Prudential Regulation Authority Rulebook

5.1

In order to take credit for an MA benefit in stress, firms need to check that their MA portfolio continues to meet the MA requirements.⁹

5.2

In particular the PRA expects firms to evidence that the MA portfolio continues to be adequately matched and that the asset eligibility criteria continue to be met.

5.3

When undertaking this assessment, firms should ensure that they have allowed for the impact of a stress event on both the assets and liabilities within the MA portfolio. For example, a longevity stress could result in an increase in the liability value, and an increase in longer dated liability cash flows. Firms should also ensure that the assumptions used in this assessment are consistent with those used to stress the assets and liabilities in the MA portfolio in the given stress scenario.

5.4

Following a stress event, firms may conclude that the result of the assessment referred to above is that the MA qualifying conditions and/or any internal policies relating to the management of the MA portfolio would no longer be met. Steps 3 and 4 of the five-step framework cover checking and maintaining continued compliance with the MA qualifying criteria. The remainder of this chapter sets out the PRA’s expectations regarding any potential actions that could be assumed to restore compliance with the MA qualifying conditions and internal policies. The PRA expects firms’ assumed actions to be limited to those necessary to restore compliance. They should not include, for example, steps to optimise an already compliant portfolio in a stressed environment.

5.5

An assumption that a firm can rebalance an MA portfolio post stress within the SCR calculation constitutes a future management action within the internal model. Firms are therefore expected to show how their proposed approach to rebalancing meets the requirements set out in Article 236 of the Delegated Regulation. In particular, firms should clearly set out how the impact of rebalancing is allowed for within the calculation of the SCR.

5.6

In determining the conditions in which MA portfolios require rebalancing, firms should consider all risks that could affect the cash flow profile of the MA portfolio and ensure that the full cost and impact of any rebalancing is captured in the SCR.

5.7

Where a firm has reinsured all or part of the business in its MA portfolio, it should consider the extent of any rebalancing that may be required in the event of reinsurer default, and the reasonableness and achievability of this.

5.8

Firms should be able to demonstrate how the actions they propose to take to re-establish matching reflect: (i) the source of the stress (eg credit default or migration, longevity); (ii) the nature of the stress; and (iii) the severity of the stress. Firms should demonstrate that their proposed actions are realistic in the given stress event and show how they have taken account of how the type of stress could affect their ability to take such actions. Different management actions will likely be required in different scenarios, ie the same management actions need not be appropriate across the probability distribution forecast.

5.9

Following a stress, the PRA expects firms to:

• re-establish cash flow matching in Component A of the MA portfolio¹⁰ as measured using the tests the firm has implemented to assess the adequacy of matching in its MA portfolio. The PRA would also expect firms to have regard to the level of matching measured using appropriate thresholds (eg using the published indicative thresholds for the PRA’s 3 tests);¹¹ and
• consider whether additional assets are needed in Component B¹² to ensure that the value of assets equals the value of best estimate liabilities within the MA portfolio and determine any costs of re-establishing MA compliance.

5.10

Any rebalancing action should be consistent with the firm’s wider risk management framework and the Prudent Person Principle (PPP).¹³ In particular, firms should consider whether their investment policies (as drafted) may prevent proposed rebalancing actions from being completed in practice.

5.11

Rebalancing actions assumed in SCR calculations should take account of any such restrictions and should either operate within the current policies (as drafted) or should clearly set out changes required to the policies together with justification as to why they are achievable. In the latter case, such justification should include discussion of the governance that would be enacted to make potential changes to the investment policies if necessary and the timescales that would be needed to do this. Any planned changes to investment policies would need to be compatible with the firm’s wider risk management framework and the PPP. On rebalancing, the PRA considers one or both of the following options to be viable provided the option is demonstrably feasible in the stress scenario in question:

• demonstrating that the required eligible assets are held outside the MA portfolio and can be injected post-stress; and/or
• assuming the required assets have to be purchased from the market and demonstrating that sufficient funds will be available to achieve this.

5.12

Firms should consider the impact of the stress event on the value of any assets to be injected into the MA portfolio, and any assets that are to be sold for the purposes of purchasing eligible assets.

5.13

In a situation where the MA portfolio has become mismatched, or is no longer complying with the MA requirements, firms have a two-month window in which to take actions to restore compliance with the requirements¹⁴. Firms should consider how this two-month window impacts their investment and rebalancing strategies.

5.14

The requirement to remedy a breach within two-months does not necessarily preclude firms from modelling further rebalancing actions, beyond those required to restore MA compliance that may be taken within the SCR timeframe in accordance with firms’ own investment strategies and risk limits. Firms will, however, need to demonstrate how any such actions comply with the relevant Solvency II requirements. Firms will need to demonstrate that such rebalancing actions are feasible given limited and uncertain timeframes and the potential scarcity of suitable assets and/or competition from other investors. The PRA expects firms to ensure that the calibration and ranking of the ‘1 in 200’ stress considers both the quantum of the stress and the window for any rebalancing actions beyond that needed to restore compliance within two months. The PRA considers that these factors are likely to set a high bar to firms being able to justify a material benefit from any such actions.

5.15

Where a firm assumes that any rebalancing can be done by injecting eligible assets from outside the MA portfolio, the PRA expects the firm to be able to demonstrate that:

• assets held outside the MA portfolio meet the MA eligibility criteria and have the same features as those already in the MA portfolio;
• the appropriate amounts of eligible assets are available outside the MA portfolio;
• the eligible assets outside the MA portfolio are of the appropriate duration and CQS (in order to meet the cash-flow matching requirements);
• the assets outside the MA portfolio are not encumbered or required for other purposes (eg to meet margin calls on derivatives held outside the MA portfolio);
• it has performed a detailed assessment of investment concentration and correlation to ensure that there is not a risk of it assuming it has assets available to inject into the MA portfolio to replace any defaulted assets when in reality the degree of common exposures means that a number of the assets outside the MA portfolio would also have defaulted; and
• it has considered the degree to which its MA portfolio may hold concentrated exposures following actions taken to rebalance the portfolio post stress and has reflected this in the SCR.

5.16

Where a firm assumes that rebalancing involves purchasing of new assets, the PRA expects the following points to be considered and appropriately allowed for in the SCR:

• the availability and liquidity of the assets being sought;
• the likely level of competition for the assets in question. After a systemic market event, it is feasible that there could be a flight to quality in the market and firms should allow for this and the impact it could have on price;
• potential new or increased risks that the assets sought could introduce to the MA portfolio (eg increased concentration of exposures); and
• whether the firm can reasonably expect to do the trading needed in the two-month timeframe available to restore compliance with the MA requirements.

5.17

The PRA expects firms to give careful consideration to the types of assets that could be purchased in stressed conditions, in particular whether less liquid assets could be purchased. In the PRA’s view, completing such transactions is likely to be particularly difficult in stress conditions and within the required timescales.

5.18

Where a firm assumes that rebalancing to remedy a breach within the required two month window involves purchasing of new assets, the PRA also expects the following points to be taken into account as to how the purchases will be funded:

• where a firm assumes it can use assets outside the MA portfolio to fund such purchases, the liquidity of these assets should be assessed in order to determine the feasibility of undertaking this action in practice;
• the PRA would not usually expect firms to assume the replacement assets are purchased using the proceeds from defaulted assets or the sale of assets downgraded below investment grade. This is due to the difficulty in objectively determining prices or recovery rates in a stressed environment and the likely delay in receiving such recoveries (ie there is considerable doubt as to whether the recoveries could be obtained within the two-month timeframe to restore MA compliance);¹⁵
• the PRA would be unlikely to consider it realistic for purchases to be funded by an assumed sale of less liquid assets; and
• the PRA would expect demonstration of the ability of the firm to sell the assets in question regardless of whether these assets sit in the MA portfolio (ie that they are not otherwise required or encumbered).

5.19

An allowance should be made for expected transaction costs, incurred through any trading activity, in a stressed environment. This allowance should take account of the likelihood that such costs will be higher in stress than in normal conditions. This is particularly pertinent where large trading volumes are envisaged – the PRA expects firms to hold capital to allow for transaction costs.

5.20

The PRA also expects firms to undertake sensitivity tests to reflect the risk that it is not possible to purchase the assets intended to be purchased post stress. In particular the PRA considers that it is a useful comparator for firms to show the impact on the stressed MA and the SCR if only gilts were available in order to indicate the extent to which reliance is being placed on obtaining assets that attract a higher MA benefit.

5.21

Firms should clearly demonstrate that sufficient MA-eligible assets are held to cover the MA liabilities in conditions as at the valuation date, and are readily available (or may be obtained) to cover the MA liabilities in stress. One possible method to demonstrate this is a ‘matching rectangle’¹⁶ assessment. If a firm chooses this approach (or similar approaches that achieve the same outcome), the assessment should be completed in both current and a suitable number of stress scenarios across the probability distribution forecast. Any such assessment should consider the balance sheet gross of the transitional measure on technical provisions (TMTP).