Prudential Regulation Authority Rulebook

3.1

The PRA expects investments to be aligned with a firm's risk appetite, risk management policies, risk tolerance limits and investment strategy alongside the firm’s overall business model (including the profile of its products and policyholders).

3.2

Firms may only invest in assets the risks of which they are able to identify, measure, monitor, manage, control, report and take into account in their assessment of own solvency needs in the own risk and solvency assessment (ORSA).^[30] Firms’ risk management frameworks should deliver this. Chapter 4 of this SS sets out the PRA’s expectations for investment risk management where firms have outsourced their investment activities.

3.3

Paragraphs 3.4 to 3.24 of this chapter do not apply to firms investing in assets covering technical provisions (TPs) for linked long-term contracts of insurance, except where the assets are held to cover the additional TPs in respect of policyholder liabilities, including those for any guarantee of investment performance or other guaranteed benefit provided under those contracts.

3.4

The PRA expects that when firms invest in asset structures or other investments where the risk exposure is dependent on the performance of underlying assets (including securitisations, open-ended investment companies and derivatives), they should also include the risks of these underlying assets within the scope of their investment risk management framework.

3.5

As part of measuring their risks, the PRA expects firms to quantify, under a range of scenarios, the potential impact of investment risks crystallising on their solvency position and their ability to pay policyholders, before and after management actions. Firms are expected to identify scenarios that would cause these risks to crystallise, and to identify and analyse potential risk management actions, in response to stress scenarios.

3.6

A firms’ investment risk monitoring should cover, but not be limited to:

• changes in the value and volatility of their investment portfolios and individual assets and the firm’s ongoing ability to monitor these;
• changes in the characteristics of the assets held (eg changes in the credit quality);
• changes in the value or characteristics of underlying exposures on which the performance of the asset(s) invested in depend;
• changes in the external environment which may affect the security of assets;
• breaches of internal quantitative limits for assets and exposures (see paragraph 3.11 of this SS);
• concentrations of single risks in the investment portfolio (eg counterparty, asset class, geographical industry or sector); and
• changes to the firm’s risk profile which may lead to asset-liability mismatch.

3.6A

The PRA expects that, in their monitoring of investment risks, firms should also consider the impact of concentrations on the solvency position, including concentrations on the amount of MA benefit claimed. Monitoring of concentrations should include the impact of the crystallisation of single risks (as set out in paragraph 3.6 of this SS) on the MA benefit.

3.7

The board and any relevant sub-committees of the board should receive appropriate, accurate and timely management information on their firm’s investment risks. This management information should be provided, at a minimum, whenever the board or relevant committee meets to review the investment strategy, internal investment limits or investment risks. Firms are reminded of the requirement to at least ensure that their investment risk management feeds in to their ORSA process and report,^[31] and the PRA expects a firm to pay particular attention to this where investment risk is assessed to be a key risk currently facing the firm or likely to face the firm in the future.

3.8

The PRA reminds firms of the requirements of Investments 5.2(1). Where firms have hedged risks with derivatives and similar commitments, the PRA expects firms to be able to monitor the effectiveness of any hedge in mitigating the relevant risk exposure, and take remedial action in the event that it becomes less effective. The PRA notes that the requirements of Investments 5.2(1) apply to derivatives and quasi-derivatives, and as such, firms may only invest in such instruments where it contributes to a reduction of risks or facilitates efficient portfolio management.^[32]

3.9

The PRA expects firms to pay particular attention to the measurement and control of credit spread and default risk (including credit transition downgrade/upgrade risk). In particular, the PRA expects firms that outsource credit risk assessments to have sufficient in-house expertise to appropriately monitor the risks associated with this practice, and reminds firms of their obligations under Article 259(4) of the Commission Delegated Regulation (EU) 2015/35. Where firms internally assign credit ratings for unrated assets, they are reminded of the PRA’s expectations as set out in SS3/17.

3.10

The risk management system in accordance with Solvency II must cover areas, including those listed below, and firms must produce policies including for these areas:^[33]

• underwriting and reserving;
• asset-liability management;
• investment risk management;
• liquidity risk management;
• concentration risk management;
• operational risk management; and
• reinsurance and other insurance risk mitigation techniques.

3.11

Firms must develop an investment risk management policy that, where appropriate, in order to ensure effective risk management, includes internal quantitative investment limits for assets and exposures.^[34] The PRA cannot envisage circumstances where it would not be appropriate to set such internal limits and, as such, expects firms to define and operate within these limits. The PRA expects that such limits would encompass at least asset class, geographic, single-name, sector and off-balance sheet exposures that the firm would expect to hold in reasonably foreseeable market conditions.

3.12

The PRA expects quantitative investment limits to be consistent with the board’s risk appetite. As such, the PRA expects a firm to document how its limits are determined and how they are consistent with its overall risk appetite and risk management. The PRA may review the appropriateness of the limits when assessing compliance with the requirements on the system of governance and investments as part of the supervisory review process.

3.13

The PRA expects that a firm will review its internal quantitative investment limits in line with reviews of the firm’s investment strategy and investment risk management policy.

3.14

When setting internal quantitative investment limits for asset classes and exposures, the PRA expects a firm should take into account at least the:

• nature and duration of the firm’s liabilities;
• nature and quantification of the risks associated with each category of asset and with individual assets;
• access to investment risk management capabilities proportionate to the complexity of the asset class involved (especially for any planned new categories of investment);
• need for proper diversification of assets, as set out in Investments 5.2(3);
• impact of any uncertainty on the valuation of assets, or on the ability of the firm to realise an asset’s value in the event of sale, including under stress;
• uncertainty around the timing and the channels through which investment risks may materialise and the actions available to mitigate them; and
• material reinsurance cessions and whether these create correlations of counterparty credit risk, particularly if collateral arrangements are used, whether, for example, as a result of the counterparty itself, or as a result of collateral arrangements, where utilised.

3.15

Internal quantitative investment limits should be set in order to ensure a properly diversified and resilient portfolio of assets (with an acceptable level of volatility) that avoids a material reliance on counterparties (or other common risk factors between the assets).

3.16

When setting quantitative investment limits, firms should consider an assessment of the impact of the failure of the firm’s largest counterparties.

3.17

Investments 5.2(4) requires firms to ensure that assets issued by the same issuer, or by issuers belonging to the same group, shall not expose the insurance firm to excessive risk concentration. This is an objective standard and must be assessed from the perspective of the hypothetical prudent person in the same situation.^[35]

3.18

Firms are also reminded of their obligations relating to risk concentration reporting under Article 295 of the Commission Delegated Regulation (EU) 2015/35. The PRA expects that firms will stress test their portfolios to demonstrate that they are not exposed to excessive risk concentration. The PRA expects, at the least, that the solvency of a firm would not be threatened by any plausible crystallisation of a risk related to assets issued by the same issuer or by issuers belonging to the same group.

3.19

Investments 5.2(3) requires assets to be properly diversified in such a way as to avoid excessive reliance on any particular asset, issuer or group of undertakings, or geographical area, and excessive accumulation of risk in the portfolio as a whole. This is an objective standard that must be assessed on an objective basis. One way the PRA expects that firms could demonstrate proper diversification is by stress testing their portfolios. More specifically, the PRA expects that with regard to risks arising from a particular asset, issuer or group of undertakings, or geographical area (eg default or downgrade resulting from a change in government policies or deterioration in market or macroeconomic conditions), or other single source of risk:

• the solvency risk appetite of the firm is not threatened in a moderate stress scenario; and
• the solvency of the firm is not threatened in a severe stress scenario and the firm is able to recover from a severe shock and restore compliance with all its regulatory requirements.^[36]

In this context, the PRA considers that what constitutes ‘moderate’ and ‘severe’ stress scenarios depends on the individual circumstances of a firm.

3.20

The PRA expects firms to demonstrate how their quantitative investment limits and forward-looking investment strategy would prevent solvency from being threatened under a range of stress scenarios. The PRA expects that firms that appear to it to have excessive levels of concentration risk within their investment portfolio will be subject to greater supervisory scrutiny. This could include supervisory expectations for relatively more severe stress scenarios. The PRA would expect a firm to use a combination of simultaneous stresses and be able to identify the set of circumstances that would threaten its solvency risk appetite.

3.21

The PRA also expects that the investment risk management policy will articulate how a firm has identified, and is managing: any potential correlation or contagion risks between assets that would lead to excessive concentration of risk; and any risks that are common to a material proportion of the firm’s investment portfolio.

3.22

In determining its quantitative investment limits, a firm should have due regard to concentration risk and set out the level of concentration exposure that it will not exceed.

3.23

Firms must ensure that their investments do not expose them to risks that cannot be managed effectively in accordance with the requirements of the rules in the Conditions Governing Business and Investments Parts of the PRA Rulebook. The more complex the risk and the less understood it is (eg climate risk), the more difficult it is for firms to manage their exposure to such risks effectively. Therefore, the PRA expects a firm to pay particular attention to such risks in its investment risk management policy and to avoid overexposure to such risks. For example, a firm should consider whether there is an excessive accumulation of financial risks from climate change in its investment portfolio, consider appropriate mitigants to those risks and note the expectations set out in SS3/19. As another example, a firm should consider its exposure to political risk, particularly when investing in assets that are ultimately backed by government.

3.24

In considering the nature and quantification of the risks associated with each category of asset and with individual assets (see paragraph 3.14 of this SS), the PRA expects a firm to limit its investment appropriately where there is insufficient data to quantify the risks.