PRA and Early Warning Indicators - Knowing me, knowing EWI...

Couple of interesting bits have popped up in the last week on the PRA's Early Warning Indicator (EWI) initiative, which I had touched on earlier in the year. At that time it was a little hard to establish the lie of the land, other than the PRA approach to preventing potential 'gaming' of internal model capital requirements was markedly different to that of their European NCA counterparts, and that EIOPA fancied their chances of doing the job on the NCA's collective behalf.

Julian Adams gave a speech at the Insurance Institute of London last week where he commenced with a rather familiar lament about how, at the outset of the FSA/BoE splice, "...we knew that there was some concern in the insurance industry that the Bank didn’t understand insurance". After collecting the award for 'understatement of the year', he then waxed lyrical about the five lessons learned by the BoE from the financial crisis, and how these are being applied currently to insurance supervision in the UK;

1. "...the need for a prudential supervisor to focus on the risks that might materialise for firms in the future"
2. "...not enough to focus on static point-in-time assessments of firms’ solvency positions"
3. "...for some issues it is not enough to just look at the risks within individual firms and address them at an individual firm level. Instead, we need to supplement this analysis with work across the system as a whole"
4. "...the need for clarity about the objectives of prudential regulation"
5. "...the need to have multiple reference points when assessing firms’ capital positions. Simple crude measures are not sufficient in themselves, but neither are complex models"

The last one is of course our context setter for comments later in the speech justifying the EWI approach, which for me reads as a laundry list of why existing model validation activity, assumption setting processes and expert judgements must be considered ineffective by default, rather than after PRA review.

One brush - two industries?

Most significantly from a strategic perspective is the confirmation that the PRA "...wouldn’t expect firms who fall beneath [the EWI limits] to release capital until we, and they, have reviewed the appropriateness of the modelled calibration".

Alongside this speech, Chris Finney has published a scathing article on the PRA's approach to EWIs, focusing on its legality at both national and EU level, its unwillingness to consult on the matter, and ultimately how the PRA's experiences with banks a few years back (well. the FSA/BoE, but let's not split hairs) have seemingly allowed the insurance industry to be smeared with the same tarry brush.

With the PRA seemingly using their "lessons learned" rationale alongside the equally informal "interest" of the IAIS and EIOPA in non-modelled capital backstops, is that really enough to fend off (current) UK statute and (pending) EU law if the industry fights back?

UK's "new" Prudential Regulatory Authority - Approach to Insurance Supervision

So a magical thing happened over the weekend: a venerable institution disappeared on Friday, only to come back reborn on Monday...

...that's right, the FSA is no more, being replaced by two more focused entities in the Prudential Regulatory Authority (PRA) and Financial Conduct Authority (FSA). This is part of the UK-specific fallout from the financial crisis, where a perceived lack of focus from the former tripartite system which housed the FSA allowed for both systemic risk (Northern Rock, RBS) and conduct risks (PPI, Interest Rate swaps) to emerge largely unchecked.

Rather excitingly, this means a new website with some natty logos from the Bank of England (which

PRA - emperor's new clothes
or Solvency II aperatif?

has rehoused the PRA side of the FSA), as well as a statement on the new supervisory approach that the PRA will be taking.

For anyone in the ERM/Solvency II/Corporate Governance space, this gives us a chance to pick up on the kind of regulatory interrogation one might expect when writing/upgrading system of governance-related materials in preparation for both full Solvency II implementation in 20??, as well as how they are accommodating EIOPA's interim measures from 2014.

Remembering that the PRA's two statutory objectives are to promote safety and soundness of the firms it regulates, as well as specifically providing appropriate protection to insurance policyholders, I thought it wise to make some notes on how they have catered for Solvency II and deference (when due) to EIOPA, as well as the general content around expectations of governance systems. I found the following worthy of note;

Control function-specific

Section 82 - "[PRA] wants to be satisfies in particular that designated risk management and control functions carry real weight within insurers"

Section 117 - Should have separate risk management and individual control functions in place (dependent on nature scale and complexity etc)

Section 118 - the PRA "expects these functions to be independent of an insurer's revenue generating functions"

Section 120 - expectation of an "operationally independent Actuarial function", which the PRA consider to be "integral to the effective implementation of a firm's risk management framework"

Section 182 - "Actuaries can play an important part in supporting prudential supervision"

Section 119 - an effective Risk function on the other hand merely "ensures that material risk issues receive sufficient attention from the insurer's senior management and Board" - just because I'm paranoid, doesn't mean the Risk profession isn't being made something of a gooseberry here, particularly as the FSA/Actuarial profession love-in started some time ago!

On Risk Appetite

Section 110 - a firm's risk appetite "[is] to be integral to its strategy, and the foundation of its risk management framework"

Remuneration

Section 84 - "remuneration and incentive schemes should reward careful and prudent management" - just like Prudential's and Standard Life's did this week!

Section 194 - Hint at potentially restricting pay in firms if intervention is warranted

Stress/Reverse Stress Testing

Section 109 - the AMSB must have "...an explicit understanding of the circumstances in which their firm might fail"

Section 145 - with regards to Reverse Stress Testing, "...management should consider the reliability of the output of the internal model compared with the results of these tests"

Section 106 - "competent, and where appropriate, independent control functions" should oversee risk management and internal control frameworks

Internal Models

Section 116 - On Internal Models, the AMSB should understand;

• extent of reliance on models for managing risk;
• limitations of their structure and complexity;
• Data used;
• key underpinning assumptions

Section 140 - "PRA expects internal models to be appropriately prudent"

Section 144 - firms may not choose the lowest capital requirement to determine whether or not to model internally

Regulatory Capital

Section 135 - for capital adequacy, firms "...should not rely on regulatory minima", and also "...should not rely on aggressive interpretations of actuarial or accounting standards"

Proportionality

Sections 212-215 - touches on treatment of "low impact" firms - is this effectively where aggressive approaches to proportionality interpretation should be expected (combined control functions, limited documentation, passive acceptance of Standard Formula etc)?

p43 - table covering the allocation of supervisory staff - 10 staff to 1 firm for the 25 largest insurers, versus approaching 10 firms to 1 supervisor at the small end.

Solvency II-specific references

• In the PRA's view "[Solvency II technical detail should] leave scope for supervisors of individual insurers to make informed judgements around risks posed"
• Confirms that elements of the Directive such as Prudent Person Principle, ORSA, Control Function requirements and Pillar 1 are all aligned with the new Threshold Conditions
• Model approval will be dependent on "adequate" risk identification, measurement, management, monitoring and reporting throughout the modelling process
• Will impose capital add-ons when necessary "to ensure insurers meet the required standards"

Bank of England and Solvency II - Tucker's Luck

Joining in with the rather boorish cacophony of UK-sponsored protectionist racket on Solvency II, one of the Bank of England's big hitters put his two-penneth worth in this week in a speech to the ABI.

Whilst his observations on the general train of thought being that insurers are not a threat to financial stability and that AIG was a "complete aberration" certainly ring true with the Geneva Association/IAIS lobbying line on SIFIs, and that all and sundry are "dismayed" with the costs to-date, I was a little less enamoured with his problems with "microregulators 'approving' specific models".

If his issue is one of staffing it at the FSA, and the likelihood of those best placed to assess being priced out of the market, fair enough, but the issue of "regulators drowning in data" could be quite easily solved by not asking for so much in the Self-Assessment Templates!