Life insurers with annuity books have spent huge amounts of time and effort over the past couple of years putting their MA portfolios and associated processes in place. With portfolios going live at the beginning of the year attention has now switched to ongoing management.
On 15 April, the PRA released a draft supervisory statement to communicate their expectations of insurers and highlight when supervisory activity may be needed, covering four areas.
"With portfolios going live at the beginning of the year attention has now switched to ongoing management. "
Secondary annuity assets
Whilst secondary annuities sound like the ideal backing asset for annuity books, by a strict reading of the MA rules they do not meet the eligibility criteria because they do not produce fixed cashflows (due to the mortality risk). The PRA has picked up on this and appears to be sticking to the rigid interpretation.
It also points out that there is likely to be a basis risk between the mortality experience within an MA book and that of a portfolio of second hand annuities, as they will cover different lives.
The key result is that the PRA are proposing to only allow secondary annuities to be held within MA portfolios where these risks are “mitigated”.
The secondary annuity market may still be a year away but the PRA is clearly keen to share its view on this asset class, and it is not what insurers considering investing in these assets were hoping for.
Insurers may therefore need to transform secondary annuity assets into fixed cashflows, perhaps using a securitisation approach (as has been used extensively for equity release mortgages). Another option may be some form of reinsurance.
Whilst longevity swaps are now used extensively for annuity books, the opposite transaction (where a reinsurer pays in the event of heavy mortality experience rather than light) is not so common, although reinsurers may relish the chance to obtain a potential hedge against their longevity swap exposure.
The PRA’s use of the word ‘mitigated’ perhaps leaves some small hope that other, less onerous solutions may also be permitted. For example, comprehensive underwriting of both liabilities (such as that performed for impaired annuities) and assets should help reduce basis risk.
Ongoing MA compliance
MA applications will have described how a firm intends to monitor compliance with the MA requirements (including the ‘PRA tests’). The PRA have proposed that they may “periodically review” this ongoing MA compliance within firms including review of documentation and management information (MI).
The potential frequency and depth of these reviews is not yet known, but those firms still transitioning their processes to meet MA requirements may want to ensure this transition is completed sooner rather than later.
Breach of MA
The PRA puts in a reminder that firms who breach the MA requirements have a period of two months to restore compliance, or risk losing the MA for two years. It asks firms to speak to the PRA “as soon as possible” where there is a risk that the MA conditions will be breached.
This is one area where the PRA are clearly very keen to monitor closely, asking firms to not only notify them of a breach but to do so as soon as possible when there is simply a risk that a breach may occur. A “risk of a breach” is not defined so firms will need to use their own judgement.
Changes to MA portfolios
Firms are expected to have a “robust process” to decide when a change in their portfolios means a new MA application is required.
Examples given include:
- restructurings, mergers or disposals;
- new, or changes to existing, reinsurance;
- changes to the way firms maintain and manage portfolios;
- changes to the scope of portfolios, including addition or removal of (different types of) assets/liabilities; and
- changes to the features of any existing asset/liability.
Most notably, the PRA proposes that applications for changes take the form of completely new applications. Further guidance is currently being developed.
It appears the PRA may be drawing on some parallels to the minor/major change structure of internal models, meaning a formalised process by which firms consider when a new application is needed.
Applications for changes need to be in the same form as a full application. This may result in disproportionate work for firms wishing to make minor amendments. It is likely to be beneficial to consolidate smaller changes together as a result.
The draft supervisory statement contains some important details that firms using the MA, or those looking to apply in future, need to bear in mind. Those impacted may wish to respond to the consultation paper, the deadline for which is 15 July 2016.