Early-warning indicators needed to address failings in Solvency II - PRA chief

Effective and prudent solution needed on Solvency II matching adjustment, says Bailey

The introduction of capital early-warning indicators is necessary to make up for the failings in Solvency II, the UK's top insurance regulator has said.

Prudential Regulation Authority (PRA) chief executive Andrew Bailey said the regulator needed to act now to introduce "sensible backstops" for insurers in order to prevent capital models being used to push capital levels too low.

"Our use of early-warning indicators is precisely because we have learned the hard way with banks that excessive reliance on modelled capital requirements lends itself to cutting capital levels too low. In banking supervision we are playing catch-up by working to raise capital levels from ones that were too low. We can avoid that outcome for insurance by acting now to introduce sensible backstops," Bailey told the Association of British Insurers.

"We still have a good way to go to make the Solvency II regime manageable in its use and implementation. I have to say I think the early design did not come up to the mark in this respect," he added.

The PRA is concerned that firms will fine-tune their internal models to pare capital requirements to below Solvency II's 99.5% value-at-risk threshold. It proposes to use a ratio between the modelled Solvency Capital Requirement (SCR) and the pre-corridor Minimum Capital Requirement (pMCR), a standardised formula based on Solvency II technical provisions.

Supervisory action will be triggered if the ratio falls below a pre-determined threshold, set at different levels for life and general insurance businesses. A capital add-on is, in all but exceptional cases, likely to be the most effective way to restore compliance with the Solvency II calibration requirement, Bailey said.

"We expect that where internal models are used for regulatory capital purposes, they should contribute to prudent risk management and measurement. And they should be updated regularly in order to reflect the insurer's risk profile and not just to ensure compliance with the letter of our requirements," he added.

Bailey said progress has been made at a European level on Solvency II's package of measures for contracts with long-term guarantees, particularly in relation to the matching adjustment used to adjust the discount rate for certain products.

But he acknowledged that the UK insurance industry still had concerns about restrictions on the classical version of the matching adjustment, particularly around the assets that can be used and the effects of possible downgrades in portfolios.

"We will continue to push for a prudent solution that will meet the needs of UK insurers and allow for the continued provision of annuities to policyholders. In doing so, we recognise that some restrictions are needed for the classic matching adjustment to be an effective and prudent measure," Bailey said.

He added: "The importance of the Eiopa [European Insurance and Occupational Pensions Authority] recommendations and their acceptance by the European Commission should not be underestimated. We have come a long way from the suggestion last year that a matching adjustment would not be part of the directive at all. The focus now has to be on making sure we end up with an operable system that doesn't introduce pro-cyclicality."

Bailey said he was hopeful that an agreement on the long-term guarantees package could be reached by the end of the year. "It is then critical that we have a clear and credible timeline for implementation so that firms can ensure they will be compliant when the new rules are introduced," he added.