The Volatility Adjustment is one of the options available under the long-term guarantees package (LTGP), introduced under Omnibus II, and allows a prescribed adjustment to the Solvency II risk-free discount. The adjustment will be 65% of the risk-adjusted spread, for each currency, based on a reference portfolio of assets.
Given the possibility of inappropriate use of the VA and the potential impact this could have on financial stability, the Treasury proposes that UK-regulated firms wishing to use the VA will be required to apply for supervisory approval prior to doing so.
In general there is limited scope for discretion to be applied in the way Solvency II is implemented. However, this proposal is in line with a safeguard included in the Solvency II Directive, which can be used by supervisors to help avoid inappropriate use of the VA and Member States can choose to make the VA subject to supervisory approval on a firm by firm basis.
The Treasury’s consultation is the second in a two-stage process; the first closed in February 2012 and this closes on 19 September. The consultation sets out the pre-approval process and highlights what the Treasury believes are the benefits to having such a process in place.
The PRA supervisory approval process will involve:
Examination of material provided by firms
- Material required by the Directive from all firms using the VA: a written policy on criteria for application of the VA; a liquidity plan; and a risk management plan.
- Any other pre-existing material.
Assessment by supervisors and actuaries of whether firms satisfy set criteria
- Correct application of the volatility adjustment to the risk-free interest rate term structure.
- Use of the VA will not result in procyclical investment behaviour, i.e. encouraging excessive risk taking during upturns that could be crystallised during downturns in the economic cycle.
- Application of the VA is consistent with other applicable requirements of the Directive.
Communication of decision
- Clear written communication.
- Decision within 6 months of application.
- Reasons included for rejected applications.
The Treasury recognises that requiring firms to apply for approval introduces an element of regulatory uncertainty initially but notes some positive elements:
- Greater confidence in the UK insurance sector overall by ensuring the VA is used in a consistent and prudent way. Specifically, firms using any of the LTGP measures must publicly disclose the quantitative impact of the measures on their technical provisions. Supervisory approval may give reassurance that material reductions are prudent.
- Potential avoidance of costs associated with remedial action if regulatory intervention is required following imprudent use of VA.
Barnett Waddingham commentary
There may be some debate over the benefits/restrictions of the proposal to make the use of the VA subject to supervisory approval. Our thoughts are:
- Whilst the process may be seen to add more to the regulatory paperwork pile, firms should be aware that they will need to produce such paperwork anyway to meet the requirement under the Solvency II Directive, if they wish to use the VA.
- Despite there being no additional paperwork, the approval process is inevitably going to incur some burden on those subjected to it in corresponding with the regulator.
- There may be initial uncertainty over whether approval of the application will be granted but there will be comfort following this that the PRA has confirmed upfront that the approach is prudent.
- Firms will have to start considering now whether or not they wish to apply a VA if they have to apply for approval, since the application and all supporting paperwork will need to be submitted to the PRA by 30 June 2015 to allow for the 6 month PRA assessment period. This is made more difficult given the limited information currently available on the VA.
- This will put additional pressure on already constrained PRA resources.