Solvency II: Prudent Person Principle
02 July 2020
On 27 May 2020, the PRA published Supervisory Statement (SS) 1/20 on Solvency II: Prudent Person Principle, setting out its expectations for insurers' investment strategies, investment risk management and governance in line with the Prudent Person Principle (PPP) under the Solvency II Directive. The Supervisory Statement, which came into effect immediately, applies to all assets, including reinsurance arrangements.
While many of the expectations set out in the SS are not entirely new, it does highlight areas where insurers need to pay particular attention in relation to the Prudent Person Principle and sets out clearly for the first time the PRA’s expectations in this regard.
What does this mean for insurers?
Insurers need to consider and implement the expected requirements across several highlighted areas. These include investment strategy and risk management, outsourcing, exposures to illiquid assets and intragroup loans and participations.
The PRA expects firms to have a clear, documented investment strategy which is updated and aligned to investment objectives and board risk appetite. It also expects firms to set internal quantitative investment limits for asset exposures, document how these limits are determined and how they are consistent with the overall risk appetite of the firm.
Firms should be able to show how their quantitative risk limits and investment strategy would prevent solvency from being threatened under stress scenarios and quantify the maximum amount of capital that can be lost as a result of a risk crystallising.
As investments into illiquid, non-traded assets on insurers’ balance sheets increase, the PRA is concerned that this could lead to greater valuation uncertainty and give rise to new concentration and liquidity risks. Therefore, firms need to articulate within their investment risk management policies how they have identified and are managing any potential concentration or contagion risk between assets, for example, thinking about risk exposure to UK property across a range of asset classes and/or duration.
Assets backing technical provisions should be invested in the policyholders’, not the shareholders’, best interests. Insurers are required to demonstrate that intra-group loans and participations (and intra-group reinsurance, where it is structured to effectively function as a loan) are in the best interests of policyholders and as such, that they are appropriate for covering the technical provisions. This may be a particular area of challenge for insurers.
The PRA’s Executive Director of Insurance Supervision, Charlotte Gerken, recently stated in a speech that strong governance around investment management and internal investment limits that are effectively implemented remains one of the top priorities for supervision of the life insurance sector. Hence, firms should expect greater regulatory scrutiny of investment risk going forward.
Practical steps for insurers
- Review and ensure your investment strategy and risk management policies are updated and aligned to the principles set out in the latest SS including setting explicit investment limits and demonstrating how the investment objectives are aligned to the business model of the firm.
- In addition to specific stress tests carried out on the portfolio, ensure you are stress-testing concentration and correlation or contagion risk. This is particularly relevant and important in a post COVID-19 world where we have experienced unprecedented market volatility and emergence of risk on both assets and liabilities.
- If you are planning to invest into new asset classes or have increased allocations to non-traded assets, ensure you have the right level of resources and expertise in-house appropriate for the scale, complexity or concentration of investments made. Where such investments are outsourced, ensure you have a robust governance process in place to provide proper oversight of the investments. Remember, you can delegate activities but not responsibility!
- Review intra-group exposure for assets backing technical provisions. Intra-group investments increase the risk of conflicts of interest, for example between shareholders and policyholders, so firms’ boards should review such exposures to ensure that any conflicts of interest have been resolved in the best interest of the policyholders.
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