The Prudential Regulation Authority (PRA) has published the following consultation papers:

• CP9/14 Subordinated guarantees and the quality of capital for insurers. This supervisory statement will require insurers to inform the PRA if their capital structures involve the use of subordinated guarantees. These firms will be expected to submit the contractual terms of subordinated guarantees by December 31, 2014 and, depending on how firms intend to deal with such guarantees, may require obtaining an independent legal opinion or submitting a restructuring plan; and
• CP10/14 Valuation risk for insurers, which requires firms to have effective governance in place to meet the requirements on valuation uncertainty and prudential valuation.

Subordinated guarantees and the quality of capital

CP9/14 seeks views on a draft supervisory statement which sets out the PRA’s expectations of insurers in relation to:

• the use of subordinated guarantees in connection with capital instruments issued by a company, whereby the payment of coupons and repayment of principal are guaranteed by a firm (the guarantor);
• how subordinated guarantees should not undermine the quality of capital held by firms to meet capital requirements (this expectation applies regardless of both the motivation for using a subordinated guarantee and the structure in which a guarantee is used); and
• how the guarantor’s regulatory capital position should be reported if the liability created by the guarantee serves to undermine the guarantor’s quality of capital.

The statement relates only to structures where guarantees are being used to facilitate obtaining finance, however, for guarantees outside of scope, firms should still consider whether those guarantees serve to undermine the quality of their capital.

Acceptable outcomes

According to the statement, subordinated guarantees should not serve to undermine the capital requirements. Any subordinated guarantee arrangement will be assessed by the PRA to ascertain whether it is consistent with one of the following situations deemed acceptable by the regulator:

1. from the perspective of the guarantor firm, if a subordinated guarantee is called upon, the guarantee should effectively extinguish or replace an existing subordinated liability. The subordinated guarantee should possess the same, or better, features regarding quality of capital as the subordinated liability it is replacing; and
2. where a subordinated guarantee does not extinguish or replace an existing subordinated liability, the firm should acknowledge the existence of the guarantee by disqualifying the guaranteed amount from the guarantor’s Tier 1 capital.

In either case, any capital instrument that is guaranteed should still fulfil its regulatory purpose. The subordinated guarantee should not override the loss-absorbing features of a capital instrument and investors in a capital instrument should not avoid bearing losses when it is appropriate for them to do so.

Assessing quality of capital

Firms are expected to provide evidence so that the PRA can make informed judgements about the quality of firms’ capital resources. Within one calendar month of the publication of the final supervisory statement, firms must inform their usual PRA supervisory contact if their capital structures involve the use of subordinated guarantees and whether the existence of such guarantees has led to any adjustment to the tiering of their capital resources. Category 1 to 3 firms that do not have these capital structures in place are expected to confirm this to the PRA, also within one month of publication of the final statement.

By December 31, firms that have made, or will make, an adjustment to capital resources in their regulatory returns for year-end 2014, should provide to the PRA the contractual terms governing the subordinated guarantee, and information as to where in the firm’s regulatory returns the adjustment has been, or will be, made.

Also by December 31, firms that have made no adjustment to their capital resources, and do not intend to, must provide to the PRA the contractual terms governing the subordinated guarantee and an independent legal opinion to support their position. The legal opinion should address the economic substance and legal form of the structure and assess whether the capital instrument that is guaranteed is fulfilling its regulatory purpose.

Firms that have made no adjustment to their capital resources but are proposing a restructuring or changes to contractual terms to address the issue should submit the terms governing the subordinated guarantee and a detailed plan of the proposed restructuring or term changes to the PRA by December 31, 2014. Firms should also include the expected implementation date of the plan, which should be no later than December 31, 2015.

The draft supervisory statement includes two situations where the quality of capital is undermined by a subordinated guarantee designed to illustrate the issue addressed by the statement.

Valuation risk

CP10/14 sets out the PRA’s expectations of firms in relation to existing rules on the valuation of financial assets. The draft supervisory statement applies to all PRA-authorised insurers and may also be relevant to insurance holding companies and other entities in the same group. The statement seeks to clarify existing rules on the valuation of financial assets in the General Prudential sourcebook (GENPRU). The PRA expects firms to have governance and processes in place to meet the requirements on valuation uncertainty and prudent valuation.

The draft statement explains that valuation uncertainty is the term used to refer to the existence, at the reporting date and time, of a range of plausible values for a financial instrument or portfolio of positions. Insurers should ensure that the assessment and quantification of valuation uncertainty is sufficiently robust and complete, particularly with portfolios of structured products and illiquid securities where valuation risk is most material. Quantification of valuation uncertainty should be underpinned by: sufficient independence in valuing assets; adequate documentation of policies and procedures; adequate control over valuation models; adequate management information; and consistent governance between internally and externally managed funds. Where firms consider valuation uncertainty to be immaterial, the PRA expects them to provide analysis as evidence.

Finally, the PRA expects firms to monitor and limit their use of client-supplied pricing (by external valuation providers) and have clear visibility of the price sources used, in particular to identify where client-supplied prices are used in their valuations. Where there are no practical alternatives to client-supplied pricing, the PRA expects firms to operate robust controls, including independent price verification and reporting of the materiality of client-supplied prices to senior management.

The closing date for both consultations is July 11, 2014.

View CP9/14 Subordinated guarantees and the quality of capital for insurers, 13 June 2014

View CP10/14 Valuation risk for insurers, 13 June 2014