Introduction
8.1 In this section I consider the effect of the implementation of the Scheme on the PAC policies, which, as described in Section 4, can be divided into the following groups:
The policies of the PAC LT SH business;
The policies in the ring-fenced funds: the PAC WPSF, the DCPSF, and the SAIF;
The policies of the subsidiaries (other than PRIL) within the PAC shareholder-backed business; and
The PAC general insurance policies.
8.2 For each group of policies, I consider the likely effects of the implementation of the Scheme on the security of the guaranteed benefits and on the benefit expectations of the holders of those policies.
The PAC LT SH business
Introduction
8.3 Under the PRIL-PAC QS agreement, the PRIL long-term insurance business is currently 100% reinsured (net of other reinsurance arrangements) into PAC and, the effect of the pari passu charge granted to PRIL in connection with the reinsurance agreement is that PRIL would be treated as if it were a direct policyholder of the PAC LT SH business and would be entitled to claim in priority to other unsecured creditors and would rank equally with the existing direct policies of the PAC LT SH business in the event of PAC’s insolvency.
8.4 In this section I consider the effect of the implementation of the Scheme on the security of the guaranteed benefits and on the benefit expectations of the current policyholders with policies in the PAC LT SH business.
8.5 The key issues to consider are:
The financial strength available to provide security for the benefits under the PAC LT SH business after the implementation of the Scheme compared to that currently available to provide benefit security;
Any change to the profile of risks to which the PAC LT SH business will be exposed as a result of the implementation of the Scheme; and
Any effect of the implementation of the Scheme on the benefit expectations of the PAC LT SH business policyholders, including the service standards, management and governance these policyholders should expect after the implementation of the Scheme.
The financial strength available to provide security of benefits Solvency II
8.6 Currently, the security of the guaranteed benefits of the policies in the PAC LT SH business is provided by a combination of:
The assets backing the technical provisions held in respect of the guaranteed benefits of the PAC LT SH business;
The assets allocated to the PAC shareholder-backed business in excess of the technical provisions in respect of the PAC LT SH business and the PAC general insurance business;
Assets elsewhere in PAC; and
The reinsurance agreements with companies outside the Prudential Group.
8.7 After the implementation of the Scheme, the security of the guaranteed benefits of the policies of the PAC LT SH business will continue to be provided by these elements. In particular:
The implementation of the Scheme will have no effect on the technical provisions held in relation to the current PAC LT SH business.
The tables in Appendices 1 and 2 show the current financial strength of PAC and PRIL and the projected post-Scheme strength of PAC as at 30 June 2015 under Solvency II Pillar 1 and show that:
Prior to the implementation of the Scheme (as at 30 June 2015):
o The capital resources of the PAC shareholder-backed business (including the value of its subsidiary PRIL) covered its SCR with a ratio of 152%; and
o The excess capital (after capital requirements and allowing for the impact of the transitional measures) in the PAC shareholder-backed business was £3.4 billion.
If the Scheme had been implemented on 30 June 2015:
o The capital resources of the PAC shareholder-backed business would have covered its SCR with a ratio of 152%; and
o The excess capital (after capital requirements and allowing for the impact of the transitional measures) of the PAC shareholder-backed business would have been £3.4 billion.
8.8 The Solvency II financial information therefore shows that the implementation of the Scheme is not expected to affect the Solvency II position of PAC’s shareholder-backed business.
8.9 The implementation of the Scheme will have no effect on the reinsurance agreements with companies outside the Prudential Group.
8.10 The implementation of the Scheme will have no direct effect on the with-profits business of PAC nor on the potential support provided by the with-profits business in the extreme scenario where the resources of the PAC shareholder-backed business are insufficient to meet its liabilities.
The previous Solvency I regulatory regime
8.11 As set out in Section 3, I have also considered the effect of the implementation of the Scheme on the various groups of policies on the old (pre 1 January 2016) Solvency I regime based on financial information as at 31 December 2014.
8.12 Based on the Pillar I financial information, the implementation of the proposed Scheme would have resulted in an improvement to the financial strength supporting the policies of the PAC shareholder-backed business. However it should be noted that this improvement resulted from the reversal of a Pillar I restriction regarding the capital resources requirement required when business is wholly reinsured and so could be considered more a “quirk” of the previous reporting regime (that does not occur under the Solvency II regime) rather than a genuine improvement in financial strength.
8.13 The implementation of the Scheme would have had no impact on the Pillar II position of PAC’s shareholder-backed business.
The PAC SRA
8.14 The risk appetite framework that applies to PAC’s shareholder-backed business is described in Section 4 and is called the PAC SRA Framework. This framework requires PAC’s shareholder-backed business to be able to meet economic and regulatory capital requirements following a stress event
8.15 The implementation of the Scheme will have no impact on the terms of the PAC SRA Framework, and no impact on the level of solvency of the PAC shareholder-backed business relative to the PAC SRA. Therefore there will be no change to the level of protection afforded to PAC policyholders by the PAC SRA as a result of the implementation of the Scheme.
8.16 Following the introduction of Solvency II, the PAC SRA is being reviewed and the potential effect of this review for PRIL and PAC policyholders is covered in Section 9.
The impact of changes to economic conditions
8.17 As discussed in Section 7, PAC has provided me with results of sensitivities that it has carried out that estimate the impact of various changes in market conditions on its financial position under Solvency II as at 30 June 2015.
These sensitivities show that the PAC shareholder-backed business remains financially strong in all the scenarios considered.
8.18 Since 30 June 2015 there have been some significant changes in the financial markets including: a decrease in fixed interest yields, a decrease in general equity values, and an increase in credit spreads. In order to consider the impact of the changes in financial markets, PAC has provided me with Solvency II financial information as at 1 January 2016, 31 January 2016 and 29 February 2016. This information shows that, although PAC’s solvency position and its position relative to its SRA has weakened:
PAC remains materially financially stronger than 100% coverage of its SCR.
The financial position of PAC will be unaffected by the implementation of the Scheme, and therefore changes in PAC’s SCR coverage as a result of changes in market conditions would not change my conclusions on the effects of the implementation of the proposed Scheme on the PAC policyholders.
PAC’s business plans, which include a reduced, selective appetite for new annuity business, are expected to result in a material improvement to PAC’s coverage of its SCR in the future.
8.19 Therefore I am satisfied that the changes to economic conditions since 30 June 2015 will not affect the conclusions in relation to the impact of the implementation of the proposed Scheme on the security of benefits of the PAC policies.
The QS reduction scenario
8.20 As described in Section 4, I have considered the impact of the implementation of the Scheme on the PAC policies in the scenario where the QS percentage reinsured is reduced to 20% - the “QS reduction scenario”.
8.21 As set out in Section 4, the “walk-away option” has negligible value to PAC in the QS reduction scenario and as a result PAC is already exposed to the risks of the PRIL business. Hence I am satisfied that the implementation of the proposed Scheme will not, from the perspective of the PAC LT SH business, have a materially different impact than in the current situation where the PRIL-PAC QS percentage is 100%.
Conclusions regarding financial strength
8.22 I am satisfied that the implementation of the Scheme will not have a material adverse effect on the financial strength available to support the security of the benefits under the PAC LT SH business.
8.23 I am satisfied that this conclusion is unchanged by the changes to market conditions since 30 June 2015 and that this conclusion holds whether the Scheme is implemented in the current situation where the PRIL-PAC QS agreement coverage is 100%, or in the hypothetical QS reduction scenario where this percentage is 20%.
The profile of risks to which the PAC LT SH business is exposed
8.24 The key risk for the policyholders of the PAC LT SH business is that the implementation of the Scheme results in an increased risk to the security of their benefits due to an increased exposure to the risks associated with the long-term insurance business currently in PRIL.
8.25 The implementation of the Scheme transfers the direct responsibility for the PRIL policies, and for holding assets sufficient to cover the capital requirements of the PRIL business, from PRIL to PAC. This means that, in the event of a loss emerging on the PRIL business, assets allocated to the PAC shareholder-backed business will fund the loss.
8.26 As described in Section 4, prior to the implementation of the Scheme there is, in theory at least, the option available to PAC to walk-away from PRIL. However, as described in detail in Section 4:
The terms of the PRIL-PAC QS agreement limit the rights of PAC to terminate the reinsurance;
PRIL has a pari passu charge over the assets allocated to the PAC LT SH business; and
There is a CSA in place between PAC and PRIL that commits PAC to provide capital support to PRIL until 31 December 2017, whether or not the PRIL-PAC QS agreement is in place.
8.27 The combination of the 100% QS agreement and the CSA means that the walk-away option has a negligible value to the PAC LT SH business, which is already exposed, for all practical purposes, to the risks associated with the PRIL business.
8.28 As described in Section 4, in the unlikely QS reduction scenario the walk-away option also has a negligible value to PAC.
8.29 Following the implementation of the Scheme, PAC will have a legal obligation to meet 100% of the liabilities in respect of the transferring business and that commitment will rank pari passu with PAC’s obligations to its current direct policyholders. Therefore, there will no longer be a walk-away option.
8.30 I am satisfied that the value of the walk-away option is negligible and that the loss of it as a result of the Scheme would not have a material adverse effect on the policyholders of the PAC LT SH business.
8.31 The extent to which PAC policyholders will become exposed to new risks as a result of the implementation of the Scheme is relatively small. However, there will be some increase in PAC’s exposure to the risk of reinsurer default in relation to PRIL’s external reinsurance treaties with Hannover Re, SCOR, Swiss Re and Pacific Life Re.
However, PAC is already indirectly exposed to this risk through the PRIL-PAC QS agreement and the PRIL-PAC CSA, and there is therefore no material change to the risk profile of PAC policyholders.
8.32 I am satisfied that the implementation of the Scheme will not have a material adverse effect on the profile of risks to which the existing policyholders of the PAC LT SH business are exposed and that this conclusion holds whether the Scheme is implemented in the current situation where the PRIL-PAC QS agreement coverage is 100%, or in the hypothetical QS reduction scenario where this coverage percentage is reduced to 20%.
The benefit expectations of the PAC LT SH business
8.33 The policies of the PAC LT SH business are non-profit or unit-linked in nature and, as such, policyholders’
expectations in respect of their benefits are that:
They receive their contractual benefits as set out under the policy;
The policies are operated in accordance with their contractual terms; and
The administration, servicing, management, and governance of the policies are in line with the contractual terms under the policies and do not deteriorate as a result of the transfer.
8.34 The implementation of the Scheme will not have any effect on the contractual benefits under any of the policies of the PAC LT SH business, the administration and service standards applicable to the holders of policies in the PAC LT SH business, or to the management and governance of policies in the PAC LT SH business.
8.35 As discussed above, I am satisfied that the implementation of the Scheme will not have a material adverse effect on the security of the guaranteed benefits of the policies in the PAC LT SH business.
8.36 For these reasons I am satisfied that the implementation of the Scheme will not have a material adverse effect on the benefit expectations of the policyholders of the PAC LT SH business and that this conclusion holds whether the Scheme is implemented in the current situation where the PRIL-PAC QS agreement coverage is 100%, or in the hypothetical QS reduction scenario where this coverage percentage is reduced to 20%.
Conclusions for the PAC LT SH business
8.37 I am satisfied that both in the current situation where the QS percentage is 100% and in the hypothetical QS reduction scenario, the implementation of the Scheme will not have a material adverse effect on:
The security of benefits of the policyholders of the PAC LT SH business;
The benefit expectations of the policyholders of the PAC LT SH business; or
The service standards and governance applicable to the policyholders of the PAC LT SH business.
The policies of the PAC ring-fenced funds (the PAC WPSF, the DCPSF and the SAIF) Policies reinsured to PRIL
8.38 The PAC WPSF and the SAIF currently reinsure some non-profit annuity liabilities to PRIL and these are then reinsured on to PAC under the PRIL-PAC QS agreement.
8.39 The reinsurance arrangements (in respect of the PAC WPSF and the SAIF business) will terminate upon the implementation of the proposed Scheme and be replaced by intra-company arrangements between these two ring-fenced funds and the PAC shareholder-backed business (the PAC NPSF) set up to replicate the effects of the terminated arrangements. Hogan Lovells has reviewed the terms of the intra-company arrangements and is satisfied that they do replicate the terminated arrangements. For the reasons given in Section 3, I consider it is appropriate for me to rely on Hogan Lovells in this matter.
8.40 The current reinsurance agreements between PRIL and PAC include terms that entitle the parties to terminate the agreements on notice in a limited range of circumstances, for example, if PRIL went into liquidation, or there was a material breach by either party of its obligations. Since the agreements are contracts between two legal entities, they could in theory also be terminated at any time by mutual agreement between the companies.
8.41 In contrast, the intra-company arrangements will not be contracts in the strict legal sense, and the termination provisions that apply to the existing agreements will not be relevant to the intra-company arrangements. The new arrangements would therefore only terminate if PAC decided to unwind them.
8.42 However, in practice, given the regulated nature of PRIL and PAC's business and the potential for any change in the risk profile of each company to affect its policyholders, any proposal to terminate the intra-company arrangements would be subject to the same regulatory principles that would apply to a termination of the reinsurance arrangements, and in particular it can be expected that termination would only occur following notice to the PRA (this would be consistent with paragraph 2.4 of the Notifications part of the PRA Rulebook) and if the relevant actuarial functions, the With-Profits Committee and the WPA were each satisfied with the proposal.
8.43 Given that the PAC WPSF and SAIF annuity policies currently reinsured into PRIL will, after the transfer be reinsured into the PAC shareholder-backed business, my conclusions in relation to PRIL policyholders in Section 7 apply equally to those policyholders whose policies are reinsured into PRIL from the PAC WPSF and the SAIF.
Changes in the risks to which the policies of the PAC ring-fenced funds are exposed
8.44 Under the proposed Scheme, there will be no business transferred into or out of the WPSF, the DCPSF or the SAIF. Therefore the only other potential changes to the risk exposure of the with-profits funds that could arise as a result of the implementation of the Scheme are:
The possibility that there may be extra calls on the capital in the PAC shareholder-backed business due to the business being transferred into PAC under the Scheme, restricting the capital available to PAC’s with-profits funds; and/or
The possibility that the implementation of the Scheme will increase the contagion risk to the with-profits funds of PAC by increasing the probability of the claims-paying insolvency of PAC (at which point the ring-fencing of PAC’s with-profits business would break down).
8.45 As described in Section 4, both in the scenario where the PRIL-PAC QS agreement coverage remains at 100%, and the hypothetical QS reduction scenario where it is reduced to 20%, the value to PAC of the theoretical walk-away option is negligible and therefore PAC is, in effect, currently exposed to the risks from the PRIL policies, and the tables in Appendices 1 and 2 show that the implementation of the Scheme would not have a material adverse effect on the financial strength available to provide support to the PAC shareholder-backed business.
8.46 Therefore I am satisfied that the implementation of the Scheme will not have a material impact on the risk of extra calls on the capital of PAC or on the probability of PAC being unable to pay its claims. This conclusion holds both in the current situation where the QS percentage is 100% and in the hypothetical QS reduction scenario.
Derivative contracts currently backed by collateral held in the PAC WPSF and PRIL
8.47 Currently, any derivative contracts entered into on behalf of any of the PAC funds are collateralised using assets
terms of an inter-fund memorandum, if the PAC WPSF is required to post any collateral in respect of a derivative contract on behalf of one of the funds, it is immediately reimbursed by the relevant PAC fund.
terms of an inter-fund memorandum, if the PAC WPSF is required to post any collateral in respect of a derivative contract on behalf of one of the funds, it is immediately reimbursed by the relevant PAC fund.