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23.07.2021

PRA Review of Solvency II Quantitative Impact Study – what’s included?

On Tuesday 20 July, the PRA released the instructions and templates for their Quantitative Impact Study (QIS).[1]  Its scope covers Risk Margin and Matching Adjustment (MA), with the impacts of the changes tested to be assessed as at YE20.  Transitional Measures on Technical Provisions (TMTPs) are to be updated to YE20 and for the impacts of changes to Matching Adjustment but no separate changes to TMTP methodology are tested.  The PRA have also indicated that a set of qualitative questions covering other aspects of Solvency II (SII) reform will follow in August.  The deadline for submissions is 20 October 2021.

Risk Margin

The QIS tests two alternative Risk Margin calculation methods.  One is consistent with the current draft of IAIS International Capital Standard (v2.0).  In this approach the Risk Margin is equal to the SCR for non-hedgeable risks multiplied by 0.4 for life business and 0.15 for non-life business.  Breaking the link with the expected lifetime of a portfolio should greatly alter the balance of risk margin for short-term and long-term business and reduce sensitivity to interest rates.  The second approach to Risk Margin is to retain the SII formula but to apply a *max(λt ,floor) factor to each future SCR for non-hedgeable risks, with λ = 0.975 and floor = 0.5.  This will reduce risk margin on long-term business substantially, with no impact on short-term business.  This approach is a subtler evolution from the Solvency II approach and is consistent with a proposal in the Dec 2020 EIOPA opinion to European Commission on potential future changes to Solvency II.  Both of these Risk Margin calculations should be straightforward.

Matching Adjustment

The QIS tests one main alternative MA calculation method, in two different calibrations, plus some variants.  For government bonds, supranationals etc the current Fundamental Spread (FS) approach is retained.  For everything else probabilities of default (PDs) are retained but rebadged as expected losses (EL).  Matching of component A remains on a PD/EL-adjusted basis.  Two new factors, Credit Risk Premium (CRP) and Valuation Uncertainty (VU) are added to EL to produce the new QIS FS.  The CRP is a weighted average of the current spread on each asset and 5yr average spread for corporate bonds of that Credit Quality Step (CQS).  The VU is nil for actively traded corporate bonds but increases to a maximum of 25bps for lower quality illiquid assets.

Requirements

The QIS asks firms to carry out both Risk Margin and Matching Adjustment calculations under a range of scenarios.  A YE20 base is stressed for risk-free up, risk free-down, two credit spreads up shocks, a credit quality downgrade stress, and credit spreads up + downgrade combined.  These should provide good clarity as to how the QIS alternative measures perform under stress events that are particularly relevant to annuity business, but the 18 runs specified by the PRA will represent a substantial undertaking for MA firms.

The output templates for the QIS are extensive.  Detailed submissions are required for best estimate balance sheet, risk margin calcs, matching adjustment calcs and internal model SCR for each scenario. In addition firms with matching adjustment approval must complete detailed asset-by-asset templates showing the Fundamental Spread and MA contributions of each asset in each scenario.  These extra asset-level submissions use a template consistent with that which the PRA published on 16 June.  MA firms have until 20 August to submit this information on their base YE20 position.  It seems likely that the PRA may intend to use these base submissions to estimate firms’ QIS submissions ahead of the 20 October deadline.

As set out above, we believe that responding to this QIS is a non-trivial exercise, particularly for life insurers with MA approval.  At APR, we have staff with a wide range of skills and experience who may be suitable for a number of roles.  This could take the form of direct involvement in the production of the QIS response or back-filling permanent staff roles while they take on the response.  If you would like to hear more about what we can offer, then please get in contact via email (ross.gordon@aprllp.com) to discuss further.

Alan Reed

July 2021

[1] https://www.bankofengland.co.uk/prudential-regulation/key-initiatives/solvency-ii/solvency-ii-reform-quantitative-impact-survey