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 NATIONAL BANK OF BELGIUM

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 undertakings (excluding small Belgian insurance undertakings referred to in Articles 275 and 276 or local undertakings referred to in Article 294 of the Solvency II Law), Branches established in Belgium of insurance or reinsurance undertakings 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 undertakings referred to in Article 275 of the Solvency II Law). For these undertakings, '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 expectations regarding undertakings in 'run-off'. The circular is based on the EIOPA supervisory statement on 'run-off', supplemented with additional clarifications. A specific chapter is dedicated to good practices in risk management for undertakings in 'run-off'.

More precisely, this applies to Belgian insurance or reinsurance undertakings that are a participating undertaking in at least one insurance or reinsurance undertaking of the European Economic Area or a third country, Belgian insurance or reinsurance undertakings whose parent undertaking is a mixed financial holding company or a mixed financial subsidiary of the European Economic Area or a third country, and Belgian insurance holding companies or mixed financial holding companies that are parent undertakings of a Belgian insurance or reinsurance undertaking, insofar as they are subject to the legal provisions covered by this circular.

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Legal References
The Law: the Law of 13 March 2016 on the status and supervision of insurance or reinsurance undertakings.
Regulation 2015/35: Commission Delegated Regulation (EU) 2015/35 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 the event of a transfer of a portfolio of insurance or reinsurance contracts as well as in the event of a merger or division.
Circular NBB_2022_08 on liquidity risk management.
Circular NBB_2022_09 on internal assessment of risks and solvency (ORSA).
Circular NBB_2022_25 on guidelines for the valuation of technical provisions under Solvency II.

Structure
I. Objective
II. Definitions
III. Additional Information
IV. Undertakings in 'run-off'
V. Good practices in risk management for undertakings in 'run-off'

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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, thus reducing costs and complexity. Furthermore, it can help insurance or reinsurance undertakings to withdraw from the market in an orderly manner. In some cases, this also allows for the replacement of 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 undertaking and its policyholders. A higher leverage effect is often observed, and the business strategy of 'run-off' companies leads to increased credit and liquidity risks. The process and revaluation of change of ownership 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 undertakings in 'run-off' in the event of portfolio transfers, acquisitions of qualifying participations, and mergers (changes of ownership), as well as regarding the management of undertakings in 'run-off', paying particular attention to investment and reinsurance strategy and the calculation of technical provisions. It addresses certain issues that do not exclusively concern undertakings/portfolios in 'run-off' but arise more frequently in the context of 'run-off'.

Furthermore, it should be noted that risk mitigation strategies of 'run-off' companies are also adopted by other market players. Thus, to ensure a 'level playing field' between different insurers, the guidelines on strategy and good practices regarding reinsurance also apply to them.

This circular also addresses the following specific issues:
Information concerning the 'run-off' decision; Specialist 'run-off' undertakings following the takeover of an insurance undertaking or a portfolio transfer; Management of the 'run-off' undertaking; Good practices in risk management for undertakings in 'run-off'.

II. Definitions
The term 'run-off' describes situations where an insurance or reinsurance undertaking has ceased to conclude new contracts and to renew contracts with existing policyholders, or situations where an old portfolio is transferred from an active insurance or reinsurance undertaking to another undertaking, which puts it into 'run-off'. An undertaking may find itself in a 'run-off' situation in different cases:
1) The undertaking closes a portfolio of contracts that does not represent its entire activity (undertaking in 'partial run-off' or undertaking with a portfolio in 'run-off');
2) The undertaking closes its entire (previous) activity (undertaking in 'full run-off');
3) 'Run-off' constitutes the business model of the undertaking (specialist 'run-off' undertaking).
4) The undertaking makes significant use of risk mitigation techniques (undertaking whose risks are significantly mitigated).

Partial run-off undertakings are undertakings that only end part of their activities, while continuing others. For the application of this circular, 'partial run-off' refers to cases where a significant part of the undertaking's activities is ended (and not cases where a minority of products or activities of non-significant importance are ended).

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Full run-off undertakings are undertakings holding old portfolios, whose technical provisions, own funds, and Solvency Capital Requirement (SCR) are traditionally oriented downwards. As no new insurance is underwritten, the profitability of these undertakings comes solely from the management of existing assets. This situation can also occur in the context of cooperation with external parties, following outsourcing.

Specialist 'run-off' undertakings are undertakings or groups whose economic model consists of acquiring portfolios or undertakings in 'run-off'. In addition to the measures adopted by full run-off undertakings, they strive to achieve economies of scale by maintaining or increasing the size of their 'run-off' portfolio. In some cases, specialist 'run-off' undertakings help active insurers or reinsurers profitably by providing capital support. These transactions often take place within the framework of a cooperation agreement and repeat over time, similar to traditional reinsurance.

Undertakings whose risks are significantly mitigated are undertakings 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 noting the differences between them where relevant.

Insurance undertakings subject to remedial measures or liquidation procedures are not covered by this circular.

III. Additional Information
This circular applies from its publication.

IV. Undertakings in 'run-off'
1. Information concerning the decision to go into 'run-off'
1. Undertakings that intend to no longer conclude new contracts of significant importance, leading to a partial or full 'run-off', must inform the Bank as soon as this decision is taken. In this context, the undertaking must provide information concerning the following elements:
the decision of the management committee and the board of directors to put the undertaking into full or partial 'run-off', including the reasons for this choice; a description of the strategy for managing residual assets, where applicable; financial forecasts regarding its assets, technical provisions, own funds, and capital requirements, including a description of the underlying assumptions (notably technical provisions) and - where applicable - adequate scenarios and stress tests; significant reinsurance and outsourcing contracts expected in the future; possible consequences for the retention of key personnel.

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2. The decision not to conclude new contracts of significant importance in the case of a partial or full 'run-off' may lead to a considerable modification of the undertaking'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 evolution having significant consequences on the relevance of published information and giving rise to an update of the SFCR, in accordance with Article 302 of Regulation 2015/35. The publication of this ad hoc SFCR report will take place immediately after the entry into force of the 'run-off'.

2. Specialist 'run-off' undertakings following the takeover of an insurance undertaking or a portfolio transfer
Early Dialogue
3. The potentially acquiring, absorbing, or benefiting company must contact the Bank at an early stage, before formally notifying the acquisition of a qualifying participation or the transfer of a portfolio under Articles 64 and 68 or 102 to 106 of the Law respectively. The undertaking 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 a report from the actuarial function 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 own funds 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 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., income statements, dividends).

Identification of risks of the acquisition or portfolio transfer
5. The acquiring, absorbing, or benefiting company must provide the necessary documentation concerning 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 own funds levels), within the framework of the Bank's review of their adequacy to guarantee a sound and prudent policy (Article 39, §2, of the Law).
This also applies when the acquirer of the undertaking is an insurance holding company subject to group supervision under Solvency II.
6. The acquiring, absorbing, or benefiting company must analyze whether, after the takeover of the new portfolio or new undertaking, its risk profile is consistent with its risk appetite and does not exceed its risk tolerance and risk-bearing capacity.

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3. Management of 'run-off' undertakings and risk mitigation
Technical Provisions
7. The Bank expects undertakings to adjust, where applicable, the assumptions for asset and liability valuation to the strategy to put activities into full or partial 'run-off' or to the business model of the specialist 'run-off' undertaking.
8. In application of Article 7 of Regulation 2015/35, insurance and reinsurance undertakings must value their assets and liabilities based on the assumption of the undertaking's going concern status. Undertakings in 'run-off' also fall under this regulation if they continue to settle their liabilities. However, the decision to end (certain parts of) the 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 for the valuation of technical provisions under Solvency II, the undertaking in 'run-off' 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:
Undertakings 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 in activities also leads to a modification of certain expenses.
The specialist 'run-off' undertaking must take into account the compensation of potential costs due to new activities via portfolio transfers or acquisitions. In this case, the specialist 'run-off' undertaking is invited to formulate specific assumptions regarding the possibility that it may not be able to acquire new portfolios. The undertaking in 'run-off' must consider future management activities in accordance with the business model of the undertaking in question and based on the possibility that the continuation of the activity is no longer economically viable at the level of fixed expenses. Undertakings 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:
Undertakings in 'run-off' must analyze the possibility that putting portfolio(s) into 'run-off' has an impact on policyholder behavior. Specific management activities can also lead to changes in this behavior and the assumptions used for the calculation of technical provisions.
Future management activities:
In the event of a portfolio transfer, merger, or acquisition of qualifying participations, the undertaking 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 in cash flows underlying the recoverable amounts from this counterparty that would occur in the event of the counterparty's default. Cash flows in the scenario of a reinsurer's default are notably determined by the insolvency legislation to which the reinsurer is subject and which is used to determine the liquidation value. In the case of a third-country reinsurance undertaking, the revaluation of the liquidation value may differ from that based on the insolvency legislation to which the cedant undertaking 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 undertaking and that of the reinsurer. If the recoverable amounts from reinsurance contracts and securitization vehicles constitute a significant part of net technical provisions, the undertaking in 'run-off' or the undertaking whose risks are significantly mitigated must ensure that both components are taken into account.

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Investment Strategy
10. The risk management system aims to identify, assess, manage, and monitor the risks to which undertakings in 'run-off' or undertakings whose risks are significantly mitigated are exposed or are likely to be exposed. This must include in particular the management of investment and liquidity risk.
11. If the undertaking adapts its investment strategy, it must ensure that investments always comply with the 'prudent person' principle defined in the Law.
12. The undertaking 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 undertakings using the standard formula, and Articles 167 to 188, for undertakings using an internal model.
13. Undertakings with significant investments in more complex or risky investments or derivative products must conduct 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 undertaking is required to evaluate the appropriateness of the standard formula, also considering the potential financial strength of the counterparty, in accordance with good practice no. 18 of Circular NBB_2022_09 (ORSA).
14. The undertaking must ensure that it develops and implements an effective system for liquidity risk governance and management. This system must comply with the various requirements of Circular NBB_2022_08 on liquidity risk management.

Reinsurance Strategy
15. The undertaking in 'run-off' or the undertaking whose risks are significantly mitigated must ensure that the risk management system includes, in particular, the risks inherent to reinsurance and other mitigation techniques:
Reinsurance concentration risk:
In the case of significant reinsurance associated with a high cession rate towards one or more reinsurers, a concentration risk may emerge regarding the reinsurance counterparty. The undertaking is required to conduct a more in-depth analysis of said concentration risk within the framework of the ORSA, in accordance with good practice no. 18 of Circular NBB_2022_09 (ORSA); Possible implications of retrocession:
In the case of significant retrocession, the ultimate risk bearer is the retrocessionaire. Particular attention is required when the retrocessionaire 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 undertaking must perform a more thorough analysis of these risks.

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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 SCR does not seem 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 undertaking cannot integrate the risk mitigation technique into the SCR calculation, in accordance with Article 210 of Regulation 2015/35.
17. Undertakings presenting significant risks arising from reinsurance contracts with a high cession rate are required to conduct risk analysis such as counterparty default risks, concentration risks, as well as potential basis risks that would result from a...