Is Prudential Authority approval needed when insurance companies wish to post collateral?
The Insurance Act, 2017 (“IA”) was implemented in South Africa in July 2018 and it repealed many of the provisions of the Long-Term Insurance Act (“LTIA”), and Short-Term Insurance Act (“STIA”). Currently there are no published Prudential Standards which regulate the use of derivatives by insurance companies (although the Prudential Authority has indicated they will be publishing these at some point). The IA states that if a provision of the LTIA or STIA is repealed but not yet operational (it needs the Prudential Standards to be operational), then the repealed sections will continue to be valid. This means that until the Prudential Standards are published, the old provisions of the LTIA and STIA in respect of derivatives transactions will continue to be valid.
The new Joint Standard 2 of 2020 (“Joint Standard”) was implemented in June 2020 under the Financial Markets Act, and this set out the requirements for margining uncleared OTC derivatives transactions.
Life and non-life insurance companies are listed as a “counterparty” under the Joint Standard and this brings them into scope to post Variation Margin (and depending on their average aggregate notional amount of OTC derivatives done on group basis, could bring them in scope for Initial Margin too).
The LTIA and STIA stipulated that a Long-Term Insurer "shall not —
(a) encumber its assets;
(b) allow its assets to be held by another person on its behalf;
(c) directly or indirectly borrow any asset;
(d) by means of suretyship or any other form of personal security, whether under a primary or accessory obligation, give security in relation to obligations between other persons;
(e) include in its assets shares held directly or indirectly in its holding company,
without the approval of the Registrar, given generally or in a particular case, and subject to such conditions as the Registrar may determine."
It was clear from this section of the LTIA and STIA that the approval of the Registrar (now called the Prudential Authority) would be required if an insurer intended to pledge assets as collateral to secure its derivatives positions, as this would constitute an encumbrance.
There was some debate about whether an outright transfer of title in collateral constituted an encumbrance and therefore required the approval of the Registrar. However, most players in the market considered an outright transfer did not constitute an encumbrance, but rather a disposal of the asset. The debate on this point was due to the LTIA and STIA not providing a definition of “encumbrance” and it was therefore left open to interpretation.
Once Prudential Standards under the IA are published, the treatment of collateral will fall under the IA. The IA states that "the Prudential Authority may prescribe requirements in respect of —investments; the use of financial instruments, including derivatives; off-balance sheet transactions; intra-group transactions; transactions that may increase, encumber or reduce assets or liabilities; or financial or other exposures to entities that are part of an insurance group."
Importantly, the IA now includes a definition for "encumbrance" as follows:
" … any pledge, restriction or limitation (including any contractual obligation that must be fulfilled before a contractual right may be exercised) that limits access to, or the use or disposal of, an asset".
The definition of “encumbrance” under the IA is broad and would include pledged collateral assets as well as assets transferred outright in title. On this basis once the IA provisions become operational, the Prudential Authority may impose requirements (like getting approval) if an insurance company wishes to enter into any collateral agreement (whether it be a pledge or outright transfer of title agreement). This interpretation however would be subject to review of the final and published Prudential Standards (as and when that happens).