Prudential Regulation Authority Rulebook

7.1

The PRA considers that for the purposes of regulation 4(6)(b) of the IRPR regulations, firms must ensure that their collateral arrangements do not undermine the MA eligibility condition for firms to manage their MA portfolios separately from the rest of their business.

7.2

While firms may be able to satisfy this condition in a range of ways, the PRA considers that separate collateral arrangements in respect of an MA portfolio would most obviously be conducive to ensuring separate portfolio management. For example, in the case of title transfer collateral arrangements, separate netting arrangements in respect of an MA portfolio would ensure that that MA portfolio is not exposed to the non-MA business of the firm. However, it is for firms to be able to demonstrate how their arrangements and processes ensure that an MA portfolio is managed separately and is not exposed to the non-MA business. In evidencing this the PRA would expect a firm to:

• explain the options it has considered and the benefits or risks of each of these;
• clearly set out the reasons for selecting its chosen approach; and
• explain the controls it has put in place to ensure successful operation of its processes.

7.3

The PRA also expects firms to review their collateral arrangements and to be able to demonstrate that these arrangements will be effective and enforceable. The PRA would expect any such demonstration to include consideration of how the arrangements would operate in a range of scenarios, including the default of one or more significant counterparties.

7.4

In the case of stock lending activities relating to assets of an MA portfolio where collateral is received against the resulting counterparty exposure, the PRA considers that unless the collateral comprises only MA eligible assets, there is a risk that the MA portfolio would cease to satisfy the MA eligibility conditions in the event of a collateral call. In that case, it may not be possible to rectify this within the required two-month period.

7.5

The PRA considers that an approach of over-collateralising exposures to counterparties using appropriately liquid and marketable assets could potentially mitigate the risk associated with collateral calls.

7.6

While the PRA is open to considering different approaches, in all cases the PRA expects firms to be able to demonstrate that the overall matching position of an MA portfolio could be restored were a call on the collateral to result in the MA eligibility conditions (including the matching of cash flows) no longer being satisfied. The PRA expects this to include a review by firms of their collateral arrangements and why they consider that these arrangements will be effective in a range of very adverse scenarios. These include scenarios that result in the failure of one or more large counterparties, with the expected consequential market dislocations and reduced ability to sell significant volumes within the two-month time frame.

7.7

Collateral arrangements may give flexibility to a firm’s counterparty to return assets that are not identical to those posted. The PRA expects that in such cases, the counterparties should return equivalent (though not necessarily the same) assets (eg in the case of financial instruments, financial instruments of the same issuer or debtor, forming part of the same issue or class and of the same nominal amount, currency and description, and in the case of cash, a payment of the same amount and in the same currency). If there are other elements of flexibility in the arrangements, the PRA would expect firms to consider this and the appropriateness of the arrangements. In any event:

• where liquid assets are posted as collateral, firms should consider whether the condition to return equivalent assets is sufficiently narrowly defined to ensure that upon return, an MA portfolio will continue to satisfy all the MA eligibility conditions including those covering asset eligibility and liability cash flow matching; and
• for illiquid assets, unless the collateral arrangement requires the return of identical assets, firms should consider whether such assets should be excluded from their cash flow matching assessment. For the purposes of calculating the PRA Matching Tests published in Appendix 1, illiquid assets posted as collateral should be excluded unless the collateral arrangement requires the return of identical assets.

7.8

The PRA expects that collateral arrangements relating to an MA portfolio that require over-collateralising positions, or that restrict the type of assets that can be posted as collateral, could restrict the ability of firms to extract surplus or to use those assets to meet other MA liabilities. The PRA expects firms to be able to demonstrate that they have considered these issues and the impact this has on their ability to extract surplus from their MA portfolios.

7.9

The PRA understands that the processes used to identify, organise and manage MA portfolios will vary across firms. However, the PRA expects all firms to be able to demonstrate that separate processes have been put in place relating to:

• accounting systems;
• investment policy and mandates;
• processes and controls, including controls to ensure that the assets within the portfolio will not be used to cover losses arising elsewhere;
• governance; and
• management information.

7.10

The PRA understands that for practical reasons, firms may wish to administer eligible and ineligible business together for some purposes. The PRA does not consider that such joint administration of eligible and ineligible business would in itself be inconsistent with the MA eligibility conditions in regulation 4(6)(b) of the IRPR regulations and Matching Adjustment 2.2(5), provided that a firm can show that systems and controls are in place at a sufficient level of granularity to ensure that an MA portfolio can be identified, managed and organised separately from the other activities of the firm and that the assets in an MA portfolio cannot be used to meet losses arising from the other activities of the undertaking.

7.11

The PRA does not consider that the notional splitting of assets (such as individual derivative contracts) between MA and non-MA portfolios is consistent with the MA eligibility conditions in terms of managing each MA portfolio separately from the rest of the business. If assets were notionally split then an MA portfolio would be reliant on the rest of the business to some extent as a result of the joint management of the assets. Where risk exposures are managed and netted across the MA and non-MA portfolios, this could result in exposures emerging between portfolios. These exposures could in turn lead to MA being lost in the event of counterparty default, if the remaining business does not have sufficient eligible assets to make good any losses in an MA portfolio.

7.12

It would not be appropriate therefore, for firms to manage derivatives forming part of an MA portfolio at a level higher than the level of the MA portfolio under consideration. Assets of an MA portfolio should be allocated exclusively to that MA portfolio and firms should put in place systems to allow them to manage exposures at the level of that MA portfolio.

7.13

For the purposes of being able to demonstrate that the conditions of regulations 4(3) and 4(5) of the IRPR regulations are satisfied, the PRA expects firms to be able to confirm or demonstrate that:

• The investment policy for the assets in an MA portfolio is based on a hold-to-maturity strategy (subject to the exception provided in regulation 4(5) of the IRPR regulations). The investment policy should distinguish this approach from speculative strategies designed to benefit from anticipated price movements over short-term investment horizons.
• There is a regular (eg monthly) process that, allowing for new business written, ensures close cash flow matching. This process should identify whether the cash flow matching is within accepted tolerances and define the actions to address any situation where matching falls outside of accepted tolerances.
• There is a regular (eg monthly) process that also takes into account all other conditions, including the condition to compare the value of the relevant portfolio of assets (components A, B and C referred to in paragraph 4.5 of this SS) with the best estimate of the MA liabilities.

7.13A

The PRA expects firms to keep holdings of sub-investment grade assets to prudent levels, taking account of the extent to which other asset holdings could downgrade to sub-investment grade in deteriorating market conditions. Sub-investment grade exposures can give rise to increased risks due to their lower credit quality and can also give rise to a greater breadth of risks compared to investment grade exposures; for example, their significantly higher propensity to default requires greater focus on work-out capabilities. The PRA expects firms to consider this, along with any potential concentrations in their sub-investment grade (or near sub-investment grade) exposures, when setting their investment strategy and limits, as part of their ongoing risk monitoring and when assessing whether their approach to managing assets in an MA portfolio is in line with the PPP. Possible further metrics, in addition to the market value of sub-investment grade exposures, that firms could consider in this regard include the contribution of sub-investment grade assets to: total PD-adjusted cash flows; total monetary value of MA benefit; and total monetary value of the FS. Firms should also consider the adequacy of their work-out processes with regard to the size of their sub-investment grade exposures. As part of the attestation process, firms should carefully consider whether the published FS allowance is sufficient for all retained risks.

7.14

The PRA expects firms to be able to demonstrate that the governance and controls around investment management, including the investment strategy and the discretion given to investment managers, ensures that any rebalancing of assets within MA portfolios is strictly for the purposes of good risk management.

7.15

Keeping in mind the constraints of the condition in regulation 4(5) of the IRPR regulations, the PRA recognises that firms may wish to undertake asset rebalancing in an MA portfolio as a result of changes in expectations of future asset cash flows. The PRA also accepts that there may be circumstances where some asset trading is required in order to implement a change to the firm’s risk and investment management strategy, for example to de-risk (or re-risk) a portfolio and to manage the MA portfolio in line with the overall credit risk appetite for the MA portfolio. Where it is specifically for the purposes of good risk management, trading an asset for one with the same yield but lower risk or for one with a higher yield but the same risk, is not necessarily precluded so long as a firm can demonstrate robust principles and practices around risk management and governance. A firm should consider how its policy on asset trading interacts with its:

• risk management objectives; and
• investment policy for the MA portfolio to hold any asset to maturity.

7.16

The PRA also expects firms to have in place a process by which trades made within an MA portfolio are reported regularly to senior management. The PRA expects to be able to review such information as part of its ongoing supervision of firms applying the MA.

The following sections (paragraphs 7.17 and 7.18) highlight examples of some good practices.

7.17

The investment strategy is drafted to reflect a hold-to-maturity strategy with limited discretion to trade. This investment strategy includes:

• the target asset allocation by broad asset group;
• the extent to which each type of asset is being held on a hold-to-maturity basis (eg long-term illiquid assets) or as a short-/medium-term position to maintain the matching position or level of aggregate risk (eg derivatives);
• appropriate limits within the investment management agreement on the turnover of the fund in the normal course of events; and
• adequate governance arrangements, appropriate to the firm’s size and investment strategies that apply to any changes to the investment strategy and policy or to any trades that go beyond discretion granted to investment managers.

7.18

The investment agreement and mandates clearly set out levels of discretion available to the investment managers and include:

• the average credit quality for the various asset groups by term bucket;
• key features required or not allowed for each of the classes (eg no bonds allowing early repayment without adequate Spens clauses);
• the target duration by term bucket and target cash flow profiles;
• concentration limits by sector and counterparty;
• levels of turnover at sufficiently granular levels, categorised by reason for trading;
• tolerances for deviations from the above targets;
• permitted use of derivatives;
• requirements on the receipt and provision of collateral in respect of derivatives within an MA portfolio (eg credit quality, and/or strength of collateral agreements);
• restrictions on the use of gearing (eg investing cash collateral received into bonds);
• any other permitted investment activities and limits on them (eg stock lending);
• frequency with which management information is provided;
• management information on a trade-by-trade basis:
  • the reason for the trading (eg changes to target cash flow profiles, maintaining risks within limits, and/or consistency with investment policy). This could be on a set of grouped trades (eg bonds and derivatives) where necessary;
  • a reconciliation of assets purchased or transferred in against the MA eligibility conditions for assets within the MA portfolio;
• management information on a regular basis:
  • summary of the trade-by-trade information; and
  • a reconciliation with the limits within the investment mandate (covered above).

7.19

Firms should be able to describe the process by which they will maintain an MA portfolio on an ongoing basis, to demonstrate compliance with regulation 4(6) of the IRPR regulations. The PRA expects the governance process around any extraction of surplus to be robust and to include assessment of the firm’s ability to continue to meet the MA eligibility conditions. The PRA expects firms to support this assessment by setting clear materiality thresholds for the change in expected cash flows and using a profit and loss attribution analysis indicating the source(s) of surplus. The PRA considers that where surplus has arisen only due to asset values changing (but there is no corresponding change in expected asset or liability cash flows) it would not be appropriate for such surplus to be extracted.

7.20

Where a surplus has arisen over time due to favourable experience (such as underwriting experience), the PRA’s view is that it may be possible for a firm to demonstrate that cash flows have materially changed and that it is appropriate for the firm to substitute assets to allow for the fact that the MA portfolio now has surplus or extra cash flows.

7.21

When assessing transferability and scope for diversification within an internal model, the PRA expects firms to be able to demonstrate that their assumptions are consistent with their policies on the ongoing maintenance of an MA portfolio, and in particular that any restrictions on the extraction of surplus are taken into account.

7.22

If a firm considers that any restriction on transferability or diversification is either immaterial or irrelevant as far as it is concerned, then it should be able to provide appropriate evidence to justify this.

7.23

Firms should also consider whether the following could limit the scope for diversification:

• whether sufficient eligible assets exist outside an MA portfolio, or can be sourced quickly, in the circumstances that assets need to be injected into that MA portfolio. If there are insufficient eligible assets available, this could result in the full or partial loss of the MA; and
• whether, in scenarios that generate large surpluses in an MA portfolio, the firm is able to extract the MA surplus in time to offset losses elsewhere. If the firm cannot extract an MA surplus, the biting capital scenario could change from one that results in large deficits in that MA portfolio to one that results in large surpluses.

7.24

[Deleted]

7.25

Further assets and liabilities may only be included in an MA portfolio where they have the same features as those assets and liabilities for which MA permission has already been granted. New asset types and liability types will likely need a variation of MA permission before being included. Firms should consider carefully whether new combinations of permitted features require a variation of MA permission. This is discussed in more detail in Chapter 9 of this SS.