Solvency UK: Matching Adjustment Reforms

The latest consultation paper published by the PRA (CP19/23) proposed a number of reforms to the matching adjustment (MA), with an overall aim of increasing the role which life insurers play towards productive investment in the UK economy. The final policy/rules are expected to be published during Q2 2024 with an effective date of 30 June 2024.  

To comply with the new rules, additional work will be required for any insurers with an MA portfolio, including updating the treatment of credit ratings and validation of the fundamental spread for the new MA attestation requirement.

Investment Flexibility

New MA regulations will widen MA asset eligibility to go beyond the current requirement for fixed cashflows, to allow assets with “highly predictable” cashflows to be included in the MA portfolio. 

To ensure that an MA benefit can still be earned with a high degree of confidence, contractual bounding in both timing and amount will be necessary. Overall, this will enhance the competitiveness and growth of the UK economy by promoting investment in UK productive assets. This would be beneficial for certain green investments and infrastructure assets as the eligibility of assets with highly predictable cash flows allow for a construction phase without costly restructuring (for projects with a construction phase, the cashflows for the full term of the project tend to be uncertain until the completion of the construction phase).

MA Attestation

The PRA proposed that firms will be required to attest on the Efficiency of the Fundamental Spread (FS) and the Quality of the Resulting MA Calculation ( you can read our overview here).

Due to our background in credit-risky assets, 4most is well placed to support the modelling and asset valuation required for the Attestation, especially in consideration of the harder to value illiquid assets.

Credit Ratings Under MA

The PRA have proposed several changes to the treatment of credit ratings under the MA framework:

• Removal of rules relating to a cap on the MA benefit of Sub-Investment Grade (i.e. below investment grade BBB-) credit quality when calculating Technical Provisions, with an aim of increasing firm investments in a wider range of assets.  This should be good news for green and environmentally friendly assets.  
• Changes to the Fundamental Spread calculation have been proposed through the recognition of ‘notched’ credit ratings (e.g. A+ or A- rather than just A), meaning a more granular assessment of credit risk in the reserves. Firms will be required to source or derive the notched ratings themselves for all relevant exposures.  We expect further clarification of the rules around notched ratings in the final policy statement. 

Introduction of a requirement for internal credit assessments, in the relevant portfolio of assets, to be comparable to those arising from an external credit rating. This proposal includes new requirements that the internal credit assessments would have to satisfy, for example, the risks that should be considered and the need for appropriate validation. The PRA considers that these requirements will increase the confidence in firms’ internal credit assessments.

MA Approvals

The PRA’s proposals relating to MA Approvals are outlined as follows:

• Prudent Person Principle (PPP) – explicit requirement for firms to include in their MA applications evidence that the assets they wish to invest in are capable of being managed in line with the PPP, both at the level of the portfolio and individual assets.
• Streamlined MA application approach – this would be suitable where applications are clearly in line with MA eligibility, or where firms propose appropriate safeguards. Overall, this proposal would help facilitate insurers’ ability to include new investments in MA portfolios.  
• Breaches of MA eligibility conditions – the proposed amendments to the consequences for firm’s breaching MA conditions will reduce the risk of instability on a firm’s balance sheet and make the regulatory treatment of breaches of MA conditions more proportionate by reducing the benefit allowed under MA rules gradually and allowing reinstatement of the benefit following timely rectification of the breach. 

Liability Eligibility

The PRA’s proposals relating to liability eligibility are as follows:

• Recovery time risk to be permitted – proposal to include recovery time risk in the list of permitted underwriting risks (this will mean that income protection business may be eligible for inclusion in an MA portfolio).
• Inclusion of guaranteed benefits – proposal to permit guaranteed benefits of with-profits annuities, where the fixed elements may be identified and for which no future premiums are payable, in MA portfolios.

Credit Modelling Capabilities

The PRA has raised concerns that the Cost of Downgrade (CoD) is not fit for purpose when calculating the FS. 4most has conducted research for a particular asset class (CRELs) where we suggest replacing the FS CoD with a Credit Risk Premium (CRP) approach:

Fundamental Spread = PD + CRP.

• The PD calculation can be achieved via a model that uses stochastic projections of the underlying cashflows supporting loan repayments, where expert judgement is required for the data, assumption and calibration inputs.
• The CRP calculation can be achieved in relation to both an average spread of reference index of n-years and the delta in the spread between the reference index and the specific asset (e.g. a CREL).

Modelling the FS in this way should make it easier to demonstrate that the FS reflects all retained risks, as the model will cover risks explicitly (e.g. market risks), but also the assumptions can be set such that it covers other risks implicitly (e.g. climate change, political, demographics.

Conclusion

With 2024 bringing significant regulatory development to the insurance industry, staying compliant is a task not to be underestimated. Partner with 4most for expert guidance and support as you navigate these changes. Contact us at info@4-most.co.uk to learn more or link in with the authors.

References:

https://edu.bankofengland.co.uk/prudential-regulation/publication/2023/september/review-of-solvency-ii-reform-of-the-matching-adjustment