PRA letter on Solvency II remuneration expectations

On 12 July 2019 the PRA published a letter to RemCo chairs regarding its expectations of the implementation of Solvency II remuneration requirements. The letter provides feedback on the collation of recent (voluntary) RPS statements from Category 1 and Category 2 firms, as well as the results of roundtable meetings with RemCo chairs. The letter is a useful update on the views of the PRA on Solvency II remuneration requirements, which have developed further from the PRA’s Supervisory Statement on remuneration which was originally issued in August 2016 (see our earlier briefing here). 

Significantly, the 12 July letter appears to indicate a slight toughening of approach from the PRA, and implies that further guidance can be expected as the PRA seeks to deal with what it regards as inconsistencies of interpretation amongst companies.

Overall, we believe that there is no need to take any immediate action as a result of the letter, but we consider it to be required reading for RemCo chairs, committee members and Reward professionals at Solvency II firms.

Main points in the letter

(i)    Material risk takers (MRTs)

The PRA recognises that the business models of Solvency II firms vary and it therefore does not seek to impose a uniform approach towards MRT identification. That said, the PRA is concerned that some firms are not fully capturing or reporting the appropriate set of individuals who have a material impact on their risk profile (or conversely, that some companies are using an unnecessarily wide approach). It notes that the number of MRTs identified in "Operational Systems and Controls" appears to be disproportionately high and there are some areas (such as "Head of Material Business Unit", "Investment Management" and “Underwriting and Pricing") where it would expect to see a higher proportion of MRTs.

FIT comment: Without access to the underlying data it is hard to comment on these observations, but the PRA did note that in the round table meetings RemCo chairs have requested the PRA to give “greater clarity on how firms should be identifying MRTs”. The PRA appears to have accepted this request and is considering further guidance as a result.

In the meantime, as a practical point we recommend that Reward and Compliance functions consider these PRA comments when looking at their Solvency II “identified persons” lists later in 2019. 

(ii)    Variable remuneration – lack of business unit performance

The PRA have commented that few firms could demonstrate compliance with the requirement in the Solvency II remuneration requirements that performance measures for variable remuneration should be based on a combination of the performance of the individual, business unit, and overall firm, or the group to which the firm belongs. The PRA commented that many firms did not include business unit performance as part of their assessment. 

FIT comment: There is undoubtedly some substance to the PRA’s criticism and RemCos would do well to take this feedback into consideration for the next compensation cycle. That said, the availability of business unit related performance measures will depend upon the underlying structure of each firm and which personnel are considered to be MRTs. For example, if the relevant MRTs are predominantly senior level executives with group-level responsibilities, we would not expect the RemCo to “invent” a business unit measure which wasn’t directly applicable to the particular responsibilities of those executives. 

(iii)    Variable remuneration – over reliance on financial metrics

The PRA appear to be making three separate points in relation to LTIP metrics: 

• Whether appropriate consideration is given to use of non-financial metrics
• Whether LTIP performance metrics (including TSR and return on equity based measures) take appropriate account of risk 
• Whether balance sheet strength is appropriately considered for LTIP measures

FIT comment:  The PRA’s challenges on LTIP metrics do warrant serious consideration, but this appears to be an area where the regulators’ perspective seems counter to the views of other external influences on pay design. For example, there is a common preference for TSR measures amongst UK institutional investors, on the basis that it is the best measure for aligning reward to shareholder experience, and also that it is formulaic and very transparent.

That said, we expect the practical outcomes of the PRA’s comments to be: 

• Greater consideration of the use of non-financial metrics in LTIPs (although such metrics are normally seen to be better suited to annual plans where it is easier to set measures reflecting year-on-year progress
• Very robust “underpins” on LTIPs, where vesting levels can be adjusted if there is insufficient performance on named non-financial measures (it is already normal for risk matters to be specifically included in LTIP underpins)
• Greater clarity that metrics based on balance sheet strength are measured after required provisions for regulatory capital

(iv)    Variable remuneration - control function staff

The letter also makes a particular point regarding the variable remuneration of control functions and notes that there is no discretion to deviate from the requirement that the variable remuneration of control function staff “should be independent of the performance of those functions they oversee and hold to account”.

FIT comment:  In our experience, annual bonus plans for control function staff are typically linked to achievement against individual and team objectives, and normally exclude any direct link to financial performance. However, control function staff in Solvency II firms often participate in long term incentive plans based on group performance, on the basis that the main concern here is the use of incentives linked to performance of a business unit overseen by the individual (rather than whole group performance).

That said, if this debate continues we may see a move to put compliance personnel in Solvency II firms into restricted stock programmes as an alternative to performance-linked long term incentive arrangements as is already the case in many CRD IV firms (banks and other FS institutions). This is a point to keep an eye on, and the PRA indicated that it is considering whether further guidance is required on this issue.

(v)    Ex-post risk adjustment

The PRA expects firms to be able “to provide evidence of how risk adjustment has been considered or used in practice” in their remuneration policy statement (RPS) submissions. The letter notes that some firms have gone further in obtaining meaningful input from their risk functions in the context of remuneration decisions. 

FIT comment: This is an observation that is also made for CRD IV regulated firms and it is interesting, although not entirely surprising, that it is now being raised in a Solvency II context as well. 

The letter is consistent with our understanding that risk adjustment does not have to be incorporated in the metric itself (for example, a cost of capital charge or similar) and can be dealt with by meaningful input from the Risk Committee (as well as the supporting risk, compliance and actuarial functions), at both the time of target setting and assessment of outcomes for variable pay.

(vi)    Role of the RemCo

The PRA has identified differences across firms over the design, roles, and responsibilities of RemCos. In particular it notes that some committees are focused largely on senior management, whereas others take a more “granular, firm-wide approach”. The letter also goes on to note that boards should be comfortable that appropriate governance and consideration has been given to remuneration issues that are not considered to be the responsibility of their RemCos.

FIT comment: The observation that RemCos need to consider remuneration across the firm as a whole is not just relevant to Solvency II regulated businesses. The expanding remit of RemCos was one of the main features of the recently updated Corporate Governance Code (see our earlier briefing here) and in our experience most RemCos are on top of this. 

CRD V timetable update

As we noted in our previous briefing in March, the latest iteration of the Capital Requirements Directive (CRD V) has now been approved by the European Parliament and published in the OJEU. The legislation came into force on 27 June 2019 and member states will have until 28 December 2020 to transpose the directive into local legislation. This means that it is likely to take effect for performance periods starting in 2021 or possibly 2022. 

This is subject to the significant caveat in the UK that we don’t yet know what form the UK's proposed exit from the European Union will take. Our previous assumption was that the UK will try to achieve some level of 'equivalence' with EU regulations, in order to maintain access for UK-based FS businesses. However, this is currently far from certain, especially if the UK pursues a “no-deal” Brexit.  

In the meantime the EBA is expected to issue new/updated guidance to aid institutions in their preparations for CRD V later in 2019 or early 2020. We will continue to keep you updated as further developments occur.
 

If you wish to discuss anything arising from this briefing, please ask your usual contact at FIT or call us on 020 7034 1111 or email us at Info@fit-rem.com.

This paper is intended to be a summary of key issues but is not comprehensive and does not constitute advice. No legal responsibility is accepted as a result of reliance on the contents of this paper.

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