Insurers should not underestimate the challenge of embedding the prudent person principle (PPP) in their investment strategies, Iain Forrester, head of ALM at Standard Life told delegates of the Insurance Asset Risk conference, before comparing it to the effort put into securing supervisory approval of an internal model.
The PPP requires insurers to invest prudently and to demonstrate they can measure and understand risk exposures in their asset holdings. Supervisors across Europe have been setting out their expectations about how this translates into practice in the run-up to Solvency II (see IERM, 20 January, Danish regulators flesh out prudent person principle).
Forrester emphasised how the PPP is an overarching concept of the new regulatory regime that will require at least as much as attention from firms as the the application processes for using internal models, the volatility and matching adjustment (VA and MA) and the transitional measures. "There has been a lot of focus on applications, but the prudent person principle is no less challenging," he said.
Forrester identified the liquidity risks arising from investments in illiquid assets and from the use of derivatives to extend asset duration, which are subject to high collateral requirements under looming European rules, as areas of major concern.
In a keynote speech on ALM strategies under Solvency II, he also flagged the constraints on investment strategies that firms applying the VA and MA are subject to. UK insurers will struggle to demonstrate that the use of the VA does not lead to procyclical investment strategies, by using the capital benefit to support investments in risky assets, he argued.
Constraints attached to MA, which requires insurers to match cashflows between assets and liabilities and manage the portfolios separately for the rest of the business, are even more demanding. Forrester explained that Standard Life has diversified its asset portfolio backing annuities away from vanilla bonds and into commercial real estate and private placement bonds in the UK, but stopped short from investing in assets denominated in a foreign currency, given collateral requirements attached to those investments.
"We deliberately steered away from diversifying into foreign currency assets, which promised high returns, but at the same time had high collateral requirements and posed operational challenges," he said.