Posted on by db

Hidden in plain view

All investors accept, or should accept, the importance of corporate transparency. The purpose of governance structures, including statutory reporting supported by independent external audit, is to ensure that minority shareholders receive reliable information about the value of firms and that company managers do not cheat them. Management should also be motivated to maximize firm value rather than pursue personal objectives (Bushman and Smith, citing Black 2000).

In my previous post I puzzled about what impact the current PRA proposals on Equity Release valuation would have on the capital of Just Group, finding that their own figures suggest a hit of nearly £1bn, in fact over £1bn if we add on the PRA expectation of a minimum 1% deferment rate. Where is this number to be found? Just’s regulatory report states that the regulatory capital has gone up, not down.  Altissimum est negotium et maioris egens inquisitionis. Let us investigate this deep mystery further!

The regulatory rabbit hole
Apologies for taking our readers down this particular rabbit hole, but it has to be done. Analysts are fond of quoting Sam Wood’s ABI speech saying

.. let me be crystal clear: when we consider whether or not firms are in a position to pay dividends, one of the main quantitative yardsticks we will use is capital levels after the benefit of transitionals.

At first sight this does not appear like one of the strangest emanations of the regulatory mind, but it is. The PRA is a prudential regulator. That means it looks after the safety and soundness of firms, rather than the interests of investors (which is the job of the FCA). To do that, it distinguishes between capital available and capital required. Capital available is assets minus debt. Remember that capital is not an asset, but rather a form of liability, namely to pay members (shareholders) whatever is left over, if anything, after the company is wound up and all creditors paid off. Capital required is not really an accounting concept, but rather the amount the PRA deems sufficient to safeguard policyholders. The amount required under Solvency II is, in theory, what is needed to withstand a 1 in 200 year shock.

Actually, that’s not so strange, so long as you have the tools available to estimate the value of a 1 in 200 shock. Up to this point it makes perfect sense. The problem is that the PRA has no jurisdiction or powers over the statutory balance sheet, the one that the company reports annually to shareholders, and which is signed off by their appointed auditors. Hence both banking and insurance regulators have this strange concept of the ‘regulatory balance sheet’, a set of numbers it devises that follows the statutory balance sheet some way down the rabbit hole, but then diverges entirely.

This regulatory balance sheet what Sam is talking about when he refers to transitionals. The thinking is like this. The purpose of Solvency II, as the name implies, is to ensure that insurance firms are solvent, through the discipline of capital required. But if the capital required turns out to be too difficult for the firm to handle, the regulator can introduce the transitional, which is treated as an asset on the regulatory balance sheet.

Now that is strange. The transitional is an asset without any corresponding debt, so by increasing the value of regulatory assets, we automatically increase the value of regulatory capital, in virtue of the fact that even a regulatory balance sheet must balance, i.e. assets must equal liabilities. (Remember once again that capital is a liability, not an asset). The regulator is saying ‘look you don’t have enough capital, so here is some we made up for you earlier’. That’s the transitional that Sam is referring to, when he talks about ‘capital levels after the benefit of transitionals’. He means, capital levels after the benefit of adding the made-up capital.

In plain view?
Turning to Just, let’s have a careful look at their 2007 Solvency and Financial Condition report. On p.83 you will find a neat table that reconciles the statutory with the regulatory balance sheet (copied below). There, under ‘other valuation differences’, note the change from end 2016 to end 2017. There appears the missing £1bn, in plain view! Of course there may be other reasons why the firm dropped such a large amount to year end 2017, but that raises two questions: was there another reason, and if so, where else do we find the impact of the change in deferment assumptions that I analysed in my previous post? I contacted the firm last week to see if they could explain, but they could offer nothing other than to repeat information already contained in the report.

The other item in the table is the change of about £800m in ‘TMTP’ i.e. Transitional Measures on Technical Provisions. This item is an asset, and the year on year change in this item largely offsets ‘other valuation differences’, and would perhaps explain why the capital position has hardly changed. If this explanation is not correct, I invite Just or its auditors to publicly comment. To all appearances, Just has lost £1bn of capital somehow, then immediately got it back!

It gets worse. Solvency II transitionals are usually amortised every year until 2032, on the assumption that they are a new regulatory item which the industry may need time to adjust to. But that seems not to be the case here. Page 53 of the SFCR explains that another regulatory paper (SS6/16) wants valuation changes, including those recommended by SS3/17, to be backdated for transitional purposes. Pages 10-11 of CP 13/18 set this this out in somewhat impenetrable regulatory-speak, saying that the proposed approach would ensure that firms holding ERM assets are not calculating transitionals ‘by reference to a level of ICAS [Solvency I] TPs that is inadequate, as a result of attributing an inappropriately large amount of the spread on ERM loans to an illiquidity premium’. That is to say, if changes to valuation are deemed not to be Solvency II specific, and should have been recognised as part of Solvency I, then the PRA would not allow them to be included as transitionals. You can only invent capital if the requirement for it is new.

Conversely, if the requirement is not deemed to be new by the PRA, none of the £1bn ‘other valuation differences’ will be offset. If so, this would have a profound and damaging effect on the balance sheet of Just, yet neither the firm nor the PRA is telling us.

Freedom with publicity
This raises the difficult question of how much information the regulator and firms should divulge. Should there be ‘freedom with publicity’, leading the risk of a market over reaction, possibly preventing the firm from raising money in the capital markets? Or should regulators and firms conceal the relevant information from the market, leading to uncertainty about regulatory risk and possibly worse market disruption? This is a difficult philosophical question, but in any case it seems that the relevant numbers were already there, hidden in plain view.

It is troubling that such a large amount should be stated in a table towards the end of the report, seemingly without any narrative or supporting explanation. If that amount were not offset by the transitional, it would be enough almost to wipe out the firm’s capital.

Equally troubling is why a genuine valuation difference has not been included in statutory capital. According to CP 13/18, the central issue is about the correct option valuation approach (p.5), and the paper even gives the correct option valuation formula (i.e. Black Scholes) that firms should use (p.20). On p.11 it mentions the regulatory INSPRU 7, which ‘embodies the principle that the valuation of assets and liabilities should reflect their economic substance and that a realistic valuation basis should be used’. Plainly the issue concerns valuation, and hence statutory capital, yet the firm has seen fit to adjust only the regulatory number. If the actual valuation is incorrect, why didn’t the auditors signal this when they signed off the Solvency Report?

Summary
All the indication is that possibly material facts about the regulatory and accounting balance sheets of some insurance firms have been hidden in plain view, scattered across different reports or couched in opaque regulatory language.

This conflicts with the whole purpose of the Solvency and Financial Condition Report, namely to provide relevant, clear and useful information about the solvency and financial condition of the firm. The difficulty in assessing Just Group’s capital position suggests that we are some way from achieving the desired level of transparency. We have no assurance so far that minority shareholders are getting reliable information about the value of firms, nor that company’s managers are not cheating them. Does there have to be another public enquiry to investigate this issue, as John Mann has suggested?

References

Appendix

Just Group
2017 2016
Statutory accounts – Shareholder funds 1,740.5 1,610.6
Deconsolidation of JRSA (4.5) (2.4)
Goodwill (33.1) (33.1)
Intangible assets (160.5) (183.9)
Risk margin (902.3) (951.0)
TMTP 2,110.4 1,336.6
Other valuation differences and impact on deferred tax (1,008.6) (35.8)
Adjustment for own shares 5.0 1.6
Solvency balance sheet – Excess Assets over Liabilities 1,746.9 1,742.6
Ineligible items (5.5) (3.1)
Subordinated debt 393.7 360.6
Own funds (= regulatory capital) 2,135.1 2,100.1

Just SFCR p.83