On Thursday 26 March 2020 Sam Woods wrote to Chief Executive Officers of UK Banks setting out the PRA’s position regarding IFRS 9, capital requirements for their firms and loan covenants. Some insurance firms have sought clarification as to how the points in that letter should be read across to their internal assessments of loan creditworthiness and treatment of unrated assets.
The PRA’s expectations for the use by insurers of unrated assets are set out in Supervisory Statement (SS) 3/17 ‘Solvency II: Illiquid, unrated assets’ (updated on Thursday 2 April 2020). Paragraphs 2.8A to 2.8L of the SS set out relevant expectations regarding risk identification and the application of judgements and methodologies. The accompanying Policy Statement (PS) 9/20 ‘Solvency II: Income producing real estate loans and internal credit assessments for illiquid, unrated assets’ further refers to published measures to alleviate operational burdens arising due to the Covid-19 outbreak.
In this context, while Sam Woods’ letter itself does not address insurers’ internal credit ratings, some points in the letter can be considered of wider applicability beyond those insurers using IFRS 9 to account for financial instruments.
Insurers are advised to read the letter in its entirety. Of particular relevance to the judgements underlying internal ratings is the paragraph stating that firms should ‘make well-balanced and consistent decisions that consider not just the potential impact of the virus, but also take full account of the unprecedented level of support provided by governments and central banks domestically and internationally to protect the economy. The need for well-balanced decisions also means that due weight will need to be given to established long-term economic trends, given the challenges of preparing detailed forecasts far into the future’. Paragraph 5 of the letter’s Annex includes further examples of considerations that insurance firms may find helpful when forming their judgements on the impact of Covid-19 on their internal credit assessments.
Similarly, regarding breaches to loan covenants arising directly as a result of Covid-19, the letter further noted that in the current uncertain environment such breaches may not necessarily be reflective of long-term credit risk, eg as noted in the letter’s section relating to the treatment of borrowers who breach covenants (see page 2 of the letter).
Nevertheless, it should be noted that firms will need to use their judgment to determine which covenant breaches do reflect increased credit risk and which do not. As set out on page 2 of the letter, it remains important that firms’ assessments of covenant breaches take into account fully the differences between ‘normal’ covenant breaches and those that might occur directly because of the Covid-19 pandemic.