Circular NBB_2023_03 on 'run-off' and risk mitigation

de Beriaimontlaan 14 - BE-1000 Brussels tel. +32 2 221 27 31 - fax + 32 2 221 31 36 enterprise number: 0203.201.340 RPR Brussels www.nbb.be Nationale Bank DE BELGIQUE VAN BELGIE Banque Nationale circular Brussels, 11 April 2023 Reference:
your correspondence:
Frank Van Steen tel. +32 2 221 21 23 frank.vansteen@nbb.be NBB__2023 03 Circular on 'run-off' and risk mitigation Scope Belgian insurance or reinsurance companies (excluding small Belgian insurance companies referred to in Articles 275 and 276 or local companies referred to in Article 294 of the Solvency II Law), Branches established in Belgium by insurance or reinsurance companies subject to the law of countries that are not members of the European Economic Area, Parent entities[] of a Belgian insurance or reinsurance group within the meaning of Articles 339, 2° and 343, paragraph 2, 1° and 2° of the Solvency II Law for which the Bank has been designated as the group supervisor within the meaning of Articles 407 and 408 of the aforementioned Law, Parent entities[] of a Belgian financial conglomerate within the meaning of Article 340, 1° of the Solvency II Law for which the Bank has been designated as the group supervisor within the meaning of Articles 471 and 472 of the aforementioned Law, Mutual insurance companies defined in Article 15, 79° of the Solvency II Law (excluding small Belgian insurance companies referred to in Article 275 of the Solvency II Law). For these companies, 'the Bank' should be replaced by 'the Office for the Control of Mutualities and National Unions of Mutualities' as defined in Article 15, 84° of the same Law. This circular provides information on the Bank's guidelines regarding run-off companies. The circular is based on the EIOPA statement on 'run-off', supplemented by additional clarifications. A specific chapter is dedicated to risk management best practices for run-off companies. More precisely, Belgian insurance or reinsurance companies that are a participating undertaking in at least one insurance or reinsurance company of the European Economic Area or a third country, Belgian insurance or reinsurance companies whose parent company is a mixed insurance holding company or a mixed financial holding company of the European Economic Area or a third country, and Belgian insurance holding companies or mixed financial holding companies that are parent companies of a Belgian insurance or reinsurance company, insofar as they are subject to the legal provisions covered by this circular. NBB_2023_03 - 11 April 2023 Circular - Biz. 1/9

Legal References
The Law: the Law of 13 March 2016 on the status and supervision of insurance or reinsurance companies.
Regulation 2015/35: the Delegated Regulation (EU) 2015/35 of the Commission of 10 October 2014 supplementing Directive 2009/138/EC of the European Parliament and of the Council on the taking up and pursuit of the business of Insurance and Reinsurance (Solvency II).
Circular NBB_2021_06: Circular on the procedure to be followed in case of transfer of a portfolio of insurance or reinsurance contracts as well as in case of merger or demerger.
The Circular NBB_2022_08 on liquidity risk management.
The Circular NBB_2022_09 on internal assessment of risks and solvency (ORSA).
The Circular NBB_2022_25 on guidelines on the valuation of technical provisions within the framework of Solvency II.
Structure
I. Objective
II. Definitions
III. Additional Information
IV. Run-off Companies
V. Risk Management Best Practices for Run-off Companies
Circular - Biz. 2/9 NBB_2023_03 - 11 April 2023

I. Objective
The 'run-off' business model can bring benefits to the insurance market, for example by allowing capital to be used for more profitable activities, thereby reducing costs and complexity. Furthermore, it can help insurance or reinsurance companies to withdraw from the market in an orderly manner. In some cases, this also allows replacing old products with new ones. At the same time, the 'run-off' business model also involves specific risks linked to the business model for the company and its policyholders. A higher leverage effect is often observed, and the business strategy of run-off companies entails increased credit and liquidity risks. The process and revaluation of ownership change therefore present additional complexity. However, there is no specific regulation regarding 'run-off' within the framework of Solvency II. This circular therefore defines the expectations regarding run-off companies in case of portfolio transfers, qualified share acquisitions, and mergers (ownership changes) as well as regarding the management of run-off companies, paying particular attention to investment and reinsurance strategies and the calculation of technical provisions. It addresses certain issues that do not exclusively concern run-off companies/portfolios but arise more frequently in the context of 'run-off'. Furthermore, it should be noted that risk mitigation strategies of run-off companies are adopted by other market actors. Thus, to guarantee a 'level playing field' between different insurers, the guidelines regarding strategy and best practices in reinsurance also apply to them. This circular specifically addresses the following issues:
Information concerning the 'run-off' decision; Specialized 'run-off' companies following the takeover of an insurance company or a portfolio transfer; Management of run-off companies; Risk management best practices for run-off companies.

II. Definitions
The term 'run-off' describes situations in which an insurance or reinsurance company has ceased to conclude new contracts and to renew contracts with existing policyholders, or situations in which an old portfolio is transferred from an active insurance or reinsurance company to another company, which puts it in 'run-off'. A company may find itself in a 'run-off' situation in different cases:
1) The company closes a portfolio of contracts that does not represent the entirety of its activity (partially run-off company or company with a run-off portfolio);
2) The company closes all of its (previous) activity (fully run-off company);
3) 'Run-off' constitutes the company's business model (specialized run-off company).
4) The company makes significant use of risk mitigation techniques (company with significantly mitigated risks).
Partially run-off companies are companies that only end part of their activities, while continuing others. For the application of this circular, 'partial run-off' refers to cases in which a significant part of the company's activities is ended (and thus not cases in which a minority of products or activities of insignificant importance are ended). NBB 2023 03 - 11 April 2023 Circular - Biz. 3/9

Fully run-off companies are companies holding old portfolios, whose technical provisions, equity, and solvency capital requirement (SCR) are traditionally oriented downwards. As no new insurance is underwritten, the profitability of these companies derives solely from the management of existing activities. This situation can also occur within the framework of cooperation with external parties, following outsourcing. Specialized run-off companies are companies or groups whose economic model consists of acquiring run-off portfolios or companies. In addition to measures adopted by fully run-off companies, they strive to realize economies of scale by maintaining or increasing the size of their run-off portfolio. In some cases, specialized run-off companies help active insurers or reinsurers profitably by providing capital support. These transactions often take place within the framework of a cooperation agreement and repeat after a certain time, in the same way as traditional reinsurance. Companies with significantly mitigated risks are companies or groups whose economic model consists of making significant use of risk mitigation techniques, such as derivatives and reinsurance, for both run-off portfolios and 'going concern' portfolios. This circular addresses the aspects and risks of the four aforementioned situations, while listing the differences between them, where relevant. Insurance companies subject to recovery measures or liquidation procedures are not covered by this circular.

III. Additional Information
This circular applies upon its publication.

IV. Run-off Companies
1. Information concerning the decision to enter 'run-off'
1. Companies that intend no longer to conclude new contracts of significant importance, leading to partial or complete 'run-off', must inform the Bank as soon as this decision is taken. In this context, the company must provide information concerning the following elements:
the decision of the management committee and the board of directors to put the company into 'run-off' completely or partially, including the reasons for this choice; a description of the residual asset management strategy, if applicable; financial forecasts regarding its assets, technical provisions, equity, and capital requirements, including a description of the underlying assumptions (notably technical provisions) and - if applicable - scenarios and adequate stress tests; significant reinsurance and outsourcing contracts expected in the future; possible consequences for the retention of key personnel. Circular - Biz. 4/9 NBB_2023_03 - 11 April 2023

2. The decision not to conclude new contracts of significant importance in the case of partial or complete 'run-off' may lead to a considerable modification of the company's risk profile and, consequently, to an ad hoc or non-periodic internal assessment of risks and solvency (Own Risk and Solvency Assessment - ORSA), in accordance with Article 91, § 6, of the Law, the results of which must be submitted to the Bank. Furthermore, the decision not to conclude new contracts of a certain importance is considered substantial information, which must therefore appear in the Solvency and Financial Condition Report (SFCR). If such an event occurs between two publications, it must also be considered a significant development having significant consequences on the relevance of published information, leading to an update of the SFCR, in accordance with Article 302 of Regulation 2015/35. The publication of this ad hoc SFCR will take place immediately after the 'run-off' enters into force.

2. Specialized 'run-off' companies following the takeover of an insurance company or a portfolio transfer
Early Dialogue
3. The potentially transferring, absorbing, or beneficiary company must contact the Bank at an early stage, before formally notifying the acquisition of a qualified participation or the transfer of a portfolio under, respectively, Articles 64 and 68 or 102 to 106 of the Law. The company intending to acquire a run-off portfolio (and requesting authorization from the Bank in accordance with Article 102 of the Law) is encouraged, in accordance with section 2 of Circular BNB_2021_006 and Article 103 §6 of the Law, to provide the Bank with the information described in point 1, as well as an actuarial function report evaluating the adequacy of technical provisions linked to the portfolio transfer. The Bank may also request a report from an external expert.
4. The financial forecast period, including figures relating to equity and SCR, must be proportional to the duration of insurance commitments. If technical provisions have a long-term character, the forecast period must be aligned with the expected duration and the uncertainty of these technical provisions. If contractual benefits are based on local GAAP, some parts of the forecasts may follow the same accounting principles (e.g., profit and loss accounts, dividends).
Identification of risks of the acquisition or portfolio transfer
5. The transferring, absorbing, or beneficiary company must provide the necessary documentation regarding its economic model and any expected changes after the takeover in its risk profile, its governance system, its risk management, and its solvency position (at both SCR and equity levels), within the framework of the Bank's re-evaluation of their adequacy to guarantee a sound and prudent policy (Article 39, §2, of the Law).
This also applies when the acquirer of the company is an insurance holding company subject to group supervision under Solvency II.
6. The transferring, absorbing, or beneficiary company must analyze whether, after the takeover of the new portfolio or company, its risk profile is consistent with its risk appetite and does not exceed its risk tolerance and capacity to assume risks.
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3. Management of run-off companies and risk mitigation
Technical Provisions
7. The Bank expects companies to adjust, if applicable, the asset and liability valuation assumptions to the strategy aiming to put activities into 'run-off' completely or partially or to the business model of the specialized run-off company.
8. In application of Article 7 of Regulation 2015/35, insurance and reinsurance companies must value their assets and liabilities based on the assumption of the company's going concern. Run-off companies also fall under this regulation if they continue to settle their claims. However, the decision to end (certain parts of) insurance activity may go hand in hand with a change in financial and non-financial assumptions when calculating technical provisions.
9. In addition to Circular NBB_2022_25 on guidelines regarding the valuation of technical provisions within the framework of Solvency II, the run-off company must formulate assumptions regarding 'run-off' that are reasonable and realistic, including, but not limited to, expenses, policyholder behavior, asset composition, future management activities, and recoverable amounts from reinsurance contracts and securitization vehicles:
Expenses:
Companies ending their activities must take into account the possibility that expenses per policy may not be compensated by the conclusion of new contracts or that the reduction of activities also entails a modification of certain expenses.
The specialized run-off company must take into account the compensation of potential costs due to new activities via portfolio transfers or acquisitions. In this case, the specialized run-off company is invited to formulate specific assumptions regarding the possibility that it may not be able to acquire new portfolios.
The run-off company must consider future management activities in accordance with the business model of the company in question and based on the possibility that continuing the activity is no longer economically viable at the level of fixed expenses. Companies must provide appropriate justification of how this translates into the calculation of technical provisions. The possibility of closing the projection horizon at this stage depends on realistic management activities regarding the transfer of remaining commitments. Policyholder behavior:
Run-off companies must analyze the possibility that putting portfolio(s) into 'run-off' has an impact on policyholder behavior. Specific management activities may also entail modifications to this behavior and the assumptions used for calculating technical provisions.
Future management activities:
In case of portfolio transfer, merger, or acquisition of qualified participations, the company must analyze whether assumptions regarding future management activities are consistent with the new strategy.
Recoverable amounts from reinsurance contracts and securitization vehicles:
Article 42 of Regulation 2015/35 provides that the counterparty default adjustment is calculated as equal to the expected present value of the variation of cash flows underlying the recoverable amounts from that counterparty that would occur in case of counterparty default. Cash flows in the scenario of a reinsurer default are determined notably by the insolvency legislation to which the reinsurer is subject, which is used to determine the liquidation value. In the case of a third-country reinsurance company, the revaluation of the liquidation value may differ from that based on the insolvency legislation to which the cedant company is subject.
The counterparty default adjustment may include two components. A first component consists of the expected credit loss as observed due to the fact that the defaulting reinsurer does not have sufficient resources to repay the cedant. A second component would result from differences in legal valuation between the insolvency legislation of the cedant company and that of the reinsurer. If recoverable amounts from reinsurance contracts and securitization vehicles constitute a significant part of net technical provisions, the run-off company or the company with significantly mitigated risks must ensure that both components are taken into account. Investment Strategy
10. The risk management system aims to identify, assess, manage, and monitor the risks to which run-off companies or companies with significantly mitigated risks are exposed or are likely to be exposed. This must include in particular the management of investment and liquidity risk.
11. If the company adapts its investment strategy, it must ensure that investments always comply with the 'prudent person' principle defined in the Law.
12. The company must ensure that the characteristics of investments are reflected in the calculation of the solvency capital requirement for market and counterparty risk in accordance with Articles 159 and 160 of the Law for companies using the standard formula, and Articles 167 to 188, for companies using an internal model.
13. Companies with significant investments in more complex or risky investments or derivative products must conduct risk analyses such as counterparty default risks, concentration risks, as well as potential basis risks arising from imperfect margins. Within the framework of the ORSA, the company is required to evaluate the appropriateness of the standard formula, also considering the potential financial strength of the counterparty, in accordance with best practice no. 18 of Circular NBB_2022_09 (ORSA).
14. The company must ensure that it develops and implements an effective system for governance and liquidity risk management. This system must comply with the various requirements of Circular NBB_2022_08 on liquidity risk management.
Reinsurance Strategy
15. The run-off company or the company with significantly mitigated risks must ensure that the risk management system includes, in particular, the risks inherent to reinsurance and other mitigation techniques:
NBB 2023 03 - 11 April 2023 Circular - Biz. 7/9

Concentration risk in reinsurance:
In the event of significant reinsurance associated with a high cession rate vis-à-vis one or more reinsurers, a concentration risk may arise regarding the reinsurance counterparty. The company is required to conduct a more in-depth analysis of said concentration risk within the framework of the ORSA, in accordance with best practice no. 18 of Circular NBB_2022_09 (ORSA);

Possible implications of retrocession:
In the event of significant retrocession, the ultimate backstop is the retrocession holder. Particular attention is required when the retrocession holder is not established in the EU. Other legislation regarding the valuation of technical provisions or the Solvency Capital Requirement may apply. In the event of significant retrocession, the company must perform a more in-depth analysis of these risks.

16. It must ensure that there is a balance between the reduction of capital requirements and risk mitigation, in accordance with Article 210 of Regulation 2015/35. When the decrease in the SCR does not appear proportional to the level of risk transferred or when new significant risks arising during the process are not appropriately taken into account by the SCR, the company cannot integrate the risk mitigation technique into the SCR calculation, in accordance with Article 210 of Regulation 2015/35.

17. Companies presenting significant risks arising from reinsurance contracts with a high cession rate are required to conduct a risk analysis such as counterparty default risks, concentration risks, as well as potential basis risks resulting from imperfect margins. Within the framework of the ORSA, the company must assess the appropriateness of the standard formula by also considering the potential financial strength of the counterparty under best practice no. 18 of Circular NBB_2022_09 (ORSA).

18. When the SCR is calculated using an internal model, this assessment is also part of the application or modification process of the model.

V. Risk management best practices
Regarding portfolios and companies in 'run-off' and companies whose risks are significantly mitigated, the specific investment and reinsurance strategy of the company may give rise to additional or amplified risks such as credit, concentration, basis, and liquidity risks.

Based on observations made in the insurance sector, specific instruments aimed at managing and mitigating these risks have been identified. These observations have led to the identification of best practices.

These complement the guidelines on 'run-off' and risk mitigation and aim to improve the risk management practices of companies. The following will be part of the assessment conducted by the Bank in the context of an acquisition or portfolio transfer under Article 102, §§ 2 and 3 of the Law:

• limiting the cession rate to a ceiling;
• recourse to reinsurance using the retained fund method;

Circular - Biz. 8/9 NBB_2023_03 - April 11, 2023

• the provision of security or reinsurance guarantees based on high-quality investments with a margin call mechanism;
• the provision of financial guarantees to ensure capital injection if the solvency ratio falls below a certain threshold;
• the inclusion in the reinsurance contract of a clause ensuring the rapid settlement of reinsurance recoveries when they exceed a given ceiling;
• the introduction of penalties in the event of unilateral cancellation of the contract;
• the definition of a capital management policy taking into account the SCR ratio abstracted from the impact of reinsurance;
• the presence of a risk appetite that takes into account an increased SCR ratio.

A copy of this is addressed to the commissioner(s), approved auditor(s) of your establishment.
Please accept, Madam, Sir, the assurance of our distinguished consideration.

Pierré Wunsch
Governor

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