Regular dialogue
Firm Dialogue and supervisory review ORSA review and post-ORSA action plan
Full
Firm initiated action
Undertaking Specific Parameters Partial internal model
Full
PRA initiated action
Full
Capital add-on, which may lead to: Partial internal model Full internal model
PRA approach to assessing SF SCR appropriateness The PRA is completing a review of the standard formula appropriateness for priority firms by December 2015 High-level review of all other firms throughout 2015 Review will be based on quantitative deviations and qualitative information including the ORSA Proportionate approach, noting idiosyncratic nature of some firms Responsibility rests with the Board to challenge standard formula appropriateness Responsibility of the firm to identify areas where the firm materially deviates from the standard formula assumptions
PRA approach to internal models •
No policy preference for firms to develop internal models
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Linked to firms’ and PRA’s view on standard formula appropriateness
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All models have limitations and need to be used with care
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Recognising that Solvency II sets a high bar for model approval and sets rigorous standards for technical modelling and supporting governance
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Boards of IM firms are responsible for ensuring that models are fit for purpose, meet the tests and standards, and that the output is credible for use in the business and for regulatory purposes
Our expectations of Boards Members of Boards need a certain level of understanding of key parts of the model so that they can safely interpret its output. We are not expecting Boards to be experts on all the intricacies of the model. Board members should ask: • Where does the model work well? • In what circumstances does the model break down? • Do I believe that the overall model output is credible? • What “moves the dial” in terms of key assumptions or judgements? • Are those assumptions/judgements justified? The ORSA under Solvency II will help to ensure there is an effective link between a firm’s business plan, risk appetite and capital plans. We would therefore encourage Boards to look closely at the ORSA reports that firms are drawing up in their preparations for Solvency II. The implantation of an effective ORSA will not be an instantaneous move and will require involvement from the top.
Own risk and solvency assessment (ORSA) •
The PRA reviewed at least one ORSA from all Category 1-4 firms during the prep phase. – Feedback was provided in an Executive Director’s letter in June 2015
Key messages: • A large number of reviews show a lack of evidence of significant involvement from the Board and senior executives • The ORSA is not a compliance exercise resulting in a report for the PRA • It should not be a ‘good news’ report but should highlight key risks and allocate mitigation to named people • The ORSA should be holistic, bringing together strategy, stress testing, risk management and solvency into one cohesive framework • The key to a ‘good’ ORSA is linking these areas together successfully
PRA findings from ORSA reviews
Linking ORSA with current risk management system
Lack of evidence of embedding and buy in from senior management board
CRO increasingly responsible for ORSA preparation (before Board input)
Delegation of ownership of the ORSA by the Board to senior management
Material risks usually well documented Current capital requirements well evidenced Good engagement with supervisors Proactive response to feedback provided
Business strategy absent from report Lack of forward looking assessment Stress and solvency test not well evidenced Lack of realistic management actions
Key questions for Boards to ask The ORSA Is the ORSA embedded within all aspects of the organisation? Is there evidence that the Board has actively challenged the ORSA report before approving the content? Has the ORSA been used as part of the strategic business planning and is it incorporated in the use test (if an internal model firm) Does the ORSA aide Boards with decision making? Does the ORSA link all the different aspects of the firm - strategy, risk, capital, solvency and stress testing? Is the ORSA forward thinking and cover the business planning period? Does the ORSA clearly allocate future mitigation actions to named people in the firm? Is there a top-down and bottom up approach to the ORSA?
