The letter focuses on the use by the PRA of a ‘Quantitative Framework’ as one tool to assist with decisionmaking, because this has been the subject of some debate with firms. In addition, for the benefit of firms and market participants I set out how the PRA views the Solvency Capital Requirement under Solvency II, whether it results from the use of an internal model or the standard formula.
The Quantitative Framework
As part of our work reviewing firms’ internal models, we have used a set of yardsticks collectively known as the ‘Quantitative Framework’. This framework covers risks such as credit and longevity, and dependencies between risks. We used the framework as one input when considering whether or not a firm’s model met the tests and standards set by Solvency II.
Some details of this framework were set out in an Executive Director’s letter in March 2015, and the annex and appendices to this letter provide further information, including how the framework was operated in practice through the model review process in 2015. In addition, I would like to explain the philosophy we have adopted in the use of this framework:
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The Solvency II Directive requires us to ensure that firms are capitalised to withstand a 1-in-200 year shock. Projecting what a 1-in-200 year shock would be is inherently a difficult and uncertain undertaking, which involves a significant degree of judgement. Inevitably, reasonable and well informed people can reach different views about this. However, it does not follow from this that the PRA should have no views on the calibration of important inputs to firms’ models. It is true that our job is to decide whether or not an internal model meets the tests and standards set by the Directive, not to set the capital requirement itself. This is one of the major changes from the previous individual capital adequacy standards (ICAS) regime, and we have followed the new approach assiduously. But in order credibly to form a view on whether a model meets those standards, we must make an assessment of the strength of the calibration of important inputs to that model. We have developed the Quantitative Framework to help us formulate those assessments.
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Bearing in mind the inherent difficulties of projecting a 1-in-200 year shock, it would be wrong for the PRA, in its Quantitative Framework, to claim a monopoly of wisdom, adopt a position at odds with the evidence, or take a black-and-white approach. We have instead aimed to take a balanced and proportionate approach and we have in no area aimed to use the arrival of Solvency II to increase capital requirements. This does not mean that the PRA will agree with all firms all of the time about the calibration of key inputs to internal models. It does mean that:
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Our views take appropriate account of industry views and expertise, and our views will evolve in response to new evidence as it becomes available.
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We take a flexible approach, for instance by expressing our view as a range in the case of some risks.
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We make use of peer analysis, but also allow for the specificities of individual firms’ risk profiles rather than taking a blanket approach.
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We focus on material issues and apply our judgement, rather than taking a tick-box approach.
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It is clear that in some respects the new regime is materially different from the ICAS regime, for instance through the introduction of the risk margin, and that this different regime may have some impact on firms’ capital positions (positive and negative), even though the underlying 1-in-200 calibration is the same in both regimes. However, this should not be confused with the PRA hardening its view of key risks, which we have not done as part of the introduction of Solvency II.
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The transitional measures allowed for under the Directive exist to cushion the impact of moving from one regime to another. As a safeguard, the benefit from the transitional measure on technical provisions (TMTP) is generally limited to make sure financial resources of UK firms cannot drop below those required under the ICAS regime as a result of using the transitional. The PRA will allow full use of transitional measures by those firms that qualify to use them, and when we consider whether or not firms are in a position to pay dividends, one of the main quantitative yardsticks we will use is capital levels after the benefit of transitionals.
Please note that while the general philosophy set out in the letter has applied to our use of quantitative metrics across all model reviews, the focus of the annex and the detailed commentary within it is on life issues.
The Solvency Capital Requirement (SCR)
Solvency II is clear that firms must hold sufficient capital to meet their Solvency Capital Requirement (SCR). I consider that we have done a thorough and robust job in making sure that for UK firms that requirement represents a 1-in-200 year standard, as set down in the legislation (partly informed, for internal model firms, by the use of our Quantitative Framework as set out in this letter, and informed by an assessment of standard formula appropriateness for firms without an internal model). It follows from this that we will hold firms to their SCR.
As we did under the ICAS regime, we will of course monitor capital more closely, and expect to discuss contingency plans, as a firm approaches its SCR. In doing so we will take into account the volatility of each firm’s capital position, the nature of its business model and the risks to which it is exposed as set out in its Own Risk and Solvency Assessment (ORSA). These factors will clearly differ from one firm to another, just as there are elements of the new regime such as the Ultimate Forward Rate which work differently for firms operating in different countries. It is also worth noting that for an insurance group’s solvency position the Solvency II SCR, as an economic measure, is much more similar to the ICAS regime than to the Insurance Groups Directive (IGD) regime, and therefore any simplistic read-across from groups’ previous IGD positions to their new Solvency II positions is unlikely to have much information value. Given this, I would like to be clear that we will not deploy a single ratio, somewhere above the SCR, as a formal intervention point across the insurance sector. That would be incompatible with the intention of legislators to deliver a 1-in-200 level of solvency across Europe, and would not take into account the different risks different firms run. Instead, we have developed monitoring tools which we will use in the operation of our judgement-based approach to prudential supervision.
Using Solvency II to compare capital positions across countries
The aim of Solvency II has been to create a more robust regulatory standard (in particular relative to the unadjusted and now very dated standard of Solvency I) and thereby establish a benchmark standard. We have commented in recent months that considerable caution is required in making comparative judgements on the basis of Solvency II capital positions. A good example of this issue is the different application of the Ultimate Forward Rate under Solvency II, which leads to different outcomes. There are other areas where we consider that further work will be required to improve the comparability of Solvency II positions; these include the differing approaches being taken to the implementation of the Volatility Adjustment, which will need to be ironed out. This is to be expected with such a far-reaching and complex measure, but in the meantime we would further emphasise that great care is required when attempting to draw comparisons on relative capital levels.
Next steps
To conclude, I would like to thank everyone who has been involved over the last decade in the UK’s preparations for the arrival of Solvency II, and in particular those within the Bank, firms and trade bodies who have put a huge amount of effort into getting us to this point. These efforts will need to continue, particularly in relation to internal models where, following discussions with us over the last 18 months, a significant number of firms decided to take more time in developing their models and are likely to bring them to us for approval during 2016 and 2017. We will apply the same standard of rigour to any further approvals sought – and to any model change requests for models already approved – that we applied in the model reviews we undertook during the second half of last year. I hope that this letter and any further communications we issue will help firms in those preparations.
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