PRA draft supervisory statements: valuation risk and subordinated guarantees

The Prudential Regulation Authority’s (PRA’s) two most recent consultation papers, published on 30th May, seek views on two draft supervisory statements for life, general and mutual insurers. The key features of each are summarised below.

The draft supervisory statements set out the PRA’s expectations in relation to existing rules and are not proposing any changes to the rules themselves.

Valuation risk (CP10/14)

Do you know the value of your assets?  Sounds easy – you just get the information from your asset manager, or read it from your Bloomberg screen, right?

This may be so for publicly listed, liquid assets, but it isn’t so easy for those over-the-counter derivatives contracts, or that illiquid infrastructure loan. In these cases, valuations are more subjective, with the potential for mis-pricing that that brings.

For obvious reasons the PRA want to make sure that any asset value uncertainty is assessed and prudently allowed for when setting supervisory reserves. The draft statement highlights that good practice should include:

• Sufficient independence of valuation
• Adequate documentation and management information
• Adequate control over valuation models (if used)
• Consistent governance between internally and externally managed funds

The risk of concentrated positions is explicitly mentioned – e.g. you may have some very plain assets but, if they represent a large portion of the available stock, they may not all be able to be realised at current market value and this should be reflected in the valuation.

“Client-supplied” prices are also specifically mentioned. These are normally used where there is no publicly available market price for an asset and an insurer or investment manager sets their own price as a result. The PRA are keen for firms to monitor and limit this practice. They want to see appropriate governance procedures and documentation in place where practical alternatives to client-supplied pricing are not available.

Finally, the PRA also expect insurers to provide analysis as evidence where valuation risk is considered to be immaterial.

Subordinated guarantees and the quality of capital for insurers (CP9/14)

Subordinated guarantees are commonly used as part of corporate issuances. It involves an insurer guaranteeing debt instruments issued by another entity (usually in the same group structure).

One example of how these structures may work is that a holding company issues Tier 2 (subordinated) debt on behalf of an insurer, with the insurer wholly owning the holding company and guaranteeing the coupon/redemption payments. A diagram showing this structure is shown below:

^{Source: Prudential Regulation Authority}

As equity is Tier 1 capital, this increases the Tier 1 capital of the insurer, but clearly when considered as a whole it is Tier 2 debt that has been issued. The statement explains that insurers should either relegate this Tier 1 equity capital to Tier 2, or have the value of the guarantee included as a subordinated liability, depending on how the guarantee is structured.

These structures can be complex. The key message is that the quality of capital should not be undermined by subordinated guarantees. The PRA state that they are happy to discuss the issues arising from the statement with affected firms, to help them make the necessary adjustments by 31 December 2015.

Firms will have to report their use of subordinated guarantees within one month of the supervisory statement being released (expected Q3 2014). Category 1, 2 and 3 firms will have to confirm that they do not employ subordinated guarantees within the same timescale.

More information

Both consultations close on 11 July 2014. The papers can be found on the Bank of England's website.