Understanding the UK’s Matching Adjustment Regime

Episode Summary

In September 2023, the U.K.’s Prudential Regulation Authority (PRA) released its second consultation paper on reforms to the Solvency II regime for U.K. insurers. These reforms relate to the use of the Matching Adjustment, a mechanism that adjusts the discount rate that can be applied to the valuation of an insurer’s insurance and reinsurance obligations.

In this episode of the “The Standard Formula” podcast, host and Skadden partner Rob Chaplin is joined by colleague Theo Charalambous to discuss the intricacies of the U.K.’s Matching Adjustment regime for insurers, including the rationale behind it, which liabilities are eligible, existing conditions and how it’s calculated.

In case you missed it, be sure to listen to the last episode, which covered groups, and stay tuned as our next installment will focus on investment rules.

Key Points

• What is the Matching Adjustment (MA)? Included within Solvency II, is a mechanism that allows insurers to recognize upfront, as capital resources, a proportion of the investment return that they project to earn over the future lifetime on the assets matching their insurance and reinsurance liabilities.
• Proposed Changes to the Fixed Cash Flow Asset Eligibility Requirement. The new framework moves away from the requirement for fixed income to allow for the inclusion of assets with highly predictable cash flows, provided they do not represent more than 10% of the total Matching Adjustment benefit claim.
• Proposed New Matching Adjustment Attestation Process. The PRA proposals would require a senior manager at each affected firm to attest to the PRA on the sufficiency of the fundamental spread and the quality of the resulting Matching Adjustment generated by the assets in their Matching Adjustment portfolios.

Voiceover (00:01):
From Skadden, The Standard Formula is a Solvency II podcast for UK and European insurance professionals. Join us, as Skadden partner Robert Chaplin leads conversations with industries practitioners and explores Solvency II developments that matter to you. Rob Chaplin (00:18):

Welcome back to The Standard Formula Podcast. Today, we’ll be talking about the UK’s Matching Adjustment regime for insurers. The Matching Adjustment is in the process of being reformed. In September 2023, the PRA published a consultation on proposed reforms to the Matching Adjustment, following on from the publication by the government of draft Matching Adjustment regulations, containing provisions covering the Matching Adjustment framework and calculation. We’ll also cover this.

(00:52):
I’m delighted to be joined by my colleague, Theo Charalambous, who will help us map out the intricacies around this topic. Theo, please run us through what we mean when we talk about the Matching Adjustment.

Theodoulos Charalambous (01:05):
Thanks, Rob. It’s great to be here to discuss this topic. The Matching Adjustment is a mechanism that allows insurers to recognize upfront as capital resources a proportion of the investment return that they project to earn over the future lifetime on the assets matching their insurance and reinsurance liabilities.

(01:26):
More technically speaking, the Matching Adjustment is an adjustment to the discount rate that can be applied to the valuation of an insurer’s insurance and reinsurance applications in certain specific conditions. It is designed to allow writers of certain types of longterm business, principally annuities, who are able to hold backing assets to maturity to use a discount rate closer to the credited adjusted market rate of return for the relevant liabilities, instead of the risk-free rate.

(01:58):
It’s helpful here to take a step back and think about the rationale behind the introduction by Solvency II of the Matching Adjustment regime for insurers. Over to you, Rob.

Rob Chaplin (02:09):
Thanks, Theo. Before Solvency II, aspects of the way in which the discount rate was calculated under the UK regulatory regime allowed insurers potentially to offset the effect of falls in the value assets held to match insurance liabilities, with corresponding reductions in the value of those liabilities. For bonds, as asset values fall, the spread on the bond will tend to increase. Provided that default risk has been taken into account, this increased spread can be used to increase the discount rate for the corresponding insurance liabilities. This is prudentially justified, where a hold to maturity approach is being followed. Since the actual cashflows, which the insurer will receive under the bond have not changed, only the market value should it wish to sell the asset prior to maturity. Default risk still needs to be accounted for, since a default would affect the cashflows received from the asset.

(03:14):
The difference between the actual increase in spreads on bonds and that needed to reflect increased default risk is often referred to as the illiquidity premium. The holder of the assets can take advantage of this illiquidity premium, where it is able to hold the relevant assets until maturity and can therefore effectively disregard changes to market value other than those which reflect default risk. To insurer, the liquidity premium is taken into account for the calculation of the present value of insurance and reinsurance liabilities, only where prudentially justified. Matching Adjustment provisions are included in Solvency II.

(03:58):
Let’s now take a closer look at the relevant Solvency II framework, as transposed in the English legal system. Theo, why don’t you start by explaining the concept of the risk-free rate?

Theodoulos Charalambous (04:10):
Thanks, Rob. Solvency II provides that the best estimate of insurance liabilities is to be calculated using a relevant risk-free interest rate term structure. The basic risk-free interest rate term structure is to be laid down and published by the PRA at least on a quarterly basis. It is to be derived based on interest rate swap rates, adjusted to take account of the credit risk and the basic risk of the corresponding interest rate swaps. Or for maturities where those rates are not available, based on government bond rates, adjusted to take account of credit risk. If these centrally derived rates were applied without any adjustment, the rate used by annuity providers as well as other insurers to discount their liabilities would not include any allowance for a liquidity premium, which would greatly increase their technical provisions. This has significant capital consequences for writers of annuity business in the UK.

(05:15):
Rob, why don’t you now talk us through the existing Matching Adjustment liability eligibility conditions?

Rob Chaplin (05:23):
Thanks, Theo. Only certain liabilities are eligible for Matching Adjustment treatment.

(05:29):
First, they must be life insurance or reinsurance obligations, or annuities stemming for non life insurance or reinsurance contracts. Second, the contracts underlying the insurance or reinsurance obligations must not give rise to future premium payments. Third, the only underwriting risks connected to the portfolio on insurance or reinsurance obligations are longevity risk, expense risk, revision risk and mortality risk. Mortality risk must be limited. The best estimate of the obligations must not increase by more than 5% under a mortality risk stress. Fourth, the contracts underlying the insurance or reinsurance obligations must not include any policy holder options other than a surrender options, where the surrender value does not exceed the value of the assets covering such insurance or reinsurance obligations at the time the option is exercised. Fifth, the insurance or reinsurance obligations of a contract must not be split into different parts when composing the matching adjustment portfolio of insurance or reinsurance obligations.

(06:46):
Theo, why don’t you now talk us through the existing Matching Adjustment asset eligibility conditions?

Theodoulos Charalambous (06:53):
Of course. The assets backing the relevant insurance or reinsurance liabilities must meet the following conditions.

(07:01):
First, the portfolio must consist of bonds and other assets with similar cashflow characteristics. Second, the expected cashflows of the assigned portfolio of assets must replicate each of the expected cashflows of the portfolio of insurance or reinsurance obligations in the same currency. Any mismatch must not give rise to material risks. Last but not least, the cashflows of the portfolio of assets must be fixed and must not be able to be changed by the issuers of the assets or any third parties.

(07:39):
There are some exceptions to the fixed cashflow requirement. First, inflation linked assets are permitted, provided that the assets replicate the cashflows of insurance or reinsurance obligations which depend on inflation. Second, a right of the issuer or a third party to change the cashflows of an asset is permitted, provided that the insurer will receive sufficient compensation to allow it, to obtain the same cashflows by reinvesting in assets of an equivalent or better credit quality.

(08:15):
The PRA addressed its expectations as to sufficient compensation in a supervisory statement, stating that firms should put in place robust governance arrangements to assess the adequacy of compensation. The PRA also stated that firms’ criteria for sufficient compensation may allow a possible partial recognition of an asset’s cashflows up to the level of contractual compensation payable and which anticipate foreseeable events, such as credit upgrades in respect of the assets. The PRA considers that this may allow firms to consider a wider range of assets as meeting the sufficient compensation requirement than would otherwise be the case.

(09:05):
Let’s now look at how the Matching Adjustment is calculated. Back over to you, Rob.

Rob Chaplin (09:11):
Thanks, Theo. The Matching Adjustment is calculated as the difference between, on the one hand, the discount rate which, if applied to the cashflows to the portfolio of insurance or reinsurance obligations, results in a value equal to the market value of the portfolio of assigned assets. And on the other hand, the discount rate, which if applied to the cashflows of the portfolio of insurance or reinsurance obligations, results in a value equal to the best of the portfolio of insurance or reinsurance obligations, calculated using the risk-free rate.

(09:50):
There are some restrictions on the level of the Matching Adjustment. A key concept here is the fundamental spread. Theo, why don’t you spend a few minutes on the concept of fundamental spread?

Theodoulos Charalambous (10:03):
Thanks, Rob. As part of the Matching Adjustment construct, the fundamental spread is the allowance insurers must make in their reserves for the risks they retain. For example, credit risk. The existing fundamental spread is determined by a single sector-wide regulator model. It is calculated as the sum of the expected cost of losses from defaults and the expected cost of losses from downgrades. The fundamental spread is also subject to a floor, based on a percentage of longterm average spreads. For sub-investment grade exposures, there is a further addition to the fundamental spread under Solvency II in order to limit the Matching Adjustment on those assets to that achievable on an equivalent investment grade asset.

(10:56):
Rob, we haven’t yet discussed the most recent consultation paper released by the PRA on the Matching Adjustment. Let’s spend a few minutes on that.

Rob Chaplin (11:06):
Thanks, Theo. The PRA proposes reforms to the Matching Adjustment regulations relating to greater investment flexibility, and revised eligibility rules, and more flexibility in Matching Adjustment processes, along with risk management enhancements, a greater role for senior manager responsibility, including through attestations and certain changes to Matching Adjustment calculation and reporting. These wide-ranging proposals can be seen as a substantial relaxation of the Solvency II requirements, around which fixed assets are eligible for inclusion in a Matching Adjustment portfolio and the scope of liabilities that they can be held against. This is tempered, however, by an enhanced governance framework for insurers, including principles based judgements, as well as a hard attestation from the insurer’s chief financial officer or other relevant senior manager that they have a high degree of confidence that the Matching Adjustment assets will deliver the intended result.

(12:13):
Theo, why don’t you talk us through the proposed changes to the fixed cashflow asset eligibility requirement?

Theodoulos Charalambous (12:20):
Absolutely. The new framework moves away from requirement for fixed income to allow for the inclusion of assets with highly predictable cashflows, provided they do not represent more than 10% of the total Matching Adjustment benefit claim. Such highly predictable assets must first, be contractually bound as to timing and amount of cashflows, with failure to pay constituting a default event. Second, B bonds or other assets with similar cashflow characteristics. And third, have a credit quality capable of assessment through a credit rating or internal credit assessment of comparable standard.

(13:06):
It’s worth noting that the PRA’s previous supervisory statements will continue to permit certain non-fixed cashflows to be treated as fixed rather than highly predictable. And hence, we continue to allow changes related to inflation indices and changes to cashflows for which suitable compensation is paid, thereby leaving available the 10% allowance for highly predictable assets. The PRA does, however, foresee that assets that were restructured to meet current Matching Adjustment requirements may be unrestructured to fall within the looser highly predictable regime and indeed, reiterates its expectation in previous supervisory statements that such assets should be included directly where possible.

(14:01):
Rob, do you now want to talk us through the proposed reforms relating to sub-investment grade assets?

Rob Chaplin (14:08):
Thanks, Theo. The PRA proposes to increase the allowance of sub-investment grade assets in a Matching Adjustment portfolio, by removing the current cap and modifying expectations about the management and modeling of sub-investment grade assets. This adjustment aims to promote investments that hover around the threshold between investment and sub-investment grade. That said, the PRA expects that any investment in sub-investment grade assets will remain limited, given that annuity policy holders do not necessarily benefit from the higher yield on these products. It states that these should, in any event, remain at prudent levels.

(14:52):
When assessing this, insurers will be required to account for the risk of investment grade asset holdings being downgraded to sub-investment grade. In line with the Prudent Person Principle, the PRA also considers that insurers should only invest in sub-investment grade assets to the extent that they have an effective risk management system for the particular assets.

(15:15):
Theo, why don’t you talk us through the proposed extension of the categories of insurance liabilities eligible for the Matching Adjustment?

Theodoulos Charalambous (15:23):
Of course. Thanks, Rob. The PRA’s proposals expand the scope of liability portfolios that may benefit from the Matching Adjustment. These would include in-payment income protection claims, including recovery time risk. That is, the risk that income protection policy holders take longer to recover from sickness than the firm’s best estimate projection, perhaps a nod to the trend for longterm illness that has accelerated since the COVID-19 pandemic. This is a noteworthy extension of the Matching Adjustment, will will produce significant capital benefits in the market concerned. The extension will also permit inclusion, in a Matching Adjustment portfolio, of the guaranteed components of with profits annuities, but with the non-guaranteed elements remaining outside. Although this is unlikely to have a significant impact on the market overall, it is likely to assist the limited number of providers of these specialized products.

(16:31):
I think it’s now a good time to consider the proposed changes to approach to Matching Adjustment condition breaches. Over to you, Rob.

Rob Chaplin (16:40):
Thanks, Theo. Currently, insurers must cease to apply the Matching Adjustment if eligibility conditions are breached and compliance is not restored within only two months. Insurers can’t apply for its restoration before a further 24 months. The PRA proposes to retain the two-month remediation period, noting that minor breaches should not necessarily impose a restriction on the application of the Matching Adjustment. However, to promote flexibility, where compliance is not remediated within this window, firms would be allowed to reduce the Matching Adjustment in a staggered fashion rather than face immediate termination of their Matching Adjustment permission, which was always a Draconian sanction. The PRA proposes that this reduction would be at least 10% of unadjusted Matching Adjustment, increasing by 10% for each month of non-compliance following the expiry of the two-month window. Where the Matching Adjustment has been reduced to zero, the PRA would expect to revoke the permission to apply the Matching Adjustment. But if the firm remediates during the reduction period, there restriction would be rescinded, subject to PRA confirmation.

(17:55):
Why don’t we wrap up by touching on the proposed new Matching Adjustment attestation process? Over to you, Theo.

Theodoulos Charalambous (18:02):
Sounds good. Thanks, Rob. The PRA proposals would require a senior manager at each affected firm to attest to the PRA on the sufficiency of the fundamental spread and the quality of the resulting Matching Adjustment generated by the assets in their Matching Adjustment portfolios. More specifically, the following formal statement is to be made by the chief financial officer or other relevant senior manager of an insurer, the fundamental spread used by the firm in calculating the Matching Adjustment reflects compensation for all retained risks and the Matching Adjustment can be earned with a high degree of confidence from the assets held in the relevant portfolio of assets. The attestation must be given annually for each Matching Adjustment portfolio within the firm, with the effective date aligned to the firm’s Solvency and Financial Condition reports, and upon any material change in the firm’s risk profile.

(19:08):
The PRA knows that the reference to compensation refers not just to the liquidity premium, but also higher spread related to barriers to entry or specialist skills in sourcing and developing a relevant asset. The PRA considers that the reference to high degree of confidence requires the Matching Adjustment to be materially more certain than a 50th percentile or best estimate basis.

(19:39):
On a more general note, the Matching Adjustment reforms are expected to be finalized and implemented by end of June 2024, subject to consultation responses and the government’s legislative timetable. The proposals on the Matching Adjustment will be part of the new UK Prudential regime for insurers, which will eventually be known as Solvency UK.

Rob Chaplin (20:06):
Solvency UK is an excellent note to end on, Theo. Thank you to our listeners for joining us. We hope you will continue to tune in for future episodes. In case you missed it, our last episode covered groups and our next topic will be investment rules. If you have any questions or comments on any of the topics we spoke about today, or Solvency II in general, do please feel free to contact us. Thank you, and we hope you’ll join us next time.

Voiceover (20:36):
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(20:49):
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