Reform of the Matching Adjustment
(This article was first published in October 2023.)
The PRA has published another Consultation Paper as part of its Solvency UK Reforms: “CP19/23 – Review of Solvency II: Reform of the Matching Adjustment”, which proposes a series of reforms to the Matching Adjustment” (MA). Under Solvency II, firms are required to value liabilities under a fixed “risk-free rate”. With approval from the PRA, a Matching Adjustment, which is an increase in the risk-free rate used to value the liabilities, can be applied to the liabilities, effectively reducing the value of liabilities. The principle behind this is that it allows the firm to realise some of the future spread it expects to earn on its portfolio of assets held against liabilities.
The first set of proposed changes focuses on improving flexibility for eligible insurers. This firstly begins with broadening the array of investments that can be held in an applicable portfolio, allowing firms to invest in highly predictable cashflows that are not fixed cash flows. Next are a set of changes relating to increasing the number of eligible insurers away from largely non-profit annuity-focused businesses and allowing for income protection policies in payment and the guaranteed elements of with-profit annuities to be eligible as well. This is ultimately aimed at allowing more firms to benefit and to encourage a wider range of policy types to be offered that have closely matched liabilities and assets. There is also a consideration concerning removing the limit of MA that can be claimed from so called “sub-investment grade” assets, so more investments will be made near the boundary and still receive MA.
The second group aims at making the matching adjustment more sensitive to risk levels. This means creating a faster application process to allow firms to more quickly adjust their portfolios making it more efficient as different investment opportunities appear. There is also a suggestion for proportional consequences to breaches of MA conditions rather than always leading to a strict removal of MA. In addition, there are changes related to adjusting the fundamental spread (“FS”) to reflect cases where the credit quality of firm’s assets varies, to further improve flexibility.
Lastly, the final set of changes focuses on making firms more responsible for risk management relating to the MA. The first step focuses on accountability by introducing a self-attestation process for the amount of MA claimed, leaving it up to the firms to ensure their FS covers the risks of their portfolio of assets. This makes it easier to invest in a greater range of investments which one model could not account for alone when valuing FS. The PRA is also planning to clarify how firms are expected to manage the risks of sub-investment grade assets. In addition to this, it will introduce a Matching Adjustment Asset and Liability Return form to declare the assets and liabilities in insurers’ portfolios that are Matching Adjusted. Finally an extra eligibility condition for MA is proposed, requiring firms to demonstrate compliance with Prudent Person Principle to ensure the assets held in the portfolio are suitable and have been properly managed for risk.
Firms are only applicable for a Matching Adjustment if payments are fixed and certain or near certain. Previously, this meant that it mostly applied to firms with large annuity businesses but there is now potential for other insurers, including income protection providers, to use an MA. In practice, however, the processes and approvals required make it still unlikely to be appropriate for smaller insurers.