DECRYPTING THE FINAL DRAFT PRIIPS RTS
On April 6th after the second round of votes by the authorities of the European Union, ESAs obtained the approval to issue the final draft version of the Final Draft Regulatory Technical Standards (RTS) on the PRIIPs KID. The expectations of the market were huge, hoping that this document would bring clarity and relief on the various challenges that the PRIIPs KID/data production and dissemination entails.
The best time to act was last year
The second best is now
Although the RTS provide more clarifications on the content of the KID, the main challenge for market players (especially asset managers of UCITS funds) is the tight timing to implement a technical solution for production and dissemination, adapt their operational processes, and produce the required information to be included in the KID. ESAs made a point to make all parts related to the KID coherent with each other and achieve partial alignment on the disclosures to be made for each investment product in scope. For example:
- A link between calculation of the Summary Risk Indicator (SRI) and performance scenarios has been introduced
- references to other regulatory requirements such as MIFID II or IDD (e.g. calculation and presentation of costs, target retail investor) have been included
Manufacturers that sell their products to retail investors through insurance products also got the confirmation that they have to meet a large part of the PRIIPs requirements as from December 2016. This especially concerns UCITS asset managers, since they have a grandfathering period until end of 2019. Regardless of the grandfathering period, these asset managers (as well as other manufacturers where products are sold to retail investors via insurance-based products) must be ready to provide information on product description and targeted investor, Summary Risk Indicator, performance scenarios and costs to insurers to whom they sell their funds. As a result, asset managers must get their hands around it right now; if not for regulatory reasons, at least for commercial reasons.
This creates a situation that was already experienced during the implementation of Solvency II: insurers will have to obtain PRIIPs documents or data from the asset managers, while asset managers need to either produce PRIIPs-compliant documents or at least provide PRIIPs-compliant data. Once done, this documents/data will have to be provided to the insurers to which their products are sold. In addition, asset managers will need to put PRIIPs-relevant monitoring rules in place to ensure that their documents/data produced are PRIIPs compliant and they are in the position to keep the insurer up to date about any relevant changes.
Risk calculation: clearer, not easier
The calculation methodologies for risk described in the draft RTS confirmed that a Market Risk Measure (“MRM”) and a Credit Risk Measure (“CRM”) must be calculated and combined into the Summary Risk Indicator (“SRI”) for each product. This principle has been kept from the consultation paper but its applicability is somewhat larger.
As far as the computation of the MRM is concerned, it is noteworthy that the suggested quantitative methodologies have been made clearer, and that the two-step approach suggested by the previous version is confirmed: qualitative assignment of a category from 1 to 4 (5 categories were outlined in the draft RTS 11/2015 before) depending on product’s features, then application of calculation methodologies according to the category assigned, as follows:
- Direct assignment for Category 1 products – e.g. all derivatives, products with valuations available no more than monthly such as real estate funds, ELTIFs, … For these products, the MRM must be assigned qualitatively (MRM = 7 for derivatives and MRM = 6 for all other products)
- Cornish Fisher expansion for Category 2 products – e.g. products with linear payoffs such as non-structured funds, unit-linked products with no guarantee, …
- Bootstrap methodology for Category 3 products – e.g. structured funds, leveraged structured products, …
- A mix of internal methodologies and bootstrap for Category 4 products – products that contain features that are not observable on the market, for example with-profits insurance products
One can also note that the mapping between the calculated annualized volatility and the MRM classes has significantly changed, and are likely to result in lower MRM assignments compared to the requirements of the consultation on draft RTS back from November 2015. According to the requirements, products will be assigned with a MRM 7 if the calculated annualized volatility exceeds 80% (25% in previous draft RTS).
Computation of the CRM has however changed dramatically compared to the previous version of the RTS. It needs to be done at the level of the underlying assets on a look-through basis, with cascade credit assessment to be done for each underlying asset to the product that has an exposure of at least 10% of its value.
The RTS also makes the use of mitigating measures possible. For instance, PRIIPs for which assets or collateral are 100% equivalent to their payment obligations, not accessible to any other creditors and either deposited on a segregated account in accordance with AIFMD or the UCITS V or identified and held on registers based on applicable law are exempted from calculating a CRM on a look-through basis.
Crystal clear: Aligning Risk & performance
Computation of performance scenarios is now much more prescriptive in the final draft RTS, as expected and requested by many market players and industry associations. One can see that performance scenarios are still to be presented net of all the costs related to the product, must reflect favourable, moderate and unfavourable scenarios and must be presented forward-looking while being calculated based on the same historical performance that was used to compute the MRM.
The alignment with the risk calculation methodologies has been made crystal-clear as it relates to the qualitative definition of categories of the products and the methodology to be applied. These methods are exactly the same for products belonging to categories 2, 3 and 4.
Performance scenarios is however the part that has changed the most compared to the previous version of the RTS.
The first change lies in the presentation of the performance scenarios for Exchange-Traded Derivatives (“ETDs”) which are futures, call or put options. For these products the manufacturer must show a payoff graph instead of presenting performance scenarios as a table.
The second change is the detailed prescription made on the selection of the favourable, moderate and unfavourable scenarios. We now have clear guidelines on which scenarios to be shown, which are the 90th, 50th and 10th percentiles of a distribution of future returns, calculated according the same methodologies as for MRM calculation.
The third change consists in defining the interim periods for which performance scenarios need to be calculated and presented. ESAs gave detailed prescriptions on how many interim periods must be shown, depending on the Recommended Holding Period (“RHP”). The prescriptions on the interim periods are as follows:
- For products that have a RHP of less than one year, only the scenario for the RHP needs to be shown
- For products that have a RHP between one and three years, performance scenarios must be shown for one interim period of one year and for the RHP
- For products that have a RHP that exceeds three years, performance scenarios must be shown for two interim periods (one year and half of the RHP), as well as for the RHP.
Although this answers the question on how to define interim periods, the comparability issue on performance scenarios for investment funds offered by insurance undertakings through Multi-Option Products remains. Insurance products with a RHP of 10 years or more will indeed show scenarios that are likely to be incomparable with scenarios of the funds that are offered as investment options, for which the asset manager may have defined an RHP that is shorter. Asset managers and insurers are still in a grey area with regards to this topic and will have to find the right balance between operational efficiency and providing comparability between insurance products and investment funds.
In addition to these methodological clarifications, the final draft RTS outlines that insurance undertakings are now allowed to reflect future discretionary profit participation in their favourable scenario and that the presentation of scenarios for regular premium products shall include a “death scenario” on top of the favourable, moderate and unfavourable scenarios.
Aggregating and disclosing detailed costs at the same time
Aggregation and presentation of costs figures remain in line with the previous version of the RTS. Although costs still have to be presented as monetary figures and as percentages, the RTS now require to have only the total costs to be presented as monetary figures over the RHP, instead of having costs shown by one-off, ongoing and incidental costs (c.f. cost over time table in the RTS). The Reduction-in-Yield disclosure and calculation methodology has not changed compared to the previous version of the RTS.
As far as the composition of costs is concerned, PRIIPs manufacturers are now required to disclose “insurance costs” and “carried interests” in addition to the costs types previously required. For insurance undertakings the “insurance costs” consist in showing the cost part of the biometric risk premium separately in the composition of costs table, which might dramatically increase the number of different KIDs to be produced, even though all other cost components remain the same.
In addition, the final draft RTS describe in details how to calculate transactions costs for investment funds but its applicability for existing funds is questionable. Indeed, considering that a 3-year history of mid prices and arrival prices must be used, how shall asset managers collect the required price history and compute transaction costs that are compliant with the requirements of the PRIIPs RTS ?
Dissemination takes centre stage
In the final draft RTS, the requirements to keep investors up to date have been further clarified. It is suggested (mentioned in the PRIIPs final draft RTS) that retail investors have to be kept up to date, as soon as their identity is known.
Due to this, there can no longer be a focus on the production of PRIIPs-compliant documents only, but on secure, reliable and effective dissemination also. Since distribution of PRIIPs may be done via various channels and distribution partners a “simple” dissemination can easily turn into a “monster” of functional and technical requirements.
In a nutshell
It does not matter whether you are a manufacturer of funds, structured products, derivatives or insurance based products. Aside from some PRIIP type specific challenges, we will all find ourselves sitting in the same boat, defining the most time- and cost-efficient ways to ensure compliance with the PRIIPs regulation and its RTS as of 1st of January 2017.
The time left for such an implementation will require, beside IT infrastructure capabilities and product know-how, also sufficient in-depth knowledge on the PRIIPs RTS requirements as well as a reflection of such in a tool to ensure daily business (production & dissemination).
In consequence, undertaking such a project on its own may put you at risk to not be compliant as of the day PRIIPs becomes obligatory. Or in case you are a manufacturer of UCITS funds, you will no longer be able to distribute these funds via an insurance-based product, if the insurer is not in possession of the PRIIPs-compliant information.