Introduction
7.1 In this section I consider the effect of the implementation of the Scheme on the PRIL policies. As described in Section 5, the PRIL business consists of non-profit pension annuities and the reinsurance of annuity business and comprises:
Immediate and deferred bulk annuities written by PRIL;
Immediate individual annuities written by PRIL;
Immediate annuity business reinsured into PRIL from PAC and PPL; and
Immediate annuity business reinsured into PRIL from UK insurance companies outside the Prudential Group.
7.2 Under the proposed Scheme, the entire business of PRIL will be transferred into PAC and will become part of the PAC shareholder-backed business so that the policies issued by PRIL will become direct policies of PAC.
Therefore, the key points to consider are:
The financial strength available to provide security for the benefits under the PRIL policies after the implementation of the Scheme compared to that currently available;
Any change to the profile of risks to which the PRIL policies will be exposed as a result of being transferred from a subsidiary of PAC to become part of PAC’s shareholder-backed business;
Any effect of the implementation of the Scheme on the benefit expectations of the PRIL policyholders, including the service standards, management and governance these policyholders should expect after the implementation of the Scheme; and
The effect of the implementation of the Scheme on those policies currently reinsured into PRIL.
7.3 These are considered in turn below.
The financial strength available to provide security of benefits
7.4 The PRIL-PAC QS agreement and other reinsurance arrangements are described in Section 4.
7.5 While PRIL currently has outwards reinsurance agreements in place with PAC, Hannover Re, SCOR, Swiss Re, and Pacific Life Re, PRIL remains responsible for paying the benefits under the policies when they are due. PRIL will, under the various reinsurance agreements, subsequently claim an appropriate amount from the relevant reinsurer.
7.6 Security for the benefits payable under the transferring PRIL policies is currently provided in the following ways:
a. PRIL’s own assets:
i. The assets in PRIL held under the “deposit back” arrangement. These assets are the first call to pay the benefits of the PRIL policies so security principally depends on the amount of assets held under the deposit back arrangement and therefore on the basis, and levels of conservatism within the basis, used for the calculation of this amount. Under the terms of the PRIL-PAC QS agreement the amount of these assets is adjusted quarterly as described in Section 4.
ii. Other assets in PRIL. Ultimate responsibility for the payment of benefits under the PRIL policies rests with PRIL, so if the “deposit back” assets are exhausted, the other assets in PRIL could be used to pay claims.
b. Assets in PAC:
i. To the extent that the deposit back amount is not sufficient to cover the liabilities of the PRIL policies, PRIL can claim under the PRIL-PAC QS agreement for PAC to inject assets sufficient to cover the shortfall.
ii. In the extreme scenario where PAC did not have sufficient assets to meet its liabilities, the ring-fenced fund structure within PAC would break down. In this scenario 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 in respect of the assets previously attributed to the PAC LT SH business.
iii. If the assets backing the PAC LT SH business were insufficient, PRIL would also be entitled to claim (as a general creditor of PAC) in respect of other assets of PAC. These assets include surplus assets held in respect of the PAC general insurance business and those in the inherited estates of the PAC WPSF and the SAIF. PRIL’s claim in respect of these assets would not be in priority to other creditors and would rank behind the claims of the direct policyholders of PAC.
c. The reinsurance agreements with companies outside the Prudential Group
Under these agreements, the reinsurers must reimburse PRIL for certain proportions of the benefit payments in respect of the PRIL policies covered by the relevant agreement.
7.7 The security provided by PAC for the benefits payable under the PRIL policies (bullet b above) would be reduced by the existence of the “walk-away option” in favour of PAC. However, as described in Section 4, in practice the circumstances when the “walk-away” option could be used are extremely remote whether the coverage percentage under the PRIL-PAC QS agreement is 100% or 20%.
7.8 In addition, the CSA in place between PAC and PRIL commits PAC to providing a defined amount of capital support to PRIL until 31 December 2017 (with an automatic one year extension if the Scheme is not implemented), which would constrain PAC’s ability to walk away from PRIL until after this date even in the absence of the PRIL-PAC QS agreement.
7.9 Following the implementation of the Scheme, PRIL policyholders will rank equally with all existing PAC policyholders in respect of all of the assets in PAC in an insolvency situation and therefore PAC will have a legal obligation to meet 100% of the liabilities in respect of the transferring business and will no longer have the option to walk away.
7.10 In the following paragraphs of this section, I consider the relative financial strength available to provide support for the transferring PRIL policies on a Solvency II basis before and after the implementation of the Scheme as at 30 June 2015. This is followed by a sub-section covering the effect on the previous Pillar I regime, and a sub-section on the protection afforded the transferring policyholders by the SRA and capital policies that apply to PRIL and PAC.
The effect of the Scheme on a Solvency II basis
7.11 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 I and show that:
Prior to the implementation of the Scheme:
o The capital resources (including the assets that have been deposited back under the quota share treaty) of PRIL covered its SCR with a ratio of 332%, with excess capital (after capital requirements) of £0.9 billion. These figures are presented taking account of the expected payment of a dividend from PRIL to PAC that is expected to take place in the third quarter of 2016 (in respect of the increase in the QS percentage to 100%) and the repayment of the contingent loan by PRIL (which took place on 24 March 2016); and
o The capital resources of PAC’s shareholder-backed business covered its SCR with a ratio of 152%, with excess capital (after capital requirements and allowing for the impact of the transitional measures) of £3.4 billion.
If the Scheme had been implemented on 30 June 2015, the capital resources of PAC’s shareholder-backed business would have covered its SCR with a ratio of 152%, with excess capital (after capital requirements and allowing for the impact of the transitional measures) of £3.4 billion.
7.12 After the implementation of the proposed Scheme, the assets of PRIL will have been transferred into PAC’s shareholder-backed business (except for those assets required to meet PRIL’s residual regulatory requirements and any extra assets specified by the Board which will be held back temporarily until PRIL is de-authorised).
Security for the transferring PRIL policies will be derived from all of the assets of PAC including the assets transferred from PRIL, the assets attributed to PAC’s shareholder-backed business and the reinsurance contracts with the various reinsurers. The existing PAC LT SH business and PAC general insurance business will also be deriving support from these assets.
7.13 As stated above, based on the financial information as at 30 June 2015, the coverage of the Solvency II SCR in PRIL is currently 332% and this coverage percentage is projected to be 152% in the PAC shareholder-backed business after the Scheme is implemented.
7.14 The assets deposited back with PRIL under the PRIL-PAC QS agreement are currently used to pay the guaranteed benefits of the PRIL policies. In a scenario in which losses on assets or liabilities emerge or increase elsewhere in PAC’s business, the deposited back assets could not be accessed to cover those losses and liabilities. This means that the PRIL policies currently enjoy “priority access” to the assets deposited back with PRIL and the deposit amount provides security to PRIL policies.
7.15 Following the implementation of the Scheme, the deposit amount will be transferred into PAC and will not be segregated to provide security for the transferring PRIL policies.
7.16 This projected decrease in the SCR coverage ratio and the loss of the priority access might, in isolation, be taken to imply an adverse impact on the security of the transferring PRIL policies. However, it should be noted that:
The SCR coverage ratios are indicators or proxies of financial strength and a significant decrease in the coverage ratio does not necessarily indicate a significant or material reduction in security. Although the financial strength of the PAC shareholder-backed business is projected to be lower after the implementation of the Scheme than that currently in PRIL, at 152% (based on 30 June 2015 financial information) the PAC shareholder-backed business remains strong and the probability of PAC being unable to pay the claims in respect of its shareholder-backed business is sufficiently remote for there to be no material change in the security of benefits under the transferring PRIL policies.
The financial information as at 30 June 2015 shows that the PAC shareholder-backed business is projected to have had a large amount of capital (£3.4 billion) available to provide support if the Scheme had been implemented on this date. This provides security to the PRIL policyholders following the implementation of the Scheme.
Although the level of capital (as at 30 June 2015) in PRIL is high at 332% of the SCR, this is significantly in excess of the regulatory requirements and the requirements set out by the Board in the SRA statement. There is no obligation for this level of capital to be maintained in PRIL and, in particular, if the Scheme were not to be implemented it would not be unreasonable for PAC (as the sole owner of PRIL) to transfer some of this excess capital out and reduce the level of excess capital in PRIL substantially.
As described in Section 4, PAC has a number of ring-fenced funds: the PAC WPSF, the DCPSF and the SAIF.
In the extreme scenario where although PAC as a whole was solvent, the assets of the PAC shareholder-backed business were insufficient to enable PAC to meet its liabilities on the PAC shareholder-shareholder-backed business as they fell due and all other lines of available capital support for the PAC shareholder-backed business had been exhausted, support could be provided by the ring-fenced funds and PAC would consider using the assets of the ring-fenced funds to meet the liabilities on the PAC shareholder-backed business. In particular it should be noted that the PAC WPSF and the SAIF have inherited estates. The tables in Appendices 1 and 2 show that the ring-fenced funds are not directly affected by the Scheme and also show that the with-profits business had a capital coverage ratio of 210% (based on 30 June 2015 financial information), so that (albeit in the extreme scenario) the with-profits business could offer substantial support to the PRIL policies after the implementation of the proposed Scheme.
7.17 I am satisfied that the reduction in the SCR coverage ratio and the loss of the priority access to the deposited back amount will not have a material adverse effect on the security of the benefits under the transferring PRIL policies.
The effect of the Scheme under the previous Solvency I regulatory regime
7.18 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.
7.19 This financial information shows that under Solvency I there is a similar picture to that under Solvency II: under both Pillar I and Pillar II the implementation of the Scheme would have led to a reduction in the capital coverage ratio for the transferring PRIL policies. For the same reasons as in respect of the Solvency II regime, I am satisfied that the implementation of the Scheme would not have a material adverse effect on the security of benefits under the transferring PRIL policies.
The PAC SRA and internal capital policy
7.20 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.
7.21 The PAC SRA will not change as a result of the implementation of the Scheme, and currently applies to the PAC shareholder-backed business, including the business reinsured into PAC from PRIL. Therefore, the transferring PRIL policyholders will be subject to the same risk appetite framework after the implementation of the Scheme and the implementation of the Scheme will have no impact on the security afforded to PRIL policyholders by the risk appetite framework to which their policies are subject.
7.22 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
7.23 PAC has provided me with results of sensitivities that it has carried out to estimate the impact of various changes in market conditions on its financial position under Solvency II Pillar 1. These sensitivities comprise:
20% fall in equity values;
40% fall in equity values;
50bps fall in interest rates;
100bps increase in interest rates; and
100bps increase in credit spreads.
7.24 The figures I have seen show that the PAC shareholder-backed business remains financially strong under all of the sensitivities listed above.
7.25 Since 30 June 2015 there have been some significant changes in the financial markets including: a decrease in fixed interest yields, a decrease in overall equity values, and an increase in credit spreads. In particular, since 30 June 2015, fixed interest yields have fallen by more than 50bps, i.e. by more than the interest rate sensitivity listed above. However, the sensitivity information provided indicates that if the interest rate sensitivity were to double to 100bps, the PAC shareholder-backed business would remain materially stronger than 100% SCR coverage.
7.26 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’s financial strength remains materially above 100% coverage of its SCR
From the point of view of the transferring PRIL policies, the changes in market conditions that affect PAC’s solvency position will affect the security of the PRIL business both before and after the implementation of the Scheme. Therefore, I am satisfied that the changes in market conditions will not affect the conclusions regarding the impact of the implementation of the proposed Scheme on the security of benefits of the PRIL policies.
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.
7.27 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 PRIL policies.
Conclusions regarding financial strength
7.28 Overall, the financial information on a Solvency II basis shows that the impact of the implementation of the Scheme on the overall financial strength available to support the PRIL business is small. I am satisfied that viewing the effect of the implementation of the Scheme through the previous Solvency I regime leads to a similar conclusion.
7.29 I am satisfied that the implementation of the proposed Scheme will not have a material adverse effect on the financial strength available to support the security of the guaranteed benefits under the PRIL policies.
7.30 I am satisfied that changes to market conditions would not cause a change to my conclusions in relation to the impact of the proposed Scheme on the financial strength available to support PRIL.
The QS reduction scenario
7.31 As described in t 4, I have considered the impact of the implementation of the Scheme on the PRIL policies in the scenario where the QS percentage reinsured is reduced to 20% - the “QS reduction scenario”.
7.32 In the QS reduction scenario, it is likely that PRIL would require capital support or an injection of capital from PAC.
As this is a hypothetical scenario it is not possible to know the form or level of such capital support nor what PRIL’s ultimate capital position would be in this scenario but it seems reasonable to assume that PAC would seek to capitalise PRIL to a level consistent with PAC’s SRA, and that at a minimum it would fulfil its obligations under the existing PAC/PRIL CSA, which would remain in place until 31 December 2018.
7.33 After the implementation of the Scheme in the QS reduction scenario, the PRIL policyholders will have access to PAC’s capital resources without the need for capital injections or other capital support from PAC under the terms of the CSA. As described above, PAC’s capital resources are considerable with £3.4 billion of assets in excess of its SCR and an SCR coverage ratio of 152%, based on 30 June 2015 financial information. Once in PAC the PRIL business would have the security afforded to PAC policyholders from the PAC SRA.
7.34 Given this is a hypothetical scenario it is not possible to compare the SCR coverage ratios before and after the implementation of the proposed Scheme but the reasons why any reduction in coverage ratios, and the loss of priority access to the deposited back assets, would not have a material adverse effect on the security of the guaranteed benefits under the PRIL policies are as set out above (paragraph 7.16).
7.35 I am therefore satisfied that, in the QS reduction scenario, the implementation of the proposed Scheme will not have a material adverse effect on the financial strength available to support the security of the guaranteed benefits under the PRIL policies.
The profile of risks to which the PRIL policies will be exposed if the Scheme is implemented
7.36 After the implementation of the Scheme, the PRIL policies will be part of the PAC shareholder-backed business and will be exposed directly to the risks of that business.
7.37 Alongside its non-profit annuity business PAC’s shareholder-backed business also contains a variety of non-profit unit-linked business, other non-profit, non-linked business, and general insurance business that is not found in
7.37 Alongside its non-profit annuity business PAC’s shareholder-backed business also contains a variety of non-profit unit-linked business, other non-profit, non-linked business, and general insurance business that is not found in