Never bet against the PRA - Outcome of Solvency II Review more nuanced than at first sight

Nelson Algren’s advice was: - Never play cards with a man called Doc. This is good advice. I have followed it faithfully. I can now add some advice of my own: - Never bet against the PRA. Come to think of it, I’m not sure if any of the PRA supervisors are called Doc, but well – anyway - you get my drift.?

There are three main pillars to the Solvency II reforms announced yesterday:

1. A reduction in the Risk Margin by 65% for life insurers and 30% for non-life insurers. Both industry and PRA agree that the Risk Margin was too large, and too sensitive to interest rates. Both sides seem happy with a reduction through a modified cost of capital method. I don’t want to rain on the parade, but the cost of capital method is crude, and a lot rides on what “modified” actually turns out to mean.
2. Widening the asset and liability eligibility criteria for the Matching Adjustment to include assets with highly predictable cashflows, not just fixed cashflows. This was a flaw in Solvency II back when it was negotiated, and it is good to see it put right. Morbidity risk will be added to the permitted liabilities. Assets with ratings lower than BBB will be treated less harshly, and there will be greater flexibility in the treatment of Matching Adjustment. All technical changes, but these are the gates through which insurers will invest more in infrastructure, net zero etc.?
3. No change to the Fundamental Spread. This is the key point. The fundamental spread is the main building block for calculating the matching adjustment. Earlier this year, the PRA argued that the current method of calculation understated credit risk, and that a revision was essential on prudential grounds. Many on the industry side agreed that some of the PRA’s concerns were justified, and conceded the case for a review of the fundamental spread - but industry and regulator could not agree on a methodology.

At first sight, the Government has now rejected the PRA's argument. To be fair, the PRA’s preferred solution, a Credit Risk Premium, took a pasting in the consultation responses. Insurers raised fundamental issues with the inclusion of current spreads in the means of calculating a long-term spread. The effect would have been to reduce own funds, add to capital buffers, increase balance sheet volatility, raise annuity prices, and deter investment in infrastructure. For life insurers, it would have wiped out the benefits of reducing the Risk Margin.

But just look at the safeguards the Treasury has proposed:

• different allowances for assets by credit rating quality (“notched allowances” in the jargon),?
• attestations under the Senior Managers Regime that the fundamental spread reflects all retained risks, and that the matching adjustment reflects only the liquidity premium (I cant wait to read these),
• add-ons to the allowance in cases where the PRA concludes that the standard allowance is inadequate,?
• new rules for uplifts in the allowance to reflect the characteristics of the newly permitted investments,?
• a review of the Financial Services Compensation Scheme. This is a threat to saddle insurers with an increased share of the ballooning costs of the FSCS, despite the inconvenient fact that few insurers fail,
• an update of the PRA rulebook to allow closer scrutiny of companies’ internal ratings.

Taken together, these “safeguards” give the PRA all the powers they need to bring in, through the back door, the higher charge for credit risk that they want. As I said, never bet against the PRA. You never win; you just go on to lose at a more granular level.

Overall, this is a much better framework than the indiscriminate blunderbuss of the Credit Risk Premium. Some insurers had stretched the use of the Matching Adjustment. This framework will allow abuses to be addressed in a targeted way. Insurers which do their internal ratings responsibly, and think carefully about their use of the Matching Adjustment, should get the benefits of the Solvency II Review. Others may not.

A final reflection for Solvency II junkies. The PRA’s Feedback Statement takes issue with those respondents who had misunderstood the way the PRA incorporated the 1930s recession into their thinking. “Credible coverage” of the 1930s experience is not at all the same as 100% of the 1930s default and downgrade loss. Of course! What a blunder! Those respondents – you know who you are – go straight into the corner with a dunce’s cap on your head.

Hugh Savill , Senior Adviser of Sicsic Advisory