05 June 2014

Risk.net: PRA ramps up monitoring of valuation risk

UK insurers are under increasing pressure to improve their assessment of asset valuation risk, as the Prudential Regulation Authority (PRA) steps up efforts to ensure the industry is Solvency II compliant by the 1 January 2016 implementation date.

The PRA released a consultation paper (CP10/14) on valuation risk for insurers on 30 May containing its expectations of firms with regard to how they estimate valuation uncertainty – particularly for structured products and illiquid securities.

CP10/14 does not include new policy proposals, but reinforces provisions contained in the UK's general prudential sourcebook (Genpru), suggesting the PRA is stepping up efforts to improve risk governance ahead of Solvency II.

Valuation risk is the existence, at the time of reporting, of a range of plausible values for a financial instrument or a portfolio of assets. The consultation paper states that the PRA expects firms to have "governance and processes in place" to meet requirements enumerated under Genpru 1.3 on asset valuation.

Neil Chapman, director at Towers Watson in London, says the paper is a "shot across the bows of the industry", warning insurers that the regulator will be monitoring firms' governance procedures for valuation risk more closely than before.

Janine Hawes, insurance director at KPMG in London, says: "The PRA is a forward-looking regulator, and reading between the lines of this consultation paper it seems they are saying they expect increased diligence now that Solvency II is so close."

She adds there might be a link between the publication of CP10/14 and governor of the Bank of England (BoE) Mark Carney's recent statements on the insurance industry. In an article for The Times on 22 May, Carney wrote that the challenges of the post-crisis landscape "could lead insurance companies towards new classes of business, less traditional types of investments, or new opportunities in emerging markets" and that the BoE would be "vigilant to the risks in any such moves".

The PRA, however, views valuation risk as meaningful. A spokesperson says: "Misstatement of a valuation or valuations can be material and, in extreme cases, could have a significant impact on the capital resources of a company. In the current low interest rate environment, insurers have been moving towards investments in less liquid asset classes with inherent valuation uncertainty. Thus, it is important for the PRA to highlight potential valuation risks that may arise and to highlight the need to report, monitor and manage these risks."

The consultation paper draws parallels with the asset quality review conducted for banks by the then Financial Services Authority (the PRA's predecessor) in the aftermath of the financial crisis. That review resulted in a slew of new regulatory requirements for the sector.

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