Restrictions on eligible liabilities and documentation requirements could discourage firms from using key counter-cyclical measure UK insurers hoping to use the Solvency II volatility adjustment (VA) face an onerous application process and may find the measure applies to fewer liability types than originally assumed. A Treasury consultation paper published on August 6 laid out the UK government's blueprint for applying the VA to UK insurers, including a proposal for the Prudential Regulation Authority (PRA) to have the power to accept or reject its use on a firm-by-firm basis. Experts suggest firms will face a complicated application process before being allowed to use the adjustment. The VA applies a parallel upward shift in the Solvency II risk-free rate (RFR) for qualifying liabilities, calibrated as a percentage of a risk-adjusted spread yielded by a reference portfolio of assets. The reference portfolio will vary in composition from country to country. Current guidelines specify that firms will be allowed to claim 65% of the additional spread on their designated reference portfolio for the adjustment. The objective of the measure is to dampen the effect of market volatility on regulatory balance sheets and prevent insurers from becoming forced sellers of assets in times of stress. But the Treasury consultation describes an application process that might put some firms off using the measure. To use the VA, an insurer would have to demonstrate to the PRA that it is using the adjustment correctly, that its use does not breach any relevant regulatory requirements and prove that the firm is not abusing the capital relief to make overly risky investments. This is in addition to the conditions in the Solvency II Directive, which require firms to provide a written policy on the criteria for application of the VA, a liquidity plan and a risk management plan. Martin Shaw, Lincolnshire-based chief executive of the Association of Financial Mutuals, says: "I'm not convinced the PRA will readily grant permission without a relatively onerous approval process. In particular, the level of proof needed might be quite high to satisfy the consumer protection test. The paper also highlights concerns about pro-cyclicality in insurance, which has been significantly scrutinised by the PRA." The PRA has a statutory objective to secure an appropriate degree of protection for policyholders, as does its counterpart regulator, the Financial Conduct Authority. Shaw says any firm applying for the VA would have to satisfy the PRA that its use does not undermine policyholder protection – something that may be burdensome to prove. In addition, at the end of July the PRA issued a discussion paper on pro-cyclicality and structural trends in investment allocation by insurance companies and pension funds indicating that the regulator is watching closely the effects of insurance company investment behaviour on financial stability and economic growth. The Treasury consultation warns that the adjustment might exacerbate pro-cyclical behaviour, despite the measure's counter-cyclical objective. The consultation states that use of the VA for products with "significant surrender risk" could encourage firms to engage in "bank-like maturity transformation" – offering bank account-type products but backed by long-term illiquid assets and using the adjustment to keep capital levels low. This suggests one of the aims of the proposal will be to discourage regulatory arbitrage between banks and insurers. "The VA is a premium to compensate for the excess volatility in spreads over a short time and as such is an increase to the risk free rate… But if the liquidity of the liability profile led to liabilities crystallising unexpectedly, firms would not be able to realise this premium, as they would have to sell those assets in order to meet their liabilities," states the consultation. Emily Penn, ALM manager at LV= in Bournemouth, says: "My read is that some general insurance liabilities would be restricted from using the VA. I think that's a UK view and one not shared on the continent, where insurers will expect blanket use of the adjustment. This could cause tensions between countries because it would place the UK on an uneven footing versus the continent." Penn explains that with-profits liabilities and certain annuity portfolios where an insurer does not wish to apply for the matching adjustment are the most likely to be eligible for the VA. But many with-profit funds in the UK have been reporting on a swaps basis for the past few years, meaning moving back to a reference portfolio-based VA basis could prove troublesome, according to an insurance asset-liability management source at a UK bank. The various hoops insurers will have to jump through to use the VA, coupled with the uncertainty over which liabilities will qualify, may discourage firms from applying for the adjustment altogether. Andrew Smith, senior partner at Deloitte in London, highlights some additional considerations: "Although the VA does reduce the reported liabilities, it adds huge complexities in relation to the reference portfolio, as no one is sure what this will contain. "It's also unclear under what circumstances the VA will be used. Some organisations assume they can use it all the time, but there was also some suggestion that came around as part of the financial crisis that it would only be used for firms going through difficulties. In that case, the market may interpret an insurer using this as in some sort of trouble. If that were the case then insurers would be reluctant to use it unless they absolutely had to," he adds. The Treasury consultation closes on September 20....
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