By Rahnuma Chowdhury, Risk and Regulation Manager, PwC
Illiquid assets, however, have captured the interest of the PRA and life insurers in almost equal measure. Illiquid assets are a significant and growing part of insurers’ investment portfolios. While the industry has pursued increasingly complex investments, the PRA has challenged it on its ability to identify, model and manage the associated risks. Through this process, the PRA has evolved its regulatory view through position papers such as CP 48/16, SS 3/17 and CP 13/18.
What is the PRA proposing to do and what are the possible consequences? In its latest consultation, the PRA focused on the valuation of Equity Release Mortgages (ERMs). Its main concern is whether firms are overstating their Matching Adjustment (MA) benefit for ERMs. As part of this, the CP sets out a minimum calibration for assessing the No Negative Equity Guarantee (NNEG) risk. By issuing a minimum calibration for the NNEG valuation, the PRA aims to provide a more prudent valuation of the guarantees using a risk-neutral option-based valuation method. The calibration may result in an increase in the cost of the NNEG and, thus, a reduction of the MA benefits associated with the ERM. It may also have a wider set of secondary effects such as a pass-through of the extra cost to ERM customers by raising mortgage rates. In a lower interest rate environment, this may trigger a loop: raising ERM rates would make the cost of the NNEG progressively more expensive and reduce insurers’ appetite for an asset class that some argue performs a vital function for the UK retirement system.
Recently, the PRA announced it would delay the implementation date of the CP until at least 31 December 2019. This significant delay is demonstrative of how difficult it can be, not to add challenging from a reputational perspective, to establish consistent principles to value and model illiquid assets.
What does shifting regulation mean for firms in practice? It means there is still room for debate (though perhaps not for spilt wine).
The delay in implementing a minimum calibration creates space for industry stakeholders to reflect, research and engage with the PRA. However, insurers must continue to understand the impact if the minimum calibration eventually comes into full effect. A reduced MA benefit for ERMs will likely result in an increase in the SCR. This may reduce insurers’ appetites for ERMs. Some insurers are already seeking to invest more heavily in other illiquid asset classes to maintain the level of MA benefit currently provided by their ERM portfolios.
As the industry moves on from ERMs to other asset classes, the PRA’s interest will follow. Ultimately, the PRA is not opposed to firms investing in illiquids; however, it has concerns that insurers are not managing the associated risks appropriately. Insurers can continue to expect questions on the internal credit rating process, the structuring of illiquid assets and how these impact the MA benefit. The PRA may consider a more prescriptive approach to valuing other illiquid assets as well.
Insurers have come a long way since early invest in ERM backbooks several years ago. For some insurers, management of their MA portfolios and illiquid asset investments have become a central part of their business model’s viability. Insurers have developed sophisticated and often bespoke approaches for the valuation and modelling of such assets. Many have developed credit risk specialisms comparable to those more typically found in the banking and investment sectors.
Nevertheless, some insurers struggle to demonstrate the robustness of the risk management and governance underlying their investment strategies. Insurers will be asked about the decision-making behind investment strategies, asset origination and allocation. They must evidence that exotic asset portfolios do not hinder their ability to comply with the Prudent Person Principle, which is increasingly cited by the PRA. This is particularly pertinent at a time when the SM&CR regime provides regulators, including the FCA, with the tools to hold individuals accountable for the prudent running of their business. Insurers face the difficult task of making the management of illiquid assets seem unexciting. Hold on to your drinks.
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