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PRA clarifies capital requirements for insurers planning to use internal models for Solvency II compliance

Out-Law News | 03 Sep 2014 | 5:00 pm | 2 min. read

Firms planning to create their own methods of managing compliance with the upcoming new regulatory regime for European insurers will not be able to use additional capital held against their day to day liabilities to meet longer-term risks, the Prudential Regulation Authority (PRA) has said.

The UK's insurance regulator has published an update aimed at those firms intending to apply to use an 'internal model' under the new Solvency II regime (2-page / 164KB PDF), which is due to come into force in January 2016. The update is intended to clarify the relationship between the risk margin and calibration of non-hedgeable risks, and the PRA's position on assessing risk for matching adjustment portfolios, taking into account the consultation paper published by the regulator since its July 2014 update.

The Solvency II regime sets out broader risk management requirements for European insurers and dictates how much capital firms must hold in relation to their liabilities. The legislation was originally scheduled to come into force in 2012; however the Omnibus II Directive, which completed and finalised the new framework, was only approved by the European legislative authorities earlier this year. It must be transposed into national laws by 31 March 2015, to come into force on 1 January 2016.

Once the new regime is in force, firms will be permitted to develop internal models in order to calculate their liabilities or will be able to use a 'standard' model, which will be likely to mean higher capital charges. Internal models will have to be submitted to the PRA for approval. The directive requires that internal models cover "all material risks" to which firms are exposed; and that the method used to calculate model technical provisions, or capital requirements, is consistent with that used for the full technical provisions calculation.

In a document setting out its proposed approach to technical provisions and internal models, published in March, it was noted that the PRA considers the risk margin to be a "significant part" of the technical provisions calculation.

The risk margin is designed to have a different purpose to, and is not a substitute for, insurers’ normal capital requirements. It relates only to the non-hedgeable risks of cash flows, such as operational, underwriting and certain credit risks. Itsmain purpose is to protect against worse than expected outcomes. The risk margin should ensure that insurers have sufficient assets to safely wind up and transfer obligations to a third party in the event of insolvency. In its latest update the PRA has confirmed that the risk margin capital requirement is separate to requirements that the insurer hold capital to meet longevity risks.

"The internal model reviews that the PRA has conducted to date indicate that some firms include the risk margin when validating the strength of their longevity risk calibrations and when considering the total amount of capital held in respect of longevity risk," the regulator said in its update.

"The PRA considers that firms' internal model longevity risk calibrations, and the amount of capital held in respect of longevity risk, should not be influenced by the presence of the risk margin. The Solvency II Directive clearly defines the risk margin and the solvency capital requirement (SCR) as separate concepts and the PRA does not consider that the Directive envisages the risk margin being used to offset longevity risk calibrations for SCR purposes," it said.

Concluding, the PRA said that its view was that such an approach "would be contrary to the intention of the Directive".

The update also set out the PRA's preliminary views on how firms that intend to use an internal model should demonstrate their compliance with Solvency II in respect of their credit risk calibration. It said that firms should "maintain flexibility in their modelling methodologies while considering carefully whether there is sufficient justification for their intended approach" rather than "mechanically" re-apply the matching adjustment in the aftermath of financial difficulty.

"Further, firms will need to perform a robust assessment of whether they would continue to meet the conditions for applying the matching adjustment in the post-stress scenario, and what actions they might have to take in order to continue satisfying those conditions," it said. "This applies to any stress scenario that may have a bearing on matching adjustment eligibility (for example longevity stresses)."