Understanding HPC assets in the Matching Adjustment framework

Solvency UK is the reformed version of the EU’s Solvency II regime, implemented in the UK following Brexit. A key component within this framework is the Matching Adjustment (MA), which allows insurers to adjust the discount rate used for calculating long-term liabilities, reflecting the illiquidity premium of assets held against these liabilities. 

The recent reforms to Solvency UK have expanded the list of eligible assets for the MA to include Highly Predictable Cash Flow (HPC) assets. This article explores the definition of HPC assets, the regulatory requirements they must meet, and implications for insurers.

What are Highly Predictable Cash Flow assets?

Under the MA requirements, asset cash flows must be fixed in both timing and amount and cannot be changed by issuers or third parties. However, there are exceptions for certain features like inflation adjustments and clauses that ensure fair compensation for early payments. HPC assets are those whose cash flows can vary but are contractually bounded in both timing and size. Key regulatory requirements for HPC assets include:

• The contribution of HPC assets to the MA benefit is capped at 10% of the total MA benefit for the portfolio.
• A minimum addition of 10 bps is applied to the fundamental spread, with specific methods for determining this top-up detailed in the SS7/18.
• Additional MA tests (Tests 4 and 5) are required.

Qualifying HPC assets

Assets with both fixed and variable cash flow components can now potentially qualify for the Matching Adjustment (MA) under two categories. Previously, regulations only allowed recognising the fixed part of the cash flows or the lowest guaranteed amount payable at the latest possible date. This often led to worst-case scenario assumptions for assets with variable components. For example, with callable bonds, it meant assuming the earliest possible call date unless there was a clause for sufficient compensation for early repayment.

Now, these assets can also qualify under the new HPC category. This category recognises the entire cash flow, including both fixed and variable components, provided they are contractually bounded in timing and amount. For some assets, this means firms can choose to recognise them under either category, offering more flexibility in applying the MA.

Examples of assets that might meet the HPC criteria

1. Callable bonds: Previously, callable bonds without sufficient compensation for early repayment were difficult to include in MA portfolios. However, they can now potentially qualify under the new HPC category as their coupon and maturity payments are contractually bounded by defined first and last call dates. Firms must assess the cash flow variability risks and allow for an additional fundamental spread to account for the optionality. This change allows insurers to include a wider range of callable bonds in MA portfolios.
2. Loans with step-up features and leases with contractual rent reviews: Loans or assets with step-up features, where interest rates or payments increase at specified intervals, can also qualify under HPC. These features must be well-defined in the contractual terms, ensuring that the cash flows are predictable and bounded in both timing and amount. Leases allowing for upward adjustments in rents are now eligible under the HPC category. The PRA has outlined in SS7/18 that firms should use reasonable assumptions for future rent increases, ensuring the cash flows are bounded, even if not entirely fixed.
3. Construction phase assets: Construction phase assets can now be included if their cash flows are contractually bounded in timing and amount. This may include payments tied to project milestones, provided these are clearly defined in the contract. Previously, these assets were only eligible if they were in the income phase, with cash flows recognised at the latest possible date and ending at the earliest possible date. 

Opportunities and challenges for insurers

The inclusion of HPC assets offers insurers increased flexibility in their investment portfolios by making more assets eligible for the matching adjustment. However, the requirement to increase the fundamental spread for these assets could make some HPC assets less attractive. Additionally, the administrative burden of satisfying the additional tests, especially with the 10% cap on MA benefit from these assets, may deter firms from investing in them. If the MA benefit, after the increase in the fundamental spread, is not substantial, insurers might prefer other private credit assets with fixed cash flows.

Several insurers already use mathematical optimisation for asset allocation and enhancing the MA benefit. Investing in HPC assets present its own challenges as insurers will have to incorporate additional MA tests into the optimisation process. The benefit to firms with already diverse portfolios of illiquid assets from introduction of HPC may be marginal, but still material. 

Next steps

These changes represent a positive step, encouraging investment in infrastructure and direct investments. While there are administrative considerations, such as calculating the fundamental spread add-on and conducting additional tests, the focus should not be solely on increasing the MA benefit. Instead, firms should consider investing in assets as part of their strategic asset allocation. By approaching these regulatory changes thoughtfully, insurers can enhance their portfolios while meeting both regulatory and strategic investment goals.

Want to learn how 4most can help your organisation navigate these changes? Contact us at info@4-most.co.uk.