Insurance 2020: Insurance Company Investment and the Prudent Person Principle

“No other protection is wanting, provided you are under the guidance of prudence”
Juvenal, Roman poet

Since the implementation of Solvency II, insurance companies have had great flexibility to determine how to invest their assets. They must invest in accordance with the Prudent Person Principle (the "PPP"). PRA is concerned that some insurers (and managing agents) are taking advantage of that flexibility without having appropriate investment strategies, risk management and governance systems in place.

As a result, at the end of 2019, PRA published a consultation paper and draft Supervisory Statement which describes areas where PRA expects firms to pay particular attention to comply with the PPP and the circumstances in which firms may be subject to "greater supervisory scrutiny". Firms will need to review and adapt their existing processes accordingly.

The core requirement of the PPP is that insurers must only invest in assets the risks of which they can properly identify, measure, monitor, manage, control and report and appropriately take into account in assessment of overall solvency needs. There are very few additional restrictions on how insurers' assets can be invested.[1]

An objective standard

PRA's Supervisory Statement emphasises that the PPP sets objective standards for prudent investment. The PRA acknowledges that those standards allow a range of investment strategies. However, it is not necessarily enough that an insurer’s board considers it has prudently invested its portfolio if, in fact, that is not the case. PRA will exercise its own judgement, often with the benefit of hindsight, and where it considers that a firm is not meeting the required standards, it will require senior management to take action. PRA specifically reminds firms of the responsibilities resting with senior managers, specifically the Chief Risk Officer, and points out that breach of the PPP may be associated with a failure to meet the requirements of the Conditions Governing Business, potentially resulting in capital add-ons.

The warnings are clear but what does PRA expect?

In summary, PRA expects:

• An investment strategy which is approved, challenged, controlled and reviewed (at least annually) by the board. The strategy should set out investment objectives, strategic asset allocation and constraints and explain how the strategy aligns with the insurer's risk appetite and business model (having regard to the nature and duration of the insurer's liabilities and the best interests of policyholders). Investment in a new asset class requires a comprehensive risk assessment first to ensure all necessary expertise, systems and processes are in place to value the asset and to identify, measure, manage, control and report on the associated risks.
• Risk management and governance, more specifically quantification, under a range of scenarios, of the potential impact of crystallising investment risks on solvency of the insurer and its ability to pay policyholders. Stress testing is required so the insurer can identify scenarios which would cause investment risk to crystallise, and the action that would be taken in response.
• Proper diversification and avoidance of material reliance on individual counterparties, including the adoption of quantitative investment limits for assets and exposures. Again, portfolios should be stress tested, looking at risks arising from any particular asset, issuer, geography or any other single source of risk.
• A particular focus on non-traded assets and valuation risk. PRA recognises that investments in non-traded assets can be an appropriate match for insurers' liabilities, particularly annuities. Assets such as equity release mortgages, for example, have become very popular. However, they also give rise to additional risk. They can be difficult to value and sell, particularly in stress scenarios, so particular care is required. Both the systemic and idiosyncratic risks arising from each investment need to be considered. Fundamental analysis of those underlying risks is required and this in turn requires expertise to understand and manage the risk and to challenge investment decisions. Non-traded assets may also give rise to new concentrations of risk which need to be considered in light of the PPP. In addition, there is typically no independently verified market price for non-traded assets, so there is a risk that the insurer may not be able to realise the value it has assigned to those assets. That itself is an additional risk that needs to be considered and managed.

What’s the impact on investment management arrangements?

Many insurers outsource investment management. Any such outsourcing is typically “critical or important” for the purposes of Solvency II, so Solvency II outsourcing rules apply in full, including requirements on due diligence, contractual terms and ongoing relationship management. Investment managers can help insurers to meet the requirements of the PPP through risk analysis, diversification etc., but they are not the complete solution. Insurers and their boards will remain responsible to the regulators for PPP compliance and will therefore need to retain proper oversight and control of investment strategy and investment risk management.

What next?

PRA's consultation has closed and changes to the Supervisory Statement are unlikely to be material. In practice, PRA is already supervising insurers in accordance with the draft Supervisory Statement. Insurers will therefore need to satisfy themselves that they are meeting all of PRA's expectations and be prepared to demonstrate that they are meeting the objective standards set out in the PPP. PRA is likely to be asking more intrusive questions in these areas and will reach its own conclusions on whether PPP obligations are being met.

[1] The principal additional restrictions are the obligations to (a) invest only in permitted links when linked long term contracts are sold to natural persons, and (b) use derivatives only for risk reduction or efficient portfolio management.