PRA letter on equity release leaves insurers puzzled

Internal structures allowed, but firms pushed towards internal models

What the UK regulator is giving insurers with one hand, it seems to be taking away with the other.

In a letter to the industry on Friday, February 20, Paul Fisher, executive director of insurance supervision at the Prudential Regulation Authority (PRA), appeared to clear a path for firms to restructure equity-release mortgages for the Solvency II matching adjustment – a contentious issue and one that is vitally important to a number of annuity providers.

At the same time, however, Fisher said the PRA would treat equity-release restructurings as securitisations, meaning they will incur onerous capital charges under the standard formula that threaten to wipe out any benefit from restructuring in the first place.

In the letter, the regulator pushes firms towards using internal models for equity-release assets, which some see as a way to avoid these higher capital charges. But opinion is split on whether that will work in practice.

"It is good news that the PRA is agreeing to wholly internal transactions," says Simeon Rudin, a partner at law firm Freshfields Bruckhaus Deringer, based in London. "But it is unclear why they treat these as being ‘in substance' securitisations.

It is good news that the PRA is agreeing to wholly internal transactions

"For firms working on internal models it means applying that model as if it were a securitisation, which may undo some of the benefits that would otherwise have been obtained. For those not on internal models this would seem to prevent them using this type of structure to obtain matching adjustments at all."

Insurers have been working for months on ways to make equity-release mortgages qualify for the Solvency II matching adjustment, a measure that allows firms to value liabilities more favourably if they hold matching assets that meet a selection of criteria, including the requirement to have stable and fixed cashflows.

Equity-release mortgages require some form of restructuring to be eligible because of the complex array of risks they include, such as prepayment and property risk, and have been a focus of attention recently as insurers await direction from the PRA on how the matching adjustment will be applied.

This feedback from the regulator is expected at the end of March following a pre-application process for the matching adjustment that the authority is running now.

Insurers had been worried they would have to transfer some of the risk of equity-release mortgages to third parties as part of restructuring transactions. But the February letter says, for the first time, that fully internal structures will be allowed.

"Restructuring of equity-release mortgages through a subsidiary company set up for this purpose, wholly owned within the insurance group, is likely to be acceptable," says the letter. This removes a potentially burdensome cost for insurers, for whom the need to externalise some of the risk threatened to make restructuring uneconomical.

However, the PRA goes on to say that equity-release restructurings will be treated as "in substance" securitisations, even if they do not meet the legal definition of a securitisation under EU rules.

For firms using the standard formula, the regulator says: "The PRA would expect that the notes issued by the special-purpose entity would be treated as a Type 2 securitisation as they are likely not to meet certain Type 1 criteria."

Under the Solvency II delegated acts, Type 2 securitisations incur capital charges upwards of 12.5% times duration. Equity-release repackaged notes are typically long-dated, so this means they will probably incur a 100% capital charge. A worked example from one banker based on a 10% cost of capital suggests any advantage gained by applying the matching adjustment would be wiped out.

However, the PRA says in the letter that insurers might choose to create an internal model or partial internal model for the repackaged assets. Doing so might be one way to reduce the capital charges in question, assuming the regulator allows a much more favourable treatment of securitised notes in an internal model than under the standard formula.

Says Paul Fulcher, managing director, ALM structuring at Nomura based in London: "The optimistic view is that the PRA is saying you need a partial internal model. The pessimistic view is they are saying: ‘This is a securitisation and so even after you've built an internal model you are still going to need extra capital.'"

David Prieul, managing director and head of the insurance and pensions solutions group in Europe at Credit Suisse, based in London, says: "The current UK Pillar II framework gives a capital charge that is reasonable for equity-release mortgages. The Type 2 standard formula securitisation gives a very high number. If you were to apply the current capital charge through an internal model then you get back to a normal market environment with no real disruption from the matching adjustment calculation."

At the same time, insurers have only a matter of months to put an internal model in place. Rudin says: "If you are not on an internal model already, it is a little late to start one. Even for a partial internal model, it is probably a little late to start."

The PRA's stance has surprised many in the industry. "None of the various structures I have seen so far meets the technical definition of securitisation. In fact, they appear to have been structured specifically to avoid meeting those criteria," says Rudin.

The technical definition of securitisation as set out in the Capital Requirements Regulation (and referred to in Solvency II) says securitisations must include tranching of credit risk where the subordination of tranches determines the distribution of losses during the ongoing life of the securitisation. Some of the structures put to the PRA are understood to include only a single tranche of fixed rate notes.

Contradictions

Meanwhile, elsewhere in the letter the PRA looks to resolve confusion about the treatment of intragroup transactions when calculating group own funds. Contradictions between the Solvency II delegated acts and Eiopa guidance on this issue led to confusion about whether the matching adjustment might be eliminated at group level for firms using restructurings that rely on intragroup transactions.

The letter seems to offer a solution in the form of a newly-created notion of ‘intra-entity' transactions. For transactions where all the tranches are held by the same entity, "any matching adjustment benefit secured at a solo level would not then be eliminated on consolidation", says the regulator.

Later, the PRA goes on to warn insurers that the approach set out for equity release will not automatically apply for other assets. The letter says: "The PRA does not consider it appropriate for firms to replicate this form of restructure in order to invest in assets, which would not be considered suitable given the nature of the liabilities that are being matched."

Fulcher says: "I think there will be push back if people try to cut and paste this for other assets. It will come down to the PRA's view of which assets are good matching adjustment assets and which are bad ones.

"I think the PRA would probably not like to see the same sort of solutions applied to callable bonds," he says, as an example to illustrate the point. Issuers of callable bonds benefit from favourable capital treatment, he points out, making it hard to see how buyers could also receive capital relief, without some form of risk transfer.

The UK regulator's stance on the externalisation of risk contrasts with that of the Dutch supervisor the DNB, which has indicated firms must transfer some of the residual prepayment risk in Dutch mortgages to a third party in similar restructuring trades being considered in the Netherlands.

Commentators believe the two positions can coexist. However a threat to UK insurers could arise, in theory, if the DNB felt obligated to query the stance of the PRA with the European Insurance and Occupational Pensions Authority (Eiopa).