The Part VII transfer of the business of Prudential Retirement Income Limited
to The Prudential Assurance Company Limited.
The report of the Independent Expert
Prepared by:
Oliver Gillespie, FIA
CONTENTS
1.
Introduction ... 4
The Independent Expert ... 4
The scope of my report ... 4
Qualifications and disclosures ... 5
The parties for whom the report has been prepared ... 5
Limitations ... 6
The Technical Actuarial Standards (“TAS”) ... 6
The Actuarial Profession Standards (“APS”) ... 6
The structure of my report ... 6
2.
The general considerations of the Independent Expert ... 7
The role of the Independent Expert ... 7
The security of policyholder benefits ... 8
Policyholders’ reasonable expectations and TCF ... 8
The conclusions of the Independent Expert ... 8
My Supplementary Report ... 8
3.
The UK life insurance market and regulatory environment ... 10
The UK regulators ... 10
The Solvency II regulatory regime ... 10
The matching adjustment ... 11
The transitional measures ... 11
Ring-fenced funds ... 12
The UK regulatory regime in force prior to Solvency II ... 12
The governance of UK long-term insurers ... 13
A firm’s risk appetite and internal capital policy ... 13
The products and long-term insurance business relevant to the proposed Scheme ... 14
The financial information in this report ... 14
Reliance on legal opinion ... 15
4.
Background on PAC ... 16
Introduction ... 16
PAC’s current fund structure ... 16
PAC’s business ... 16
PAC’s long-term insurance business: the with-profits business and the LT SH business ... 17
PAC’s general insurance business ... 19
Recent relevant events ... 19
The Capital Support Arrangement (“CSA”) ... 21
The Pension Mis-selling Costs Assurance and capital support agreement ... 22
The PAC Shareholder Risk Appetite (“SRA”) Framework ... 22
The management of PAC’s long-term insurance business ... 23
The Prudential UK & Europe Investment Committee (the “Investment Committee”) ... 23
The PAC Risk Function ... 23
5.
Background on PRIL ... 25
Introduction ... 25
The PRIL-PAC QS agreement ... 25
Other reinsurance agreements ... 25
The CSA ... 25
Loan arrangements ... 25
Bulk pension contracts ... 26
The administration and servicing of the PRIL policies ... 26
6.
The proposed Scheme ... 27
The motivation for the implementation of the Scheme ... 27
Summary of the implementation of the proposed Scheme ... 27
The structure after the implementation of the proposed Scheme ... 29
7.
The effect of the implementation of the Scheme on the PRIL policies ... 30
Introduction ... 30
The financial strength available to provide security of benefits ... 30
The profile of risks to which the PRIL policies will be exposed if the Scheme is implemented ... 34
The governance and management of the PRIL policies ... 35
The benefit expectations of the PRIL policyholders ... 36
The effect of the proposed Scheme on the policies currently reinsured into PRIL ... 36
The effect of the proposed Scheme on the bulk purchase annuity (“BPA”) policies ... 37
Conclusions for the PRIL policies ... 38
The reinsurance agreements with companies outside the Prudential Group ... 38
8.
The effect of the implementation of the Scheme on the PAC policies ... 39
Introduction ... 39
The PAC LT SH business ... 39
The policies of the PAC ring-fenced funds (the PAC WPSF, the DCPSF and the SAIF) ... 43
The policies of the subsidiaries (other than PRIL) of the PAC shareholder-backed business ... 45
The PAC general insurance policies ... 46
9.
Other considerations arising from the Scheme ... 47
The approach to communication with policyholders ... 47
Developments for PRIL and PAC since 30 June 2015 ... 47
Project Atlas ... 48
The future operation of the Scheme ... 48
The effect of the proposed Scheme on previous schemes ... 49
Solvency II requirements ... 49
Solvency II approvals ... 49
The ORSA ... 50
The transition of the SRA Framework to Solvency II ... 50
The CSAs ... 51
Quality of capital ... 51
The non-implementation of the Scheme ... 51
The reinsurance where PAC or PRIL is the cedant ... 51
Tax ... 52
The costs of the Scheme ... 52
Policyholders’ rights under the FSCS and FOS ... 52
10.
Conclusions ... 53
Appendix 1 – Selected financial information before the implementation of the Scheme ... 54
Appendix 2 – Selected financial information after the implementation of the Scheme ... 55
Appendix 3 – Data relied upon ... 56
1.
INTRODUCTION
The Independent Expert1.1 When an application is made to the High Court of Justice of England and Wales (the “Court”) for an order to sanction the transfer of long-term insurance or reinsurance business from one insurer to another, the application is subject to Part VII of the Financial Services and Markets Act 2000 (“FSMA”) and approval by the Court under Section 111 of FSMA. FSMA requires the application to be accompanied by a report on the terms of the Scheme by an Independent Expert.
1.2 I have been appointed by The Prudential Assurance Company Limited (“PAC”) and Prudential Retirement Income Limited (“PRIL”) to report, pursuant to Section 109 of FSMA, in the capacity of the Independent Expert, on the terms of the proposed scheme providing for the transfer of the entire business of PRIL to PAC.
1.3 As with the other costs of the Scheme, and as set out in Section 6, my fees will be borne by the surplus in PRIL and by PAC’s shareholder-backed business.
1.4 The purpose of this report is to review the proposed transfer of the business of PRIL to PAC and, in particular, to consider the impact of the proposed transfer on the security of the benefits and the benefit expectations of the existing policyholders of PRIL and PAC.
1.5 In this report (“my report”) I refer to this proposed scheme as “the Scheme” or “this Scheme” and throughout the remainder of this report, these terms are used to cover all the proposals included in the scheme of transfer, including any documents referred to therein relating to the proposed implementation and operation of the scheme of transfer.
1.6 The Scheme will be presented to the Court for sanction under Section 111 of FSMA.
The scope of my report
1.7 My terms of reference have been reviewed by the Financial Conduct Authority (“FCA”) and the Prudential Regulation Authority (“PRA”).
1.8 My report has been prepared under the terms of the guidance set out in the PRA’s Statement of Policy, “The Prudential Regulation Authority’s approach to insurance business transfers” (the “PRA Statement of Policy”), and Chapter 18 of the Supervision Manual (“SUP 18”) contained in the FCA Handbook.
1.9 My report considers the consequences of the Scheme for those policyholders likely to be affected by the implementation of the Scheme: the policyholders of PAC and PRIL.
1.10 I understand that similar schemes are to be presented to:
The Royal Court of Jersey to transfer the long-term insurance business carried on by PRIL in or from within Jersey to PAC; and
The Royal Court of Guernsey with respect to any policies of long-term insurance business of PRIL issued to residents of Guernsey.
and that this report will be presented to the Royal Court of Jersey and the Royal Court of Guernsey, respectively, to satisfy the requirement for a report by an Independent Expert on the terms of those schemes.
1.11 I confirm that the comments and conclusions in this report apply to all policyholders of PRIL and PAC (including PAC’s general insurance policyholders) irrespective of their place of residence and/or the jurisdiction within which the business is said to be carried on or in which their policy was issued. References to “the Scheme” or “this Scheme” should be taken to include the local schemes in Jersey and Guernsey.
1.12 My report will be presented to the Court and will be made available to policyholders via the Prudential website (www.pru.co.uk/prilpartvii) and a summary of my report will be included in the communications pack that is sent to
policyholders.
1.13 In assessing the impact of the implementation of the Scheme on the policyholders of PAC and PRIL, and whether those policyholders are being treated fairly as a result of the implementation of the Scheme, I have had regard to:
The likely effect of the implementation of the Scheme on the security of policyholder benefits and on the benefit and other expectations of policyholders created by past practices employed, or statements made, by each company;
The Principles and Practices of Financial Management (“PPFM”) of PAC; The report of the Chief Actuary of PAC and PRIL; and
The report of the With-Profits Actuary (“WPA”) of PAC.
1.14 There are no documents or other information that I have requested and that have not been provided. Appendix 3 contains a list of the data upon which I have relied.
1.15 As far as I am aware, there are no matters that I have not taken into account in undertaking my assessment of the Scheme and in preparing my report, but that nonetheless should be drawn to the attention of policyholders in their consideration of the terms of the Scheme.
1.16 I have only considered the terms of the Scheme presented to me and I am not required to consider possible alternative schemes.
Qualifications and disclosures
1.17 I am a Fellow of the Institute and Faculty of Actuaries, having qualified in 1999, and hold certificates issued by the Institute and Faculty of Actuaries in respect of practising as a life actuary for non-profit, unit-linked and with-profits business.
1.18 I am a partner of Milliman LLP (“Milliman”) and I am based in its UK Life Insurance and Financial Services practice. I am an approved person on the Financial Services Register and I currently hold a number of Chief Actuary roles. I have fulfilled the role of Independent Expert in relation to a number of Part VII transfers that have subsequently been approved by the Court.
1.19 My appointment as the Independent Expert was approved by the PRA (after consulting with the FCA) in a letter dated 25 July 2014 to PAC and reconfirmed in a subsequent letter on 3 November 2015.
1.20 I submitted a statement of independence to the PRA and FCA for review before my approval and this statement of independence has been approved by the PRA and FCA. I confirm that neither I nor Milliman LLP have or have had any direct or indirect interest in either PRIL or PAC or other related firms that could influence my independence.
The parties for whom the report has been prepared
1.21 This report, and any extract or summary thereof has been prepared particularly for the use of: The Court;
The Royal Court of Guernsey; The Royal Court of Jersey;
The Directors and senior management of PAC; The Directors and senior management of PRIL;
The FCA and the PRA, and any governmental department or agency having responsibility for the regulation of insurance companies in the UK;
The insurance regulator of any EEA country who requests a copy of the report; The Guernsey Financial Services Commission;
The Jersey Financial Services Commission; and The professional advisers of any of the above.
1.22 In accordance with the legal requirements under FSMA, copies of my report may be made available to the policyholders of PAC and PRIL and to other interested parties.
Limitations
1.23 In preparing my report, I have had access to certain documentary evidence provided by PAC and PRIL, the key elements of which are listed in Appendix 3. I have also had access to, and discussions with, senior management of PAC and PRIL. My conclusions depend on the substantial accuracy of this information without independent verification. I have considered, and am satisfied with, the reasonableness of this information based upon my own experience across the industry.
1.24 This report must be considered in its entirety as individual sections, if considered in isolation, may be misleading. Draft versions of this report should not be relied upon for any purpose. I have provided a summary of my report for inclusion in the policyholder information booklet (and, where relevant, distribution to any persons requesting a copy of it) and, other than this, no summary of my report may be made without my express consent.
1.25 This report has been prepared on an agreed basis for PAC and PRIL in the context of the Scheme and must not be relied upon for any other purpose. No liability will be accepted by Milliman, or me, for any application of my report to a purpose for which it was not intended, nor for the results of any misunderstanding by any user of any aspect of the report. In particular, no liability will be accepted by Milliman or me under the terms of the Contracts (Rights of Third Parties) Act 1999.
The Technical Actuarial Standards (“TAS”)
1.26 My report has been prepared subject to the terms of the TAS applicable to Transformations (“Transformations TAS”) issued by the Financial Reporting Council. In my opinion, my report complies with the Transformations TAS and is compliant with those elements of the TASs on Data, Modelling, Reporting and Insurance that are applicable to transformations. In complying with these requirements, I note that a number of the key documents listed in Appendix 3 have been prepared or reviewed by individuals who were subject to professional standards in undertaking their work, including, where appropriate, TAS requirements.
The Actuarial Profession Standards (“APS”)
1.27 In accordance with the APS issued by the Actuarial Profession, APS X2 requires members to consider whether their work requires an independent peer review.
1.28 In my view this report does require independent peer review and this has been carried out by a senior actuary in Milliman LLP who has not been part of my team working on this assignment.
The structure of my report
1.29 Section 2 of this report covers the considerations of the Independent Expert for a Part VII transfer in the UK and Section 3 gives background information on the regulatory regime in the UK.
1.30 Sections 4 and 5 of this report provide background to PAC and PRIL, and Section 6 provides a summary of the Scheme and summarises the key aspects of the Scheme.
1.31 The effects of the implementation of the Scheme on the policies of PRIL and PAC and on the holders of these policies are covered in Sections 7, 8 and 9, and Section 10 contains my conclusions on the Scheme.
1.32 The appendices contain financial information relevant to the companies involved in the Scheme and some relevant background information.
2.
THE GENERAL CONSIDERATIONS OF THE INDEPENDENT EXPERT
The role of the Independent Expert2.1 I have compiled my report in accordance with the PRA Statement of Policy (paragraphs 2.27 to 2.40) and with paragraphs 31 to 41 of section 2 of SUP 18, which give guidance on the form of the Scheme Report.
2.2 In considering the proposed Scheme, the concept of treating customers fairly (“TCF”) should be applied. To ensure that customers are treated fairly in the future, it is necessary to establish the ways in which customers have been treated in the past. From the policyholders’ perspective, the successful implementation of the Scheme must be on the basis that their benefits and fair treatment are not materially adversely affected.
2.3 As described in Section 1 of this report, the Scheme concerns two life insurance companies: PRIL and PAC where PRIL is a wholly owned subsidiary of PAC. I need to consider the terms of the Scheme generally and how the different groups of policyholders of PRIL and PAC and the different generations of policyholders within the different groups are likely to be affected by the implementation of the proposed Scheme. In particular I need to consider: The effect of the implementation of the Scheme on the security of the policyholders’ contractual rights,
including the likelihood and potential effects of the insolvency of the insurer;
The effect of the implementation of the Scheme on the reasonable benefit expectations of policyholders; and The effect of the implementation of the Scheme on the service standards and governance applicable to
policyholders.
2.4 I am only required to comment on the effects of the implementation of the proposed Scheme on policyholders who enter into contracts with PRIL and PAC prior to the Effective Date of the Scheme.
2.5 Policyholders for this purpose includes persons with certain rights, including contingent rights, under PRIL and PAC’s policies. For the purpose of this analysis I have also taken the members of pension schemes which have taken out policies with PRIL or PAC to be policyholders.
2.6 In this report I have not restricted my assessment of the Scheme to adverse effects.
2.7 As described in Section 1, two life companies are involved in the Scheme, each with a different mix of policies and policyholders.
2.8 The type of policy held by a policyholder will be a key determinant of the risks to which the policyholder is exposed. Other than this, the key determinants of the policyholder’s risk exposure will be the characteristics of the company in which the policy is held, for example:
The size of the company;
The amount and quality of capital resources available, other calls on those capital resources and capital support currently available to the company;
The internal capital policy of the company; The investment strategy of the company; The mix of business of the company;
The company’s strategy, and governance around its objectives and strategy: for example, its acquisition and new business strategy; and
Other factors, such as operational risks faced by the company, reinsurance arrangements of the company, the company’s governance framework and its tax position.
2.9 Some of these risks are company-specific, for example risks arising from the particular mix of business written or from the company’s strategy, and some are common to various different groups of policyholders across the companies subject to the Scheme.
The security of policyholder benefits
2.10 As part of my role as Independent Expert for the Scheme, I need to consider the security of policyholder benefits, that is, the effect of the implementation of the Scheme on the likelihood that policyholders will receive their guaranteed benefits when these are due.
2.11 In considering and commenting upon policyholder security, I shall primarily consider policyholders’ guaranteed benefits and, as appropriate, their reasonable benefit expectations. The amount by which the assets available to support the long-term insurance business exceed the long-term liabilities provides security for the guaranteed benefits. Security is also provided by other capital resources in the insurance company.
Policyholders’ reasonable expectations and TCF
2.12 As Independent Expert, I also need to consider the proposals in the context of the FCA’s TCF regime and, in particular, the effect of the implementation of the Scheme on policyholders’ reasonable benefit expectations. 2.13 This involves considering the effect of the implementation of the Scheme on areas where discretion is involved on
behalf of the relevant insurance company with regard to the charges applied to a policy and the benefits (including with-profits bonuses) granted to the policyholder, to confirm that the implementation of the Scheme will not have a material adverse impact on policyholders’ reasonable expectations in respect of their policy benefits.
2.14 In addition, I need to consider the effect of the implementation of the Scheme on the management, service and governance standards of the company in question to ensure that policyholders’ reasonable expectations in relation to these areas are not materially adversely affected.
The conclusions of the Independent Expert
2.15 As Independent Expert, my assessment of the impact of the implementation of the Scheme on the various affected policies is ultimately a matter of actuarial judgement regarding the likelihood and impact of future possible events. Given the inherent uncertainty of the outcome of such future events and that the effects may differ across different groups of policies, it is not possible to be certain of their effect on the policies.
2.16 In order to acknowledge this inherent uncertainty, the conclusions of the Independent Expert in relation to transfers of long-term insurance business are usually framed using a materiality threshold. If the potential impact under consideration is very unlikely to happen and does not have a significant impact, or is likely to happen but has a very small impact, then it is not considered to have a material effect on the policies.
2.17 The setting of my conclusions in this framework is a consequence of the Court’s consideration of prior schemes. In particular, principles stated by Evans-Lombe J. in Re Axa Equity & Law Life Assurance Society plc and AXA Sun Life plc (2001) (based on principles outlined by Hoffman J. in Re London Life Association Ltd (1989)) are often used as the basis for the consideration of insurance business transfers by the Independent Expert and by the Court.
2.18 In particular, Evans-Lombe J. stated in Re AXA Equity & Law that “the court is concerned whether a policyholder, employee or other interested person or any group of them will be adversely affected by the scheme”. He went on to state: “That individual policyholders or groups of policyholders may be adversely affected does not mean that the scheme has to be rejected by the court. The fundamental question is whether the scheme as a whole is fair as between the interests of the different classes of persons affected”. The most common interpretation of these (and other relevant) statements has been that a conclusion that “no group of policyholders is materially adversely affected by the Scheme” provides a sufficient condition to conclude that the fairness of the Scheme as a whole has been demonstrated.
2.19 This is therefore the framework in which I undertake my consideration of the proposed Scheme.
My Supplementary Report
2.20 I will prepare a further report (the “Supplementary Report”) prior to the final Court Hearing to provide an update for the Court on my conclusions in respect of the effect of the proposed transfer on the different groups of policyholders in light of any significant events subsequent to the date of the finalisation of my main report.
2.21 My Supplementary Report will include analysis of the effects of the proposed Scheme based upon the Solvency II financial results as at 1 January 2016.
3.
THE UK LIFE INSURANCE MARKET AND REGULATORY ENVIRONMENT
The UK regulators3.1 Prior to 1 April 2013, regulation of insurance companies was the responsibility of the Financial Services Authority (“FSA”). Since 1 April 2013, responsibility for the regulation of such companies has been split between the PRA and the FCA.
3.2 The PRA is a subsidiary of the Bank of England, and carries out the prudential regulation and supervision of banks, building societies, credit unions, insurers and major investment firms.
3.3 The FCA regulates the conduct of all financial services firms in relation to consumer protection, industry stability and the promotion of healthy competition between providers.
3.4 The PRA has statutory objectives to promote the safety and soundness of the insurers that it regulates, and to contribute to ensuring that policyholders are appropriately protected. More generally, these statutory objectives can be advanced by seeking to ensure that regulated insurers have resilience against failure and that disruption to the stability of the UK financial system from regulated insurers is minimised.
The Solvency II regulatory regime Introduction
3.5 A new regulatory solvency framework for the European Economic Area (“EEA”) insurance and reinsurance industry came into effect on 1 January 2016. This new regime is known as Solvency II and aims to introduce solvency requirements that better reflect the risks that insurers and reinsurers actually face and to introduce consistency across the EEA. All but the smallest EEA insurance companies are required to adhere to a set of new, risk-based capital requirements and the results will be shared with the public.
3.6 Solvency II is based on three pillars:
Under Pillar 1, quantitative requirements define a market consistent1 framework for valuing the company’s assets and liabilities, the results of which will be publicly disclosed.
Under Pillar 2, insurers must meet minimum standards for their corporate governance and their risk and capital management. There is a requirement for permanent internal audit and actuarial functions. Insurers must regularly undertake a forward looking assessment of risks, solvency needs and adequacy of capital resources, called the Own Risk and Solvency Assessment (“ORSA”), and senior management must demonstrate that the ORSA actively informs business planning, management actions and risk mitigation. Under Pillar 3, there are explicit requirements governing disclosures to supervisors and policyholders. Firms
will produce private reports to supervisors and a public solvency and financial condition report.
The Pillar 1 requirements
3.7 The determination of a market consistent value of liabilities under Solvency II requires the insurer to calculate the best estimate liabilities (“BEL”). The expected future obligations of the insurer are projected over the lifetime of the contracts using the most up-to-date financial information and the best estimate actuarial assumptions, and the BEL represents the present value of these projected cash-flows.
3.8 Under Solvency II, a company’s Pillar 1 liabilities are called the “technical provisions” which consist of the sum of the BEL and the “risk margin”. The risk margin is an adjustment designed to bring the technical provisions up to the amount that another insurance or reinsurance undertaking would be expected to require in order to take over and meet the insurance obligations in an arm’s length transaction.
3.9 The Pillar 1 assets are, broadly speaking, held at market value.
1
A market-consistent framework requires the values placed on assets and liabilities to be consistent with the market prices of
listed securities and traded derivative instruments.3.10 The Solvency Capital Requirement (“SCR”) under Solvency II is the capital requirement under Pillar 1, and is intended to be the amount required to ensure that the firm’s assets continue to exceed its technical provisions over a one year time frame with a probability of 99.5%.
3.11 The Minimum Capital Requirement (“MCR”), which is lower than the SCR, defines the point of intensive regulatory intervention. The MCR calculation is simpler, more formulaic and less risk-sensitive than the SCR calculation. 3.12 In calculating the SCR, it is expected that most firms will use the “standard formula”, as prescribed by the European
Insurance and Occupational Pensions Authority (“EIOPA”). However, Solvency II also permits firms to use their own internal models (or a combination of a “partial internal model” and the standard formula) to derive the SCR. These internal models and partial internal models are subject to approval by the relevant regulator: in the UK this is the PRA.
3.13 On 9 March 2015, “The Solvency 2 Regulations 2015” were laid before the UK Parliament. These regulations implement, in part, the Solvency II Directive (as amended by the subsequent Omnibus II Directive) into UK law and came into force on 1 January 2016.
3.14 The remainder of the Solvency II Directive has been implemented by the FSMA, by rules and binding requirements imposed by the PRA and the FCA, and by directly applicable regulations made by the European Commission. The PRA has issued final statements on the transposition of Solvency II, as amended by the Omnibus II Directive, into the UK national framework. These set out its approach to the prudential regulation, and its expectations, of firms subject to Solvency II.
3.15 EIOPA has published the implementing technical standards (“ITS”) and guidelines for the new regime and these have been endorsed by the European Commission and are legally binding and apply to all national regulators under the scope of Solvency II.
3.16 Any UK firms intending to use an internal model, transitional measures, a matching adjustment or a volatility adjustment must formally apply to the PRA for approval. Applications have been accepted by the PRA since 1 April 2015 and the PRA has issued a number of consultation papers and other communications which provide further clarity on the approval processes and set out the PRA’s expectations of firms.
3.17 The outcome of firms’ applications for measures to take effect from 1 January 2016 was communicated by the PRA in late 2015.
The matching adjustment
3.18 In calculating the BEL, the Solvency II rules permit firms to apply to their regulator to make use of the “matching adjustment”. The matching adjustment is an increase to the discount rate used in the calculation of the BEL that allows firms to take credit for the additional investment return they expect to earn from a “hold to maturity” investment strategy for their illiquid assets, which are used to back their most stable and predictable liabilities, typically non-profit in payment annuity liabilities.
3.19 Firms using the matching adjustment are subject to various restrictions around the types of asset that are permitted to back the relevant liabilities, the circumstances in which the assets may be traded, and the extent to which mismatching of asset and liability cash flows is permitted.
The transitional measures
3.20 Insurers are also permitted to apply to their regulator (the PRA in the UK) to make use of transitional measures. Transitional measures allow firms to phase in the balance sheet impact of moving from the former Solvency I regulatory regime to the Solvency II regulatory regime. The transitional measures can be applied in one of two ways:
The transitional measure on technical provisions allows firms to phase in the increase in technical provisions under Solvency II Pillar 1 (in relation to business written prior to 1 January 2016) over a sixteen year period. In the UK, the increase is measured relative to the firm’s Solvency I Pillar II liabilities.
The transitional measure on the risk-free interest rate allows firms to phase in any reduction in the discount rate used to calculate their liabilities under Solvency II relative to the current regime over a sixteen year period.
3.21 In the UK, it is expected that most life insurers will benefit from the transitional measures.
Ring-fenced funds
3.22 Solvency II includes the concept of a ring-fenced fund. This refers to any arrangement where an identified set of assets and liabilities are managed as though they were a separate undertaking, meaning that there are restrictions on the extent to which surplus in the ring-fenced fund may be transferred to shareholders or used to cover losses outside the ring-fenced fund.
3.23 In the UK, many firms have set up ring-fenced funds in order to reflect the arrangements applicable to their with-profits funds (as defined under the previous Pillar I and Pillar II regime) and the with-with-profits and non-profit business within the with-profits fund.
The UK regulatory regime in force prior to Solvency II
3.24 At the 2004 year end the FSA introduced a new risk based capital framework under which companies were required to assess solvency under two regimes, commonly referred to as Pillar I and Pillar II. I describe Pillar I and Pillar II briefly below.
Pillar I
3.25 Under Pillar I, assets were, broadly speaking, valued at market value and are subject to various admissibility criteria and limits.
3.26 Liabilities were known as mathematical reserves, and were generally calculated using prudent assumptions, although additional rules applied to firms with significant volumes of with-profits business.
3.27 The overall capital requirement under the Pillar I regime was called the Capital Resources Requirement (“CRR”). The CRR had a number of different components, many of which were calculated using formulae based on various balance sheet statistics, such as mathematical reserves, expense levels and sums insured. Although the CRR did contain some risk-based components, in contrast to the SCR it was not intended to be a fully risk-based measure. 3.28 Additional solvency and reporting requirements were imposed under Pillar I on firms that had significant volumes of with-profits business (commonly known as realistic reporting). PAC was subject to these additional requirements but PRIL was not.
Pillar II
3.29 Pillar II was intended to provide a more realistic and complete view of the risks to which the company was exposed. 3.30 The capital requirement under Pillar II was the Individual Capital Assessment (“ICA”), which was the company’s own assessment of its risk exposures and the amount and type of capital required to mitigate those risks. The PRA set the capital requirement as being consistent with a 99.5% confidence level that the firm would have been able to meet its liabilities over a one year timeframe or, if appropriate to the firm’s business, an equivalent lower confidence level over a longer timeframe.
3.31 The capital requirements so determined were aggregated, allowing for any diversification benefits deemed achievable between those risks. The company was not required to make public the results, or any other details, of its Pillar II exercise.
The long-term fund and shareholders’ fund
3.32 Prior to the implementation of Solvency II, proprietary firms writing long-term insurance business were required to identify the assets attributable to their long-term insurance business and keep those assets separate from shareholder funds in what was referred to as a long-term insurance fund (the “LTF”). The other assets of a proprietary company were typically allocated to the shareholders’ fund (the “SHF”). The assets in the LTF were only to be used to support the firm’s long-term insurance business and firms were required to maintain assets in the LTF sufficient in value to cover the fund’s mathematical reserves.
The governance of UK long-term insurers
3.34 The Board of Directors of a long-term insurer is normally the firm’s governing body, and is ultimately responsible for setting the strategic direction of the firm, overseeing the activities of the firm’s day-to-day management and approving the firm’s financial statements.
3.35 Under Solvency II, all insurers are required to establish an actuarial function, but it is not defined as being performed by an individual. The actuarial function is responsible for, amongst other things, coordinating the calculation of the technical provisions and expressing opinions on the firm’s underwriting policy and the adequacy of the firm’s reinsurance arrangements. The person having responsibility for the actuarial function under Solvency II is known in the UK as the Chief Actuary.
3.36 The PRA is introducing a new governance regime for UK insurers called the Senior Insurance Managers Regime (“SIMR”) which became effective on 7 March 2016, and which defines a set of senior insurance management functions (“SIMF”), including:
Chief Executive Officer (“CEO”); Chief Financial Officer (“CFO”); Chief Risk Officer (“CRO”); Chief Actuary;
Head of Internal Audit; and
Chief Underwriting Officer (general insurance firms only).
3.37 The individuals responsible for these functions will be subject to PRA approval, although there are grandfathering arrangements under which currently approved individuals may take up approved roles under SIMR.
3.38 In addition to the roles listed above, those firms with with-profits business must appoint an actuary (or actuaries) to perform the “with-profits actuary function”. This individual is the WPA, and his responsibilities include advising the firm’s management on the key aspects of the discretion to be exercised affecting those classes of the with-profits business of the firm in respect of which he has been appointed. The WPA role will continue to exist under SIMR and will be one of the SIMFs.
3.39 In relation to each with-profits fund, firms must appoint a with-profits committee (“WPC”) (or a “with-profits advisory arrangement” if appropriate given the size, nature and complexity of the fund in question). The WPC’s role is to advise and provide recommendations to the firm’s governing body on the management of the with-profits business, and to act as a means by which the interests of with-profits policyholders are appropriately considered within a firm’s governance structures.
A firm’s risk appetite and internal capital policy
3.40 The Board of a firm is responsible for the management of the company and for its exposure to risk. The Board will typically set out its appetite for risk in a form which references the probability that the Board is willing to accept of not being able to pay policyholder liabilities as they fall due and/or meet regulatory requirements.
3.41 In order to ensure that day-to-day fluctuations in markets and experience do not lead to a breach of their risk appetite and regulatory capital requirements firms usually aim to hold more capital than strictly required to meet the regulatory minimum. The details of the target level of capital buffer are typically set out in the firm’s internal capital policy.
3.42 The internal capital policy of a firm is owned by the Board and describes the capital that the Board has determined should be held in the company. Changes to the internal capital policy usually require Board approval and appropriate consultation with the regulators (the PRA).
3.43 The level of capital required may also be driven by the desire of the Board to maintain a certain credit rating with the rating agencies.
The products and long-term insurance business relevant to the proposed Scheme
3.44 The long-term insurance business that will be the subject of the transfer in the proposed Scheme comprises non-profit pension annuity business. The particular product types are described below.
Immediate individual annuity policies where the policyholder is receiving a regular income at a fixed level (a fixed or level annuity) or regular income with fixed increases or with increases in line with an index (an index linked annuity). These are also called annuities in payment.
Deferred group annuity contracts where the underlying policyholders are not yet receiving immediate annuities but will (if they maintain the contract) do so in the future.
Individual annuity policies where the policyholder is a former member of a pension scheme that has purchased a “buy-out” policy with PRIL.
Bulk purchase “buy-in” annuity contracts where the legal policyholder is the group of trustees of a particular UK pension scheme, although the members of the pension scheme also have an interest in the contract. 3.45 A buy-out is a transaction whereby an insurance company takes over legal responsibility for some or all of the
liabilities of an occupational pension scheme in return for a single premium. In this way the insurer takes on the investment risk2 and the longevity risk3 (as well as any inflation risk4) associated with the scheme’s liabilities. 3.46 Under a buy-out, the trustees and sponsor of the pension scheme no longer have any legal links or obligations
associated with the scheme (or that part of the scheme that is subject to the transaction), and the members of the scheme become policyholders of the insurer.
3.47 A buy-in is a transaction where an occupational pension scheme buys a bulk annuity contract from an insurance company that is designed to perfectly match some or all of the liabilities of the scheme. In common with a buy-out, the insurer takes on the investment risk and longevity risk (and any inflation risk) but, in contrast to a buy-out, the links of the liabilities with the sponsor and the trustees are maintained and the pensioners remain members of the scheme. The sponsor of the scheme retains ultimate responsibility for meeting the liabilities of the scheme in the event of the failure of the insurer to do so.
The financial information in this report
3.48 During 2015, the PRA has granted approval to:
PRIL to use the matching adjustment and its internal model for Solvency II reporting; and
PAC to use the matching adjustment, the transitional measure on technical provisions and the PAC internal model for Solvency II reporting.
3.49 Appendices 1 and 2 show pro-forma Solvency II balance sheets as at 30 June 2015 for PAC and PRIL which reflect:
The use of the matching adjustment;
The use of the transitional measure on technical provisions;
The use of the final and PRA approved version of the internal model methodology and assumptions;
The repayment by PRIL of the contingent loan (£49 million) from PAC – this occurred on 24 March 2016; and
2 Investment risk (in the context of the pension scheme) is the risk that the investments of the pension scheme perform worse than expected, resulting in a shortfall in the assets available to meet the liabilities of the scheme.
3 Longevity risk (in the context of the pension scheme) is the risk that the members of the scheme live longer than expected, resulting in higher than expected liability cash flows for the scheme.
4 Inflation risk (in the context of the pension scheme) is the risk that inflation is higher than expected, resulting in inflation-linked annuity benefit outgo being higher than expected.
The payment of a dividend from PRIL to PAC (expected in the third quarter of 2016).
3.50 The financial information used in the analysis of the effects of the proposed Scheme as set out in Sections 7, 8 and 9 is the Solvency II information shown in Appendices 1 and 2.
3.51 The old (pre 1 January 2016) Solvency I Pillar I regime was in force for over 10 years and Solvency I Pillar I financial information was made publicly available in insurance companies’ PRA returns so, although it is no longer in force, in my view it is the solvency regime most likely to be understood by policyholders. Therefore, I have considered the effect of the implementation of the Scheme on the various groups of policies under the Solvency I Pillar I regime and, in order to provide useful information and additional reassurance to policyholders, I have included, in Sections 7 and 8, a brief summary of my conclusions from this and confirmed whether these conclusions reinforce or contradict the conclusions formed by consideration of the Scheme under the Solvency II regime.
3.52 I have also considered the effect of the proposed Scheme on a Solvency I Pillar II basis and included a similar summary in respect of Solvency I Pillar II.
3.53 I have not carried out an independent review of the Solvency II results as at 30 June 2015 but I note that the Solvency results have been:
Reviewed by Prudential’s external auditors (“KPMG LLP”);
Approved by the Prudential plc Group Audit Committee for external disclosure at the Prudential plc investor conference; and
The pro-forma post-Scheme Solvency II numbers have been approved by the appropriate committee within PAC (the Financial Reporting Group).
3.54 I am satisfied it is appropriate to rely upon these Solvency II results for the purpose of this report.
3.55 My Supplementary Report will contain analysis of the effect of the proposed Scheme based upon Solvency II numbers as at 1 January 2016.
Reliance on legal opinion
3.56 There are a number of aspects of the proposed Scheme that are legal matters and outside of my expertise. For these areas, I have considered whether it is appropriate to take independent legal advice and I have decided that it is appropriate for me to rely on the advice provided to PAC and PRIL by Hogan Lovells International LLP (“Hogan Lovells”), the legal firm retained by PAC and PRIL in respect of this Scheme.
3.57 My reasons for this are:
Hogan Lovells is a large international legal firm with a wide range of experience in UK insurance law and Part VII transfers and it is my view that they have the relevant and appropriate qualifications and knowledge of the laws and regulations governing insurance business transfers in the UK.
The nature of the information and advice from Hogan Lovells upon which I have relied is factual and in particular concerns how a particular aspect of PAC or PRIL (pre or post the implementation of the proposed Scheme) works in accordance with UK law. As such, I am satisfied that the advice or information given by Hogan Lovells would not be different if they were retained directly by me in respect of the proposed Scheme. For the same reason, I consider it unlikely that I would receive a different answer from a different (but similarly
qualified) legal expert.
3.58 I am therefore comfortable that it is appropriate for me to rely on the conclusions of Hogan Lovells in forming my view on the Scheme.
4.
BACKGROUND ON PAC
Introduction4.1 PAC is a proprietary company, whose immediate parent company is Prudential plc, which is also the ultimate holding company of the Prudential Group.
4.2 PAC’s principal activity is long-term insurance business, although PAC also conducts some general insurance business.
PAC’s current fund structure
4.3 PAC currently has three ring-fenced funds as defined under Solvency II. These are: The PAC With-Profits Sub-Fund (the “PAC WPSF”);
The Defined Charge Participating Sub-Fund (the “DCPSF”); and The Scottish Amicable Insurance Fund (the “SAIF”).
4.4 Under Solvency II all assets not in a ring-fenced fund must be allocated to either the long-term insurance business or the general insurance business, and there is no required segregation of the long-term insurance business assets between an LTF and an SHF.
4.5 The business outside the ring-fenced funds is called the “PAC shareholder-backed business” as the working capital for such business has been provided by the PAC SHF. The PAC shareholder-backed business consists of: The PAC long-term shareholder-backed business (the “PAC LT SH business”);
The PAC short-term shareholder-backed business which is the “PAC general insurance business”; and All other assets and liabilities of PAC outside the PAC ring-fenced funds including the wholly owned
subsidiaries of PAC: PRIL;
Prudential Holborn Life Limited (“PHLL”); Prudential Hong Kong Limited (“PHKL”);
Prudential General Insurance Hong Kong Limited (“PG HKL”); Prudential Pensions Limited (“PPL”); and
Prudential International Assurance plc (“PIA”).
PAC’s business
4.6 PAC’s business can broadly be split into three parts: PAC’s with-profits business
The long-term insurance business of PAC’s ring-fenced with-profits funds (whether non-profit or with-profits in nature) is referred to in this report as PAC’s “with-profits business”.
PAC’s LT SH business
The PAC LT SH business is all non-profit business and includes the long-term insurance business reinsured in from PRIL under the PRIL-PAC quota share reinsurance agreement.
PAC’s general insurance business
PAC’s general insurance business is maintained separately from the PAC LT SH business but is part of the PAC shareholder-backed business. These policies were originally written in the PAC SHF.
PAC’s long-term insurance business: the with-profits business and the LT SH business
4.7 PAC’s long-term insurance business mainly comprises life and pensions business:
Industrial Branch (“IB”) and Ordinary Branch (“OB”) life and pensions conventional with-profits business and OB unitised with-profits (“UWP”) business;
Pensions non-profit business consisting primarily of pension annuities in-payment; and Life non-profit and linked business.
4.8 As well as the business written directly by PAC, and the business reinsured in from the other PAC subsidiaries, there have been a number of transfers of long-term insurance business into PAC:
Non-profit annuity business transferred in from Prudential Annuities Limited (“PAL”) on 1 October 2014. All of the long-term insurance business of PAL was transferred into the PAC WPSF;
Business transferred in from PHLL and from Prudential (AN) Limited (“PANL”) on 31 October 2010. All the non-profit and unit-linked business of PANL and PHLL was transferred to the PAC Non-Profit Sub-Fund (a sub-fund under the previous solvency regime) (the “PAC NPSF”). All of the with-profits business of PANL was transferred to the PAC WPSF.
With-profits annuity business transferred in from The Equitable Life Assurance Society (“ELAS”) on 31 December 2007 which was principally allocated to the DCPSF.
Business transferred in from Scottish Amicable Life plc (“SAL”) on 31 December 2002: the with-profits elements were allocated to the PAC WPSF and the rest was allocated to the PAC NPSF.
Business transferred in from Scottish Amicable Life Assurance Society (“SALAS”) on 30 September 1997 which was allocated principally to a newly created sub-fund, the SAIF.
4.9 PAC also has business written outside the UK. This consists of: Business written by branches of PAC in France, Malta and Poland;
Business reinsured into PAC, either from subsidiaries of PAC, or from other insurers outside the Prudential Group; and
Business written by branches of ELAS and transferred into PAC on 31 December 2007.
4.10 As described above, under Solvency II the long-term insurance business is divided into the ring-fenced funds (the PAC WPSF, the DCPSF and the SAIF) and the PAC LT SH business. The business written in each of these is described in turn below.
The PAC WPSF
4.11 This ring-fenced fund consists of a significant volume of with-profits business, comprising: Business written by PAC, both OB and IB;
Transferred business from SAL; and Transferred business from PANL.
4.13 The PAC WPSF also contains a significant volume of non-profit business. This consists of: Pension annuities transferred in from PAL on 1 October 2014 under the PAL Scheme;
Pension annuities in-payment arising from with-profits pension policies choosing to vest their annuities internally with PAC, that had previously been reinsured to PAL but that were recaptured by PAC on 31 August 2011;
Non-profit (including unit-linked) business written by PAC and not allocated to the PAC shareholder-backed business; and
Certain types of business originally written by SALAS, and now contained in the Scottish Amicable Account (“SAA”). These are non-profit life policies, unit-linked life policies and unitised with-profits life policies (other than the investment component, which was transferred into the SAIF).
4.14 The PAC WPSF contains the PAC inherited estate (called “surplus funds” in Solvency II regulations), which is the excess of the assets in the fund over those expected to be paid out over time to policyholders.
4.15 Up to 10% of the surplus arising in the PAC WPSF is attributable to PAC’s shareholders, and the remaining surplus arising within the fund is attributable to the with-profits policyholders (i.e. the PAC WPSF is a “90:10” fund). 4.16 The PAC WPSF is open to new business, and PAC aims to ensure that there is enough capital in the fund to
support new business sales without adversely affecting the existing with-profits business.
The DCPSF
4.17 This ring-fenced fund consists of two types of business:
The accumulated investment component of premiums paid on the Defined Charge Participating (“DCP”) business. This is calculated as the accumulation of premiums less explicit charges. This component is either reinsured into PAC from PIA or other companies, or written through PAC’s branch in France (between 1 January 2001 and 31 December 2003).
The with-profits annuities transferred from ELAS on 31 December 2007. For this business, charges are defined in the ELAS transfer scheme.
4.18 DCP business is a type of with-profits business on which policyholders only incur charges as specified in the policy or, where relevant, a scheme of transfer. These charges generally accrue to the PAC shareholder-backed business, which also bears any expenses (charges on the reinsured PIA business accrue to PIA). Hence the PAC shareholders receive the profit or loss arising from the expenses on this business.
4.19 The PAC WPSF inherited estate provides capital support for the DCPSF to meet regulatory solvency requirements and to support bonus and investment policy. The PAC WPSF inherited estate also provides a bonus smoothing account for this business, to meet smoothing costs as they arise. In return for this support, an annual capital support charge is payable from the PAC DCPSF to the PAC WPSF inherited estate.
4.20 An annual charge for guarantees is also payable from asset shares in the PAC DCPSF. For non-ELAS business, these charges accrue to the appropriate bonus smoothing accounts. For ELAS business, the charges are paid to the PAC WPSF in return for the PAC WPSF agreeing to meet any guaranteed benefit payments in excess of asset shares.
4.21 All of the profit from the PAC DCPSF is attributable to the PAC DCPSF policyholders (i.e. the PAC DCPSF is a “100:0” fund), and this profit arises solely from the investment performance.
The SAIF
4.22 This ring-fenced fund is closed to new business and contains most of the SALAS business: SALAS’s pensions and annuity business (with-profits and non-profit);
SALAS’s conventional with-profits life business; and The investment component of SALAS’s UWP life business.
4.23 The balance of SALAS’s business was transferred to the SAA, within the PAC WPSF. The with-profits investment component of the SAA policies is invested in the SAIF.
4.24 This fund also contains the SAIF inherited estate.
4.25 The PAC WPSF provides financial support to the SAIF in the form of the Scottish Amicable Capital Fund (“SACF”) in exchange for an annual charge. SACF remains in the PAC WPSF and does not form part of the SAIF inherited estate. However, SACF is treated as part of the free assets of the SAIF for the purpose of setting bonus and investment policies.
4.26 100% of the profit from the SAIF is attributable to the SAIF policyholders (i.e. the SAIF is a “100:0” fund) and the SAIF inherited estate is to be distributed to the SAIF and SAA with-profits policyholders over the lifetime of their policies.
The PAC LT SH business
4.27 The LT SH business consists of non-profit (including unit-linked) business and is open to new business. It includes business written in the UK and Poland, the accepted reinsurance business under the PRIL-PAC quota share reinsurance agreement (see below), and unit-linked business transferred from SAL, PAN and PHLL.
4.28 Certain DCP business is included. The investment content of this DCP business (i.e. the accumulated investment content of premiums paid) is held in the DCPSF but the balance of the charges and expenses of the DCP business accrues to the PAC shareholder-backed business.
4.29 The business sold through VitalityLife and its predecessor PruProtect is also included. PAC divested its stake in the joint venture with Discovery (which sold business through the PruHealth and PruProtect brands) in 2014. 4.30 There is a quota share reinsurance agreement in place with Hannover Rueck SE (“Hannover Re”) under which
Hannover Re reinsures some of the individual annuity business that was: Written by SAL before 2002 and transferred to PAC in 2002; or
Written by PAC between 2002 and 2007 arising from SAL pension policies transferred to PAC in 2002.
PAC’s general insurance business
4.31 PAC does not currently write or sell general insurance policies and does not have any current in-force general insurance policies apart from a small number (approximately 1,000) of claims in payment/under management. These policies currently form part of PAC’s shareholder-backed business.
Recent relevant events
The PAL Scheme
4.32 On 1 October 2014, the entire long-term insurance business of PAL was transferred by means of a Part VII transfer into the PAC WPSF. PAL was de-authorised on 10 March 2015 and the process of liquidating PAL began in November 2015 and should be completed by the end of March 2016.
The Hong Kong Scheme
4.33 A reorganisation of the business of PAC was approved by the High Court and by the Court of First Instance in the Hong Kong Special Administrative Region of the People’s Republic of China, and was implemented on 1 January 2014. Under this reorganisation, the long-term insurance business of PAC’s Hong Kong branch, including capital to support the writing of future new business in Hong Kong was transferred to PHKL, which is a wholly owned subsidiary of PAC domiciled in Hong Kong. In my report I will refer to this transfer as “the Hong Kong Scheme”. 4.34 As part of the Hong Kong Scheme, 10.5% (as at 1 January 2014) of both the non-profit annuity liabilities previously
reinsured from PAC to PAL and the non-profit annuities transferred into PAC under the PAL Scheme were reinsured on a quota share basis to PHKL. This enabled an appropriate part of the investment of the PAC WPSF inherited estate in this non-profit business to be transferred to PHKL.
4.35 The Hong Kong general insurance business of PAC, which was written in the PAC SHF was also transferred to a Hong Kong incorporated company (Prudential General Insurance Hong Kong Limited), a wholly owned subsidiary of the PAC SHF, on 1 January 2014.
The quota share reinsurance agreement with PRIL (the “PRIL-PAC QS agreement”)
4.36 Effective from 1 January 2016, PRIL currently reinsures 100% of its liabilities (net of other outwards reinsurance arrangements) to PAC on a quota share basis.
4.37 The premium payable to PAC under the PRIL-PAC QS agreement has been retained by PRIL under a "deposit back" arrangement. This arrangement reduces PRIL's credit risk exposure to PAC.
4.38 When the PRIL-PAC QS agreement was set up, the deposit back amount was set to be the quota share (currently 100%) of the Solvency I Pillar I liabilities. Following the introduction of Solvency II the definition of liabilities has been amended to be a fixed percentage of the Solvency II BEL. The percentage has been set at 1 January 2016 as the ratio of the Solvency I Pillar I liabilities as at 31 December 2015 to the Solvency II BEL at that date. Hence from now on, the deposit back amount will run-off in line with the Solvency II BEL.
4.39 Under the terms of the PRIL-PAC QS agreement the deposit back amount is adjusted quarterly. To the extent that the deposit back amount is not sufficient to cover the fixed percentage of the Solvency II BEL (multiplied by the quota share which is currently 100%), PAC must transfer assets to PRIL sufficient to cover the shortfall. Any surplus over the fixed percentage of the BEL is transferred to PAC.
4.40 As part of the reinsurance under the PRIL-PAC QS agreement, PRIL and PAC have granted each other the following security:
(a) PRIL has granted PAC a charge over the assets allocated to its long-term insurance business (including the deposit amount).
(b) PAC has granted PRIL a charge over the assets allocated to the PAC LT SH business.
4.41 The effect of the charges is that, in an insolvency situation, PRIL or PAC (as the case may be) would rank pari
passu with the holders of direct insurance policies issued by the other company. This addresses the fact that,
under the Insurers (Reorganisation and Winding-Up) Regulations 2004, as unsecured creditors each company's security interest would otherwise rank behind the holders of direct policies.
The permanence of the PRIL-PAC QS agreement
4.42 Prior to 1 January 2016, the PRIL-PAC QS agreement reinsurance percentage was 20% (having previously, until 31 December 2014 been 15%). The legal contract between PAC and PRIL was amended with effect from 1 January 2016 to reflect the increase in the quota share to 100%.
4.43 The terms of the PRIL-PAC QS agreement impose significant restrictions on the circumstances under which either party may terminate the reinsurance agreement. These circumstances include:
A material breach by PRIL that is not cured within 60 business days; PRIL losing its regulatory permission;
Performance of the agreement becoming unlawful; and A change in control of PRIL.
4.44 PAC is not entitled to terminate the reinsurance agreement as a result of either PRIL’s or its own insolvency. 4.45 Save for the specific circumstances set out in the PRIL-PAC QS agreement (including those outlined above), any
termination or reduction in the percentage reinsured of the PRIL-PAC QS agreement would require PRIL’s consent. It is unlikely that PRIL would consent to the termination of the agreement unless PRIL’s solvency position in the absence of the agreement were to improve to such a level that it could provide policyholder security at least equivalent to that achieved through the PRIL-PAC QS agreement.
4.46 Therefore, it is my view that it is very unlikely that the PRIL-PAC QS agreement would be terminated and that neither PRIL nor PAC would wish to terminate or reduce the quota share percentage from 100%.
4.47 The increase in the coverage under the PRIL-PAC QS agreement to 100% occurred only after an extensive and thorough process including a number of reports, meetings, and reviews by the PRA in order to secure the required non-objection from the PRA.
4.48 In order to change this reinsurance percentage again, I understand a similar process would be required to obtain non-objection from the PRA so any subsequent change to the PRIL-PAC QS agreement coverage would be subject to scrutiny from the PRA and due process including (but not limited to): reviews, actuarial and risk reports, and legal scrutiny.
The scenario where the PRIL-PAC QS agreement coverage is reduced – the “QS reduction scenario”
4.49 As set out above, circumstances in which the PRIL-PAC QS agreement would be terminated or the percentage reinsured reduced are very unlikely to arise as it is difficult to foresee realistic circumstances in which PRIL or PAC would want to terminate or reduce the QS coverage. However, the PRA has stated that it would review its non-objection to the PRIL-PAC QS agreement coverage being increased to 100% if the Part VII transfer were not completed in 2016, and so there is at least a theoretical possibility that the PRIL-PAC QS agreement coverage could be reduced back to 20%.
4.50 Therefore, for completeness, an analysis has been carried out of the impact of the implementation of the proposed Scheme on the PRIL policies starting from a position where the percentage reinsured under the PRIL-PAC QS agreement is reduced from 100% to 20%. This is referred to as the “QS reduction scenario”.
4.51 The PRA’s non-objection was in respect of the increase in the PRIL-PAC QS agreement percentage reinsured from 20% to 100% and therefore the withdrawal of this non-objection would see the percentage reinsured reduced to the pre-increase percentage of 20%. I do not consider the termination of the PRIL-PAC QS agreement to be a realistic possibility, principally because it is extremely unlikely that either PAC or PRIL would want this to happen, and I have not carried out analysis of this scenario.
The Capital Support Arrangement (“CSA”)
4.52 In December 2014, a legally binding CSA was put in place between PAC and PRIL.
4.53 Under the terms of the CSA (which was amended for Solvency II purposes with effect from 1 January 2016), PAC has undertaken to provide capital support to PRIL when PRIL notifies PAC that its regulatory solvency has fallen below a pre-defined level.
4.54 The aggregate amount of capital support available to PRIL from PAC under the CSA is capped at an agreed amount over a period ending 31 December 2017 (although this will be extended by 12 months if the PRIL Part VII transfer is not completed by this date). Any support beyond this cap would be at the discretion of PAC’s directors and would fall outside the terms of the CSA.
The PAC “walk-away” option with respect to PRIL
4.55 In theory PAC has the option to “walk away” from PRIL in the event that PRIL becomes insolvent on a realistic basis and is unable to pay its claims. As PAC’s interest in PRIL is limited to owning the entire issued share capital of PRIL, all of which is fully paid-up, under company law PAC is currently under no legal obligation to provide capital support to PRIL just because it is a shareholder in PRIL. However, PAC is subject to a number of contractual and regulatory obligations which link PAC’s financial position to that of PRIL and limit PAC’s ability to walk away from PRIL. These are listed below and include PAC’s obligations to support PRIL under the PRIL-PAC QS agreement and the CSA.
4.56 While the PRIL-PAC QS agreement reinsurance percentage is 100%, the ability of PAC to walk away from PRIL is significantly restricted: PAC may only terminate the reinsurance agreement in limited circumstances and, in particular, PAC is not entitled to terminate the reinsurance agreement as a result of either PRIL’s or its own insolvency. In addition, PRIL has a pari passu charge security over the assets backing the PAC LT SH business. This means that:
PAC would only have a realistic walk-away option in the unlikely event that PRIL had the right to terminate the PRIL-PAC QS agreement and recapture the reinsured business, and decided to act on this right; and
For all practical purposes, policies in the PAC LT SH business are already exposed to the risks associated with the PRIL business.
4.57 In the QS reduction scenario, there remain a number of reasons why in practice it is highly unlikely that PAC would walk away from PRIL:
PAC’s status as the shareholder of PRIL means that it is the “participating undertaking” in respect of PRIL and PRIL is managed and reported on as part of PAC. In particular, PAC’s Solvency II and internal economic capital results are prepared on a consolidated basis so PAC’s financial resources incorporate the financial position of its subsidiaries including PRIL.
The financial position of PRIL will therefore affect PAC’s financial position and the failure of PRIL or PAC to meet the solo SCR and group-level SCR respectively could lead to regulatory intervention from the PRA. If the financial position of PRIL was such that it affected PAC’s capital position, then PAC’s ability to pay a dividend would be constrained.
PAC cannot freely sell its shares in PRIL to a third party without the prior approval of the PRA and FCA to the change in control over PRIL and this approval would only be given if the PRA and FCA were satisfied with the suitability of the acquirer and financial soundness of the acquisition. PAC would not be able to abandon the shares in PRIL as this would result in PRIL having no shareholder, which is not permitted under English law. Under section 192C of FSMA, the PRA has the power to require an unregulated company to provide capital support to any of its regulated subsidiaries. This means that the PRA may require Prudential plc to provide support to PRIL (or to PAC), restricting the ability of Prudential plc to walk away from PRIL.
PRIL and PAC are both members of the Prudential Group, and the policies they sell are marketed under the Prudential brand name. Given the number of policyholders of PRIL and the nature of its insurance business, any attempt by PAC to walk away from PRIL would be likely to result in significant adverse publicity that the Prudential Group would be unlikely to sanction.
4.58 Therefore, I am satisfied that the value to PAC of the walk-away option is negligible whether the PRIL-PAC QS agreement coverage percentage remains at 100% or reduces to 20%.
The Pension Mis-selling Costs Assurance and capital support agreement
4.59 Prudential gave an assurance in July 1998 referred to as the “Pension Mis-Selling Costs Assurance”, that deducting personal pension mis-selling costs from the PAC inherited estate would not have an adverse effect on the level of the bonus paid to policyholders or their reasonable expectations, and that in the unlikely event of this proving not to be the case, the intention was that an appropriate contribution to the long-term fund would be made from shareholders’ funds.
4.60 A capital support agreement was put in place in 2013 between Prudential plc and PAC to formalise Prudential plc’s obligations under the Pension Mis-selling Costs Assurance and to support PAC’s solvency. This stipulates that Prudential plc can be required to provide capital support to PAC in that event that PAC’s solvency falls below specified levels. The capital support provided under the agreement includes the capital support that might be required to support the Pensions Mis-Selling Costs Assurance in relation to with-profits business. This agreement terminates at the latest in 2028.
The PAC Shareholder Risk Appetite (“SRA”) Framework
4.61 The PAC SRA Framework includes PAC’s internal capital policy in relation to its shareholder-backed business. It is based on a “twin peaks” approach that makes reference to the regulatory capital requirements (the “regulatory peak”) of the PAC shareholder-backed business as well as PAC’s internal view of its capital needs (the “management capital peak”). It requires PAC to hold a capital buffer that is resilient to stresses that are relevant to the PAC shareholder-backed business and is calibrated to specified confidence levels.
4.62 The PAC Board approved proposals to transition this SRA Framework to Solvency II and these came into effect at the start of 2016. The “twin peaks” structure has been retained with Solvency II Pillars 1 and 2 forming the regulatory and management peaks respectively.
