Prudential Regulation Authority Rulebook

3.1

The Appendix below shows, at a high level, how firms could use their applications to demonstrate compliance with each of the three statutory conditions in Regulation 43(4) of the Statutory Instrument. The suggested content is not exhaustive, but instead aims to indicate what the PRA will look for when assessing whether the conditions for approval are met.

3.2

Supporting detail about the PRA’s assessment of each of the three statutory conditions is below.

3.3

The PRA must be satisfied that the correct VA would be applied to the insurance obligations, taking into account their currency and country of sale.

3.4

To evidence this, firms should clearly describe the liabilities to which the VA is intended to apply, the currencies in which these obligations are denominated, and the countries in which they are sold. Firms should also confirm that they do not apply a matching adjustment to these obligations. These items should form part of a firm’s written policy on criteria for application of the VA.

3.5

At no time should a firm’s use of the VA result in the firm breaching other requirements of the Directive. Some of the prudential risks created by inappropriate use of the VA were highlighted by HM Treasury in its consultation document relating to the VA.^[5] In light of the risks that the VA may introduce, the PRA expects firms to consider their compliance with the risk management requirements under Conditions Governing Business 2.5 and 3.1–3.7, and the Prudent Person Principle (PPP) under Investments 2–5 of the PRA Rulebook, in particular.

3.6

Consistent with its intended purpose, the VA enables a firm to smooth the balance sheet impact of short-term volatility in financial markets. This smoothing relies on the underlying assumption that the volatility (and any resulting depression of asset prices) is temporary and that the firm can continue to meet claims as they fall due without resorting to selling assets at temporarily depressed prices.

3.7

Firms should show that this underlying assumption is appropriate given their risk profile. As part of this, firms should demonstrate that they have fully identified any liquidity risk (or other risks) that may be introduced through the use of the VA, and that they have the adequate understanding, risk mitigation techniques and financial resources to manage those risks.

3.8

A key factor is the liquidity of the liabilities to which the VA is applied. The claim characteristics and surrender terms of insurance products vary widely. The PRA expects firms to consider the liquidity of their liabilities as part of the policy on the criteria for applying the VA. In general, the liability cash flows to which VA is applied should be sufficiently predictable that the firm can demonstrably manage any resulting liquidity risk.

3.8A

Products containing financial guarantees may pose particular risks where a VA is applied, such as the risk that the cost of providing the guarantee is inadequately provisioned for.

3.8B

The PRA expects firms to be able to demonstrate, as part of their risk management framework, how they will identify, measure, manage, monitor and report all of the risks that are introduced by use of the VA. Where firms consider risk management actions regarding guarantees (eg hedging decisions), the PRA expects firms to use valuation bases which are appropriate for their business and risk profile, independently of whether the VA is used.

3.8C

Firms should also ensure that the SCR calculation is appropriately updated to reflect the firm’s use of the VA.

3.8D

The Own Risk and Solvency Assessment (ORSA) must include an assessment of the significance with which the risk profile of the firm deviates from the assumptions underlying the SCR.^[6] This assessment should be updated once the VA has been incorporated into the SCR calculation.

3.8E

The ORSA must also include the firm’s overall solvency needs taking into account the specific risk profile, approved risk tolerance limits and the business strategy of the firm,^[7] which should include risks that are not adequately captured within the SCR. For example, Solvency Capital Requirement – General Provisions 3.6 prevents insurers from reflecting the risk of loss of basic own funds resulting from changes to the VA in the SCR but where firms are materially exposed to this risk it should be included within the ORSA.

3.9

The Prudent Person Principle (PPP) requires that assets held to cover technical provisions are invested in a manner appropriate to the nature and duration of the liabilities. Firms should demonstrate that they have considered the compatibility of their investment strategy with the PPP, given that the VA is used. This consideration should encompass how closely the asset and liability cash flows are matched, and whether the firm is able to meet its obligations as they fall due, including under stressed conditions. It should also take into account the yield on the assets the firm currently holds (or intends to hold in future, following the investment of future premium income or asset maturity proceeds) to cover the insurance liabilities, relative to the yield implicitly assumed in the liability discount rate. This comparison of yields should be performed on an ongoing basis, and not only at the point that an application is submitted. Firms reliant on the yield from assets with an uncertain return, or on the yield from assets they intend to purchase at a future date, should consider the risk that the assumed return is not achievable in practice and demonstrate how this risk will be monitored and managed.

3.10

The PRA must be satisfied that a firm’s use of the VA will not result in pro-cyclical investment behaviour. In this context, pro-cyclical behaviour can be described as a firm increasing the risk profile of asset portfolios (by buying risky assets) during stable or upturn periods, and then derisking those asset portfolios (by selling those risky assets) during unstable or downturn periods.

3.11

To demonstrate that this condition is satisfied, firms should describe the interaction between the investment policy and the use of the VA. Where a firm holds an asset that it would reasonably expect to sell to meet outgo during a stressed or downturn period, the firm should be able to show that its decision to hold that asset is independent of its decisions to use the VA. Conversely, if use of the VA is a material driver for a firm to invest in a given asset, the firm should demonstrate that it expects to be able to hold that asset throughout any period of market stress.

3.12

The liquidity plan, and the demonstration of the effect of forced sales of assets on the firm’s own funds, will also help the PRA to determine whether the firm’s proposed use of the VA will support the underlying policy intent of reducing pro-cyclical behaviour.