CP19/23 – Review of Solvency II: Reform of the Matching Adjustment

In view of the feedback and the results from the call for evidence on various improvements to Solvency II which was initiated in October 2020, the Prudential Regulation Authority (PRA) has now launched a consultation (CP19/23) on targeted amendments to Solvency II regarding the Matching Adjustment (MA). The MA is highly relevant for insurance undertakings as it allows them to use potentially higher yields from assets (e.g. corporate bonds) as the discount rate for specific liabilities, rather than the lower risk-free rate, which would otherwise have to be used. The application of higher yields – in turn – leads to smaller present values of future liabilities and thus corresponding lower own fund requirements.
In an effort to improve the flexibility of insurance companies as regards their investments and thus encourage more investments in the UK economy and yet – at the same time – ensure sufficient own funds to meet future obligations, the PRA is proposing various changes to the MA. The key proposed modifications are briefly summarized below; for more detailed, comprehensive information, please refer to the enclosed consultation. It shall be noted in this context that the proposed revisions would come alongside the proposed Solvency II reforms of the UK government which the government itself intends to implement directly via regulation (over statutory instruments) in accordance with the above noted feedback to the call for evidence.
#### Proposed revisions to the Matching Adjustment
In anticipation of the upcoming statutory instrument, the PRA intends to make the following changes to its PRA Rulebook and various supervisory statements:
(1) Improving Business Flexibility:
The proposed revisions would allow insurers to invest in assets with „highly predictable cash flows“ (rather than just fixed cash flows as currently required) for being considered for a MA. For an asset to be considered an asset with „highly predictable cash flows“, the PRA would require the asset to meet the following criteria – as quoted:
– the cash flows are contractually bound, and failure to meet the contractual terms is a default event;
– the contractual bounding applies to the timing of cash flows; and
– the contractual bounding applies to the amount of the cash flows.
Furthermore, the „highly predictable cash flows“ could only make up for a maximum of 10% of the overall MA benefit a firm seeks to claim. Moreover, the PRA would require additional risk safeguards for those investing in assets with „highly predictable cash flows“ such as the requirement to perform additional asset-liability matching tests.
To further improve business flexibility, the PRA also proposes to remove the limit on the amount of MA that can be claimed from sub-investment grade assets to enable more investments near the boundary between investment and sub-investment grade assets.
(2) Expanding Eligibility of Liabilities for Matching Adjustment:
The proposed revisions would also include an extension of the types of insurance business that can claim MA to promote good risk management practices. Specifically, the PRA proposes to permit underwriting risks, which is currently permissible for MA, to include recovery time risk defined as „the risk that income protection policyholders take longer to recover from sickness than is assumed in a firm’s best estimate projection“.
(3) Being More Responsive (to Risk):
In an effort to improve both supervisory and firms‘ operating efficiency, the PRA proposes to streamline the MA application process for suitable assets. Specifically, the PRA would require itself to reach MA application decisions „as quickly as possible“, but in no case later than six months following the receipt of an application. Under the streamlined approach, a shorter decision timeframe would apply. The „streamlined approach“ could be applied, if the applicant’s proposed MA assets and liabilities are „in line with the MA eligibility conditions, propose less complex changes, or where firms propose appropriate safeguards“. Additionally, the streamlined approach would be available for firms that have already been granted MA permission for assets and liabilities that are similar to those they are applying for.
Furthermore, the PRA suggests to make regulatory treatment of MA condition breaches more proportionate. Specifically, the PRA proposes – instead of immediately terminating MA permission following two months of continuous breach of the MA conditions – a gradual reduction of at least 10% of the unadjusted MA if compliance isn’t restored within two months. This reduction would increase by 10% for each additional month of non-compliance. If the MA is reduced to zero, the PRA would likely revoke the permission to use the MA.
(4) Enhancing Risk Management:
To promote risk management and accountability among insurance undertakings, the PRA proposes to implement an attestation requirement for senior managers with regulatory responsibilities regarding the adequacy of the fundamental spread (difference between the yield an insurance company expects to earn on its assets and the risk-free interest rate) and the quality of the resulting MA. The attestation requirement would include a verification that the MA can be earned with confidence from the assets in the relevant portfolio. In this context, the PRA would require firms to have a formal attestation policy and to submit the attestation on a yearly basis to the PRA. The content of the proposed attestation would be set out in the Rulebook.
Furthermore, the PRA proposes to increase the granularity of the fundamental spread to reflect differences in asset credit quality by requiring all assets available for MA to be assessed based on their fundamental risks for default. This approach would enhance the current credit quality step approach which categorizes assets into six categories based upon the fundamental credit rating ranges.
(5) Formalizing Data Submission:
In an effort to standardize reporting and collect relevant supervisory data, the PRA proposes to introduce a new Matching Adjustment Asset and Liability Information Return (MALIR) to report on assets and liabilities in MA portfolios. The MALIR would have to be filed on an annual basis by all Solvency II firms with the approval to use the MA. The reporting requirement would start from the reporting year ending in 2024 and would have to be submitted within 130 business days after a firm’s financial year-end. One report would thereby have to be filed for each MA portfolio.