Articles - How to be a prudent person and what the regulator expects

Some things never go out of fashion, and the regulator’s focus on prudence is one of those things. I clearly remember more than a decade ago when interest rates plummeted, most people in the industry were really worried about how insurers were going to survive such an environment for long. The expectation was that it could not last - so what has happened over the past ten years and what role does prudence play?

 By Kareline Daguer, director, PwC

 It is important to note that Solvency II does not include any hard limits or rules around investments, as long as the risks from investments are identified, measured and reflected in capital requirements. As a result, management only has to comply with the prudent person principle to guide its investment strategy and policies. This was a significant change compared to the Solvency I regime, where insurers were subject to a range of limits for exposures to different types of asset classes and counterparties. The current pressure to obtain higher yields on investments is compounded by investment rules solely based on the prudent person principle.

 In the UK, life insurers have increased their exposure to illiquids significantly over the past few years, with exposures to assets such as equity release mortgages and commercial real estate loans reaching 20% to 30% of the portfolios. This has driven the PRA to increase its focus on illiquids, where they have been at the top of the agenda for life insurance supervisors for the last few years.

 But in September the PRA issued a consultation paper that could have a more significant impact and not just for those investing in ERMs. In Consultation Paper 22/19 - Solvency II: Prudent Person Principle (‘the paper’) the PRA spells out what it considers insurers must do to demonstrate that they are complying with the principle. Some of the proposals are very granular and if implemented will result in most insurers having to review their investment policies, procedures and governance. Even more significantly, for some it might involve significant changes to their investment portfolios.

 The paper includes proposals around setting and documenting the investment strategy, and how to carry out investment governance and risk management. So far, so within expectations.. However, there are three specific proposals that are more hard hitting and likely to result in changes to insurers’ investment behaviour or at the very least increase scrutiny and reflection. The first is the PRA’s expectation that all insurers will develop internal quantitative investment limits by asset class, geography, counterparty, sector and off-balance sheet type exposures. In setting these limits an insurer is expected to consider a number of factors such as the nature of its own liabilities and the risks of the investments, valuation uncertainty, its own capability to value complex assets, and the need to have a diversified portfolio. It also includes the expectation that firms that invest in non-traded assets will set internal limits to the level of valuation uncertainty resulting from those investments. Obviously, once limits are set, all insurers are expected to operate within them. The expectation to set internal quantitative limits by type of investment and operate within them seems a very reasonable request, but it also opens up the possibility of detailed regulatory scrutiny where the PRA might have its own views on what these limits should be.

 The second specific proposal deals with the need for insurers to have a well diversified investment portfolio. To demonstrate this the PRA expects insurers to stress test their portfolios, In particular, the PRA expects insurers to demonstrate that risk from a single source including type of asset, counterparty or geographical area does not threaten the insurer’s solvency position under a stress scenario. They will also have to demonstrate that the application of the internal limits described above would prevent the deterioration of its solvency position under different scenarios. The PRA might increase the severity of the scenarios for insurers that seem to have more significant concentration risk in their portfolios.

 Finally, the third specific area that might set off alarm bells for some relates to investment in intra-group loans and participations. The PRA states that insurers should demonstrate their investments backing technical provisions are in the best interest of policyholders. It considers it unlikely that investments in intra-group loans could satisfy this condition and therefore firms might have to cease investing in this way. Investment in intra-group loans or participation should be subject to the same level of scrutiny as other investments. In particular, potential conflicts of interest should be discussed and resolved to continue investing in these types of assets.

 Once these proposals go ahead in 2020 there will be some significant homework for insurers to do but more importantly it will give the PRA tangible angles for scrutiny and possibly intervention. The quest for higher yields at the expense of increased uncertainty and concentration risk might look less attractive but after all this is exactly what the regulator needs to stave off any potential danger.




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