PRA - Q&A from December's Industry Briefing

Following on from the PRA's Industry Briefing on Solvency II prior to Christmas, they have released a set of Questions and Answers, which appear to have prompted by questions asked on the day as opposed to being more generic. A useful document to push around your programmes in the UK in particular, even if you are not part of ICAS+/IMAP.

I was particularly interested to see if they had rowed back on any topics where they have previously expressed an opinion, as well as any new insights which aren't necessarily made public as a matter of course. The Q&A is broken out into topics, so I have grouped my thoughts accordingly.

Proportionality

• For ICAS+, the PRA are "...focusing in on those areas which move the dial the most", referring specifically to the ICA calculations.
• They will therefore apply "a relatively higher view" in some areas than others (later referred to in terms of their intensity of focus).
• They use their IMAP approach as an example of this, where they have grouped the 300+ requirements into 15 categories.
• My common-sense read of this is, to be proportionate in the above context, the first 7 consecutive categories on the IMAP template would receive less time and attention than the following 8, all of which have the potential to numerically "move the dial".
• They are already looking prospectively at firm's risk profiles during planning sessions, in advance of ORSA, so that they work and plan proportionally, but with the future in mind.
• They suggest that firms provide their own opinions on materiality if they wish for the favourable application of the proportionality principle (though they don't guarantee it!).

Documentation-specific proportionality

• Confirm that "...there is definitely a need for an improvement in the quality of documentation".
• Seem to specifically align the calibration requirements of Solvency II with the need for additional documentation, therefore a good area to be elaborate in your work.
• On expert judgement, they suggest that documenting why a judgement was made, and what were the alternatives will help firms currently falling short.
• "...no aspiration" to revisit documentation review work already conducted and concluded.

PRA's Supervisory Statement

• They confirm that letters confirming whether a firm is covered by the reporting guidelines will be sent this month. They suggest categories 1-3 (p20) will be the bulk of participants
• There are national-specific reporting templates to come, currently under consideration. While they are not certain on submission format for those, they reiterate that xBRL is required for QRT submission.
• QRTs can be submitted incomplete, but they reserve the right to intervene if you take too many liberties!
• Acknowledge that, due to most firms' ORSA Processes operating around year-end balance sheets, that they expect to receive a flood of ORSA Supervisory Reports, and that this will delay feedback (presumably worse in 2015 than this year?).
• A question regarding 'who is the ORSA for' was answered rather dismissively. However, bearing in mind the content of their "good and bad documentation" letter (which constantly refers to "the reader", which for me meant "the PRA"), it felt like a reasonable question. Clearly if the PRA do not like your style, it will add to your review time.
• They seem to indicate that the amount of time one's Board should spend on reviewing/using their ORSA is not subject to any periodic expectations. That means if you are planning for annual intensive interaction, or something more regular and fluid, you should get a fair hearing from the PRA.

Standard Formula

• Without much subtlety, they seem to be encouraging firms to look at the appropriateness of Standard Formula asap, encouraging further by stressing "...that internal models do not need to be overly complex". This feels like early positioning for their planned SF work with the industry, where no doubt they will find a few firms ripe for USPs/PIMs during the next 18 months. 

Early Warning Indicators (EWIs)

• Following on from a post in October, they are evidently still stuggling to calibrate them!
• They confirm that the purpose of automatic capital add-ons (in the event of a future EWI breach) is to freeze the modelled capital figure to prevent distribution

Trilogue

• Question 29 is a good example of the PRA showing where their hands are now tied, and where EIOPA will be the provider of guidance.
• Interesting confirmation that the Commission has apparently asked that as little as possible of the Draft Implementing Measures be changed. Those of us working on non-mathematical areas can perhaps take some comfort from that!

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"

EIOPA consultation on "Solvency II Preparation Guidelines" - Wham!

In between Mickey Mouse cartoons today, my young lad said "EIOPA just don't publish enough consultations about Solvency II, I hope we see some more soon" - well wait no further son, this year's motherload has just arrived!

EIOPA Guidelines - supervisors have
been 'hanging on like a yo-yo'

What was mooted back in December as EIOPA's interim measures, intended to make sure that impatient  individual national supervisors didn't 'plan on going solo' have been released today for public consumption and comments, covering the 4 areas "fundamental to ensure effective preparation for Solvency II".

The consultation is open until June 19th, but the guidelines once finalised will apply from Jan 1st 2014.

EIOPA will apply them proportionally to the national supervisors, who in turn are asked to "...regard the burden on small and medium sized undertakings" when incorporating these guidelines into national regulatory landscape. May be the first acknowledgement of disproportionately burdening SMEs I have seen from EIOPA!

Those 4 areas are:

1. System of Governance (L2 final advice here)
2. Forward-looking assessment of Risk/ORSA (issues paper here)
3. Submission of information to national authorities (L2 advice here)
4. Pre-application for internal models (L3 guidance here)

I'll pick these off as separate posts and link them back to this page, so sers toi in the meantime and happy reading!

Equivalence, captives and Solvency II - different strokes...

A subject close to my heart as a Manxman, I keep an eye on equivalence-related material, and this has been a relatively busy week. Guernsey have had a nice soiree in London to emphatically support their captive industry by confirming there would be no Solvency II equivalence sought.

For a captive-heavy country this makes sense - Ireland (who like a bit of captive themselves) have been prominent in catering for some element of proportionality at national level, and at a Solvency II presentation in the Isle of Man (where we are also partial to captives) in November 2010, the locals were equally vociferous on the problems it could cause them, so were delighted to hear that equivalence was not on the agenda.

This contrasts to the Bermudans, who are seemingly happy enough to trod the path to equivalence as early as possible. However, there seems to be a desire for a specific carve-out to put some meat on the bones of the proportionality concept which, at this juncture, is most certainly not a given.

Four captive-loving islands, four different approaches - whoever's approach is ultimately victorious, I hope it is for the right reasons.

Solvency II and Proportionality

For my own benefit I am posting my notes on the proportionality guidance issued by CEIOPS back in 2008 - feel free to use as you wish!

In particular, if the Internal Model levies are likely to be proportional to the nature scale and complexity of the undertaking, it is important to be able to argue the toss if one feels one is being overcharged!

Fundamentals

Level 1 – proportionality established as general principle, leaving details to L2

Article 28  - proportionality linked to “nature scale and complexity of the risks inherent in the business”

Nature criteria

•  Classes of business (short/long tail)
• Low frequency/high severity or vice versa
• Reinsurance/captives get bespoke treatment

Scale criteria

• Size criterion (assets. liabilities or risks)
• Governance processes via scale and cost benefit analysis

Complexity

• Cash flows of investments not interest-rate sensitive
• Homogeneity of portfolio
• Similar characteristics of policies mean valued using model points
• Product lines with increasing complexity (Life business with/without options and guarantees, Non-Life with/without renewal options)

Applies to all provisions, and therefore by proxy, all future implementing measures

Applies to both implementation of directive and conduct of supervision

“The individual risk profile should be the primary guide in assessing the need to apply the proportionality principle”

Pillar 1

“Justifies simpler and less burdensome requirements for low risk portfolios”

“In order to be considered proportionate a measure has to be, at least, suitable and necessary to achieve its objective as well as appropriate”

“Lack of resources can never be an excuse for not complying with supervisory standards”

Pillar 2

“function” denotes that a person/s must perform the task, not that they are precluded from doing other tasks.

“high risk undertakings may also be expected to introduce a code of conduct” – this followed by a piece on “complex risk profile” undertakings needing expertise in ‘the development of an internal model’. Not sure if the implication is high/complex risk means all internal model applicants.

“Insurers risk management function should be closely integrated with its capital management function, and its risk management policy should describe how this interaction takes place” very important!

“there will be very limited scope for proportionality with regard to the quantity and quality of its regulatory capital requirements”

“One aim of documentation is helping communication between the board of directors, management and personnel. The description should be intelligible and comprehensible also to a knowledgeable third party.” – benchmark for policy writing

“Not only can the compliance function be outsourced but it may also be performed by members of the management or administrative body”

Pillar 3

“CEIOPS places particular importance on the proportionality principle where supervisory reporting is concerned”

“CEIOPS believes that public disclosure as a principle is required in order to enhance market discipline and thus must apply to all undertakings”

Internal Model

“Proportionality should never be put forward to justify a failure of the use test, not meeting the statistical quality standards or not properly validating the internal model and its use.”

“Proper segregation of duties, as appropriate given the nature complexity and scale of the business, can be viewed as a mitigating factor” – for key person risk on Internal Model

“As regards the validation function, CEIOPS does not consider that each company must have this task fulfilled by independent staff” – followed with “it is also essential that the individuals performing the validation possess the necessary up to date skills, knowledge, expertise and experience”