CP12/23 Countdown: Reflections ahead of the consultation closure and gearing up for September

The CP12/23 consultation period ends on 1 September, and focus is beginning to shift towards the upcoming September consultation. With this in mind, we have been reflecting on CP12/23.

Initial sentiment on CP12/23 and other ongoing regulatory developments was provided by 21 UK life insurers in July by way of a short survey in advance of our WTW breakfast roundtable. The roundtable itself was attended by 40 participants representing 26 UK life insurers and subsequent discussions with industry participants have highlighted further views on the consultation and other aspects.

Since our roundtable, we have also been considering what the much awaited September consultation may bring. Some are anticipating a potentially contentious consultation which is likely to contain some hotly debated proposals as well as some surprises.

This article provides some of our high-level reflections on CP12/23, as well as some thoughts on the upcoming September consultation. While CP12/23 generally appears to have landed well with firms, there was a lot of detail to work through and a number of aspects that will likely require further detail and clarification. Attention will soon turn to the September Prudential Regulation Authority (PRA) consultation with key topics including matching adjustment attestation, notching and investment flexibility.

As always, please get in touch if you would like to discuss CP12/23 or the upcoming September consultation further.

Reflections ahead of the consultation closure

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The length of CP12/23 certainly came as a surprise to many in the insurance industry. The main consultation document ran to 182 pages and was then followed by 30 appendices, spanning 390 pages of further detail. This first consultation of 2023 was generally expected to be more straightforward covering topics requiring less debate, with the September consultation covering aspects which may be more divisive.

Nearly 600 pages of detail was a lot for firms to work through with certain details in appendices creating some uncertainty on the intended nature of implementation for these proposals. Firms are now expressing concerns about the potential volume of information to be included in the upcoming September consultation, with some already looking to line up resource to support the review of the September consultation when it lands.

Will the PRA’s September consultation manage to top the 1,225 pages of Tolstoy’s War and Peace? Or will it be more concise, given it is likely to focus on a small number of key topics?

Smoother sailing compared to previous consultations

The overall sentiment from the 21 life insurers that took part in our mini survey on CP12/23 was much more positive than previous consultations and discussion papers on the reforms, with firms generally suggesting that the consultation was in line with their expectations.

While internal model (IM) firms are slightly less satisfied than standard formula firms, which is perhaps unsurprising given a number of the proposals focus solely on IMs, the PRA’s consultation generally appears to have landed well.

In particular, where firms do have feedback on proposals, they have indicated an intention to provide views on how the proposals could be amended, rather than simply disagreeing with them, to help Solvency UK deliver on its stated objectives.

Transitional Measures on Technical Provisions – from raised eyebrows to embracing simplicity.

Immediately following the release of the consultation, a number of firms suggested to us that they would want to pursue the legacy approach to the calculation of the transitional measures on technical provisions (TMTP), rather than adopt the proposed simplified method. Firms’ rationales included: operational burden, lack of sensitivity of the simplified method, and materiality of the impact between the two approaches.

However, once firms had assessed the impact of the simplified method versus the legacy approach and further understood the PRA’s high bar of expectations and requirements to use the legacy approach, only two firms in our mini-survey sample still suggested they would want to pursue using the legacy approach.

There still remain some points of detail relating to the TMTP simplification proposals that will need to be ironed out including inconsistency of timing between proposed TMTP and risk margin changes. The risk margin changes are expected to come into force at YE23 whereas the Financial Resource Requirements (FRR) test, which is used in the current TMTP calculation approach, would continue to apply until YE24. It is likely that a number of firms will suggest in their consultation responses that the timing of the FRR test should be accelerated in order to align with the proposed risk margin implementation date.

Swimming in a sea of acronyms but left in a fog of uncertainty

CP12/23 introduced a number of new acronyms and concepts relating to IMs such as Residual Model Limitation Capital Add-Ons (RML CAOs) and Model Limitation Adjustments (MLAs). RML CAOs have been introduced as a mechanism to speed up the time taken to obtain regulatory permission to use an IM, with firms suggesting that this appears a useful mechanism in principle.

However, from our various discussions with the industry, it is not immediately obvious that there will be many existing standard formula firms looking to develop an IM as a result of the proposals. In addition, firms do not feel there is sufficient clarity as to how the introduction of RML CAOs apply where existing IM approvals are already in place. For firms with existing partial or full IM approvals, it is less clear if or how this proposal will serve to speed up the model change process.

Given the PRA’s expectations and standards will remain largely unchanged under the new regulatory regime, it is not obvious that the proposals will result in any material change from the existing process. Further detail on how the PRA plans to implement concepts such as RML CAOs and MLAs, and how processes such as major model changes will be affected, would be beneficial to help firms better assess any potential impacts.

Reporting changes – a few flies in the ointment

Reporting changes being proposed in CP12/23 have generally been welcomed by firms, with the removal of the Regular Supervisory Report being viewed on the key list of benefits.

However, there have been some concerns from firms about proposals to change existing templates due to the operational burden this would create. Smaller-sized insurers have also suggested that the impact of the combined reporting proposals on them is likely to be fairly immaterial.

Further to this, some firms have suggested that they plan to maintain some of the proposed removed requirements, such as the Profit and Loss Attribution (or variants of this), as they are already well embedded into existing processes and provide useful management information.

Internal Model attestations and CAO disclosures – a few bumps in the road.

Proposals that would require the Chief Risk Officer (CRO) to attest to the appropriateness of the IM have generally been viewed as reasonable, with many firms commenting that this broadly aligns to the existing ongoing validation requirement.

However, the key change for firms is likely to be the precise meaning and requirements of an attestation. Firms may need to undertake some additional work to ensure that the format and content of the attestation aligns to the expectations of the CRO (and regulator) such that the CRO is comfortable to provide sign-off.

The PRA is also proposing that CAOs will be disclosed, and while it is important to encourage transparency where appropriate, there are some concerns that initial disclosures may lead to some market volatility if a firm is perceived to have problems within their IM. Further to this, firms may feel pressure from investors and analysts to individually disclose details of CAOs which may not align to the PRA’s intended principle of CAOs.

Untangling the web of rule changes

There are a number of appendices to the consultation which provide mappings of proposals against existing tests and standards, regulatory requirements or laws, to help understand linkages that already exist. However, a summary of changes would be helpful to provide further clarity.

Given the volume of changes that are being proposed to the rulebook and the interconnectedness of various changes, firms have suggested that they would want to see a full rulebook refresh in one place. This will enable an assessment of whether all the changes work when the different pieces have been put together, as well as whether there are any obvious gaps compared to the existing rules, to be conducted.

Gearing up for September

The consultation shrouded in a mist of uncertainty

There has been much discussion and speculation over the summer months about the content and form of the PRA’s September consultation.

The various Subject Expert Groups (SEGs) between the PRA and industry discussed the key topics which are likely to feature in the September consultation, but firms who participated in one or multiple SEGs do not have much of a sense of the extent to which the discussions at the SEGs will have helped the PRA to shape its proposals. For example, based on discussions at the SEG focussed on the notching of the Matching Adjustment (MA), a simple approach based on interpolation was generally favoured, however there is a possibility that the proposed approach in the consultation may differ from this.

Proposals relating to investment flexibility and the definition of “highly predictable” cash flows, which are linked to HM Treasury’s economic growth and investment objective, have the most potential to lead to disappointment.

We anticipate that many firms may feel that the proposals that end up being consulted upon do not go far enough to enable any material change in investment approach compared to the existing regime. In particular, the investment flexibility SEG suggested that any proposed framework should contain sufficient flexibility for inclusion of new asset classes in the future without the need for case-by-case applications for approval. While this is sensible from operational and management perspectives, it is very difficult in practice to find and agree a robust regulatory framework to allow such a degree of flexibility whilst ensuring a level of consistency between firms.

In many areas there were also a wide range of views on the best way forward between firms with numerous potentially conflicting proposals discussed in the SEG sessions.

Matching Adjustment attestation – opening a can of worms

The proposals on the MA attestations are likely to be the most hotly discussed and debated aspect of the September consultation, given this is being newly introduced as part of Solvency UK. There is a split of opinion on the attestation, with some firms sceptically suggesting that the MA attestation is being introduced as a mechanism for Fundamental Spread (FS) add-ons to be applied, while others more optimistically consider that it could help strengthen their defence of the level of MA being achieved.

Regardless of which side of the fence they fall on, all firms are expecting the MA attestation to be a material undertaking and that the PRA is likely to require significant additional granularity on the MA and FS compared to previous MA-related information requests. There is also some ambiguity surrounding what firms will be required to attest on – will it be the MA, FS, Liquidity Premium or something else? If the attestation is on the liquidity premium, a clear definition of what is meant by liquidity premium would be helpful to ensure consistency in attestations.

While the PRA’s expectations for the MA attestation will be covered in the September consultation, we have been developing views on the analysis and format required for an MA attestation to help firms accelerate the process.

Internal Model treatment – the elephant in the room

The majority of discussion on key issues at the SEGs focussed on base balance sheet treatment, but participants in the SEGs did flag that there would likely be knock-on impacts on the IM treatment. However, it is not clear whether the upcoming September consultation will include any proposals surrounding the regulator’s expectations of allowing for any developments under stress to update Supervisory Statement SS8/18 – this was similarly the case following the introduction of the Effective Value Test (EVT) for equity release where the regulatory expectations for the EVT in stress (and the requirement to consider this) developed in the years following the EVT being consulted upon and implemented for the base balance sheet.

The two key aspects likely to need consideration in stress are notching and the removal of the BBB cliff.

For notching, an interpolation approach is likely to be favoured in base due to an absence of data, so it is difficult to see how firms could be expected to allow for notching under a 1-in-200 stress other than through a similar interpolation approach if deemed required. However, to do so would still require a notched view of ratings in the IM (potentially in all modelled simulations over a multiple year time period) which would be spurious and overly complicated in an already complicated area of model calibration for credit risk.

The removal of the BBB cliff in base may not naturally lead to the PRA being comfortable with its removal in stress (in models where it is applied) given the potential implications for the level of investment in sub-investment grade assets. We understand that the PRA has been asking firms whether they view the removal of the BBB cliff in their IMs would constitute a major change and it is possible expectations on this may be clarified within the consultation. Ultimately, the overall level of credit capital that firms are expected to hold by the regulator is unlikely to materially reduce as a consequence of the reform changes. Any reduction in one area may result in increased scrutiny of the overall modelling approach with an expectation the reduction will be offset by an additional capital allowance elsewhere in the calibration.