Prudential Regulation Authority Rulebook

6.1

The PRA recognises that there is inherent uncertainty in the valuation of any asset. This will be most material for any asset where there are no quoted market prices in active markets in the same assets, as it is not possible to know for certain what a buyer would pay to a seller for such an asset at a point in time. The less deep, liquid and transparent the market for a particular asset, the greater reliance a firm will have to place on modelled values, and hence the greater the valuation uncertainty.^[38]

6.2

Valuation uncertainty is therefore a key risk for non-traded assets, and is also likely to be a risk for listed assets that are thinly traded, including cases where an investor holds a material proportion of an issuance. The PRA expects that firms take into account valuation uncertainty risk for the purposes of complying with the PPP and be able to demonstrate that they comply with the risk management requirements set out in Conditions Governing Business 3.4 in relation to valuation uncertainty risk.

6.3

When assessing whether firms are appropriately managing valuation uncertainty risk, the PRA will consider (among other things) the extent to which the firm complies with its requirements under the Delegated Regulation in relation to the valuation of assets. In particular, in relation to the alternative valuation methods referred to in Article 10(3) of the Delegated Regulation, which are used to value the non-traded assets, the PRA will consider whether the firm has credibly justified the alternative valuation approach used. The PRA will also consider whether the firm has adequately assessed the valuation uncertainty of those assets in accordance with Article 263 of the Delegated Regulation. 

6.4

When assessing firms’ management of valuation uncertainty risk for the purposes of complying with the PPP, the PRA will also consider the extent to which the firm satisfies the requirements under Article 267 of the Delegated Regulation relating to the internal control of valuation of assets. The PRA expects that the more material the firm’s exposure, the greater the skills and expertise that will be required of the persons involved in the valuation of these assets.

6.5

In accordance with Conditions Governing Business 7.1, firms remain fully responsible for discharging all of their obligations under the rules and other laws, regulations and administrative provisions adopted in accordance with the Solvency II Directive when they outsource functions or any insurance or reinsurance activities. Accordingly, firms must take the steps necessary to adequately assess and manage valuation uncertainty risk, regardless of whether the valuation function is outsourced. In assessing a firm’s compliance with the requirements of the PPP in the context of its investment in non-traded assets, where the firm does outsource the valuation function, the PRA will consider (among other things) the extent to which the firm complies with the requirements for outsourcing set out in Article 274 of the Delegated Act.

6.6

The PRA expects that firms will have effective systems and controls in place to limit and manage their exposure to valuation uncertainty. This should include a framework for quantifying or grading their exposure to this risk, to enable them to define appropriate internal investment limits (in line with paragraph 2.2 of this SS) in respect of their investment in assets that expose them to valuation uncertainty. The appropriateness of that framework will depend on all the circumstances in each case, taking into account the principle of proportionality. The PRA expects that the level of valuation uncertainty and associated risks should be consistent with the defined risk appetite and investment strategy of the firm, including in stress scenarios.

6.7

When undertaking a risk assessment to determine the appropriateness of investment in assets not yet approved by the board (in line with paragraph 2.2 of this SS), the PRA also expects that firms will quantify valuation uncertainty.

6.8

The PRA notes that valuation uncertainty is distinct from uncertainty about the potential realisable value of an asset in the future. However, where the value of an asset is uncertain, this will obviously increase uncertainty about the potential realisable value of that asset. Firms should therefore take valuation uncertainty into account when stress testing their portfolios in line with the expectation set in paragraph 3.18 of this SS.