Background

The Prudential Regulation Authority’s (PRA) published its Policy Statement “Review of Solvency II: Reform of the Matching Adjustment” (PS10/24) and the associated finalised rules and guidance[1] on 6 June 2024. This followed the publication of the PRA’s consultation paper in September 2023 and the enactment of The Insurance and Reinsurance Undertakings (Prudential Requirements) Regulations 2023.[2]

This publication marks the completion of the reform of the UK Matching Adjustment (MA) requirements that comprised a key part of HM Treasury and the PRA’s broader review and reform of the Solvency II requirements in the UK (Solvency UK). The new rules became effective from 30 June 2024.

A shifting of the dial?

At the heart of the MA reforms lies the aim of harnessing the capital of the long-term insurance industry for deployment in “productive investments” in the UK. It is intended that this will be achieved by increasing the investment flexibility of insurers within the MA regime. This reflects the broader political thrust of the Solvency UK reforms, which are consistent with the new UK Government’s manifesto priorities for UK investment. These productive investments are considered by the PRA to include UK infrastructure investment, in particular social housing projects and green investment (including energy generation).

The PRA has now thrown down the gauntlet to the industry. Gareth Truan, Executive Director, Insurance Supervision, delivered a speech reflecting upon the MA reforms on 9 July 2024. The PRA’s published summary declares that “insurers have now everything they need to use the Solvency UK reforms to support their plans for UK productive investments. The onus is now on them to make the most of the opportunity the reforms present.”[3]

The extent of that opportunity in practice remains to be seen. Running through the MA reforms are protections that embed the PRA’s commitment to maintaining robust prudential standards for policyholder protection. There is an inherent tension between those protections and the new investment flexibility, which are considered in this article.

What is the MA?

Where cash flows of investment assets are used to closely match the cash flows of certain long-term liabilities of insurers, the MA allows insurers to take credit upfront for part of the expected investment returns   of such assets above the risk-free rate. The MA is applied as an increase in the “discount rate” used to calculate an insurer’s future liabilities. The higher the discount rate the lower the current value of the expected liability. The MA is calculated by reference to a Fundamental Spread (FS) (i.e, as the amount of the market spread in excess of the FS).  This therefore reflects risks retained by the insurer, such as credit risk on the issuer, but allows the insurer to benefit from that part of the asset’s valuation which reflects the illiquid or long-term nature of the asset. The MA framework therefore has a significant capital benefit for long-term insurers; one that recognises that insurers with closely matched predictable asset and liability cash flows are not materially exposed to the risk of being forced sellers of such assets.

What are the key reforms?

The PRA’s reforms are largely unchanged from its consultation phase, although there have been some helpful clarifications of the requirements and the PRA’s expectations. The reforms support the PRA’s stated goals of improving investment flexibility, increasing the responsiveness of the MA framework to risk and enhancing insurers’ responsibility for risk management. The reforms are summarised in high level terms below, although this article focuses on changes relating to asset eligibility and sub-investment grade (SIG) assets.

Investment flexibility:

  • Asset eligibility: the new rules expand MA asset eligibility beyond assets with fixed[4] cash flows to allow up to 10% of the aggregate MA benefit for which credit can be taken to derive from assets with highly predictable cash flows (HP assets). The PRA has clarified that existing MA approvals (including the characterisation of fixed cash flow assets) will continue to be valid.
  • Liability eligibility: the types of long-term insurance business that can benefit from the MA have been expanded to include recovery time risk[5] on income protection claims in payment; and allowing in-payment income protection liabilities, the guaranteed element of with-profits annuities and in-payment group death in service dependants annuities to fall within scope of MA portfolios.
  • Cap on SIG assets: the limit on the amount of the MA that may be credited from sub-investment grade assets has been removed. This is particularly relevant for assets that are close to a BBB- rating, known as the “BBB cliff”. These changes are balanced by clarified expectations around the risk management of such assets, including the need for compliance with the Prudent Person Principle[6] and the appropriateness of internal model calibrations.

Responsiveness to risk

  • Streamlined application process: while MA applications are complex and highly technical, requiring significant investment from firms, the PRA intends to speed up its review process to allow firms to take advantage of the expanded investment opportunities. It has implemented a target deadline of six months for a decision on non-streamlined reviews. It intends, once the new framework has been operational, to introduce a shorter target for streamlined reviews where applications clearly comply with the MA eligibility conditions, involve fewer complex changes, or where there are appropriate safeguards. The PRA is also putting in place a framework for pre-application engagement.
  • A more nuanced approach to breach: the PRA has retained the two-month period within which firms must restore compliance with the MA requirements following a breach. However, rather than MA eligibility falling away entirely at this stage (which the PRA considered punitive and potentially adversely affecting stability), there will be a staggered reduction of the MA benefit over time.
  • A more granular FS: the PRA has introduced a more granular FS calculation, considered to be more sensitive to risk by allowing different notched allowances to be made within major credit ratings.  

Enhanced responsibility for management in relation to MA risks

  • Attestation: the PRA will require the senior management function holder responsible for the firm’s financial information and regulatory reporting to attest to the PRA that the FS used by the firm in calculating the MA reflects all retained risks (i.e. not just credit risk) and that the MA can be earned with a high degree of confidence (HDC) from the assets held in the relevant portfolio of assets. The HDC standard is higher than the best estimate standard applied for technical provisions more generally. The attestation will need to be made annually at the effective date of the Solvency and Financial Condition Report and additionally upon any material change in the firm’s risk profile. This could include a significant or complex transaction (e.g. a bulk annuity transaction). This will require a formal attestation policy, with an accompanying report and evidence, and one would expect firms to apply significant governance and assurance to this.
  • Formalising expectations in relation to internal credit assessments (ICAs): while not intended to be a change in supervisory approach, the PRA has set out formally its expectations in relation to ICAs. These need to be of a comparable standard to a credit rating issued by a credit rating agency and must consider all risks to which assets are exposed as part of the assessment. There are also requirements for ongoing validation and appropriate independent external assurance.
  • Formalising reporting requirements: the PRA has introduced a new annual reporting requirement for firms with MA permissions. Such reporting to take the form of a new return called the Matching Adjustment Asset and Liability Information Return or “MALIR”.
  • Inclusion as an MA eligibility condition that firms must demonstrate compliance with the Prudent Person Principle: this reflects a renewed emphasis through the PRA’s rules and guidance on the need for compliance with the Prudent Person Principle to be considered in the context of the MA portfolio specifically and not just across the balance sheet as a whole.

HP assets and the removal of the SIG asset cap: a boon to productive investment?

The expansion of the MA asset eligibility requirements to HP assets for up to 10% of the aggregate MA benefit and the removal of the limit on the MA benefit that can derive from SIG assets are perhaps the most eye-catching elements of the reform package and the clearest expression of the intent to increase the deployment of long-term insurers’ assets to productive investment in the UK.

HP assets

HP Assets are defined as assets where: (i) the cash flows are contractually bound in time and amount; and (ii) failure to meet the contractual terms is a default event. The PRA has explained that it sees this contractual bounding as achieved where the legal terms set out a finite range for the cash flow timings and amounts, for example:

  • the cash flow profile (the payment dates and amounts or how the cash flow amounts are to be calculated);
  • the circumstances in which the cash flow profile may or must be varied by the issuer; and
  • where the cash flows can be varied, the amount and timing of the varied cash flows.

The HP assets must also (like other MA assets) be bonds or other assets with similar cash flow characteristics, have a credit quality capable of assessment through a credit rating or internal credit assessment of comparable standard and be managed in line with the Prudent Person Principle. 

HP asset eligibility potentially opens up a wider range of lending opportunities, for example loans for construction phase development in commercial property and infrastructure projects and floating rate lending where the interest rate or the timing or payments are not fixed but the ability to vary them is specified in the underlying contract. Commentators have also suggested that HP assets could include callable bonds and mezzanine tranches of securitised equity release mortgages.

The quid pro quo of the eligibility of HP assets, reflecting the higher risk profile of HP assets compared to assets with fixed cash flows – in, particular reinvestment and liquidity risks – is the imposition of an addition to the FS to provide for these additional risks to matching from the potential cash flow variations. There are therefore two additional matching tests for HP assets which test the exposure to HP cash flows arising both sooner and later than expected and/or of lower amount and also a 10 basis point allowance in the FS for reinvestment or rebalancing costs. These amendments to the FS for the HP assets will reduce the MA benefit gained from HP assets.

SIG assets

Prior to the PRA’s reforms, firms were disincentivised by the cap on the MA benefit that can derive from SIG assets from investing in assets that were rated BBB or lower because of the disproportionate impact of a downgrade.  

However, whilst the removal of the BBB cliff edge should allow insurers to finance earlier-stage developments, the PRA has clearly set out that it expects firms to keep holdings of sub-investment grade assets to prudent levels due to the increased risks (in particular, default-risk) they pose. Insurers should also consider these risks and potential concentrations when setting their investment strategy (and related limits) and in assessing their compliance with the prudent person principle.

Commentary

The expansion of the MA eligibility criteria to HP assets and the greater incentive to invest in SIG assets does give significantly improved investment flexibility to insurers. This is most clear in the case of BBB- rated bonds and other SIG assets, which may now be materially more attractive from an MA perspective. We expect internal and external asset managers and actuaries will closely scrutinise portfolios to identify opportunities to maximise the MA benefit and consider a wider range of origination options. 

However, we anticipate that hopes for a fundamental shift in investment strategy and deployment of significant additional capital to a wider range of productive investment (consistent with the political aims of the Solvency UK reforms) will be considerably tempered by the policyholder protection considerations inherent in the existing and reformed MA framework. These manifest in specific provisions such as the FS addition for HP assets, the increased governance required by the MA attestation and the formalised requirements for ICAs, all of which add to the complexity, and the cost to firms, of operating within the MA framework. Further, policyholder protection is clear in the broader emphasis by the PRA on the need to ensure there is no material risk of the relevant cashflows not matching the underlying liabilities and the application of the Prudent Person Principle to investment in HP assets, SIG assets and the MA portfolio as a whole.

While the PRA considers that the widened eligibility criteria “materially shift[s] the dial for insurers”, our review of market commentary indicates that, taken together, these factors may discourage any significant changes in risk-taking and innovation. The impact of the changes will become clearer over time as investment strategies develop and portfolios are adapted. Gareth Truan’s 9 July speech emphasises that the PRA, for its part, considers that the new regime meets the core demands of the industry and warns firms not to lose sight of what has already been delivered. It appears that any expectations of significant further changes have therefore been politely but clearly discouraged.

However, the PRA has committed to keep under review “how the regime might evolve further in future” and to support “safe innovation”. In this regard, the PRA notes that, in response to the industry calls for the ability to execute on investment opportunities more quickly, it is considering an ”Accelerator” scheme that would allow firms to self-certify eligibility for MA of a limited portion of assets, in advance of seeking formal approval from the PRA. This was noted as potentially being a “useful future enhancement”, which suggests the market should watch developments in this space closely.

[1] See in particular SS7/18: “Solvency II: Matching adjustment” June 2024

[2] Consultation Paper 19/23: “Review of Solvency II: Reform of the Matching Adjustment”, September 2023; The Insurance and Reinsurance Undertakings (Prudential Requirements) Regulations 2023 (No. 1347)..

[3] https://www.bankofengland.co.uk/speech/2024/july/gareth-truran-at-insurance-asset-risk-webinar

[4] For example, cashflows which cannot be changed by the issuer except where they are linked to inflation or where sufficient compensation is payable on an early repayment to allow the insurer to replicate the cashflows

[5] This is the risk that policyholders take longer than expected to recover from certain illnesses.

[6] This requires insurers to only invest in assets whose risks they can properly understand, monitor and manage while bearing in mind the best interests of policyholders and ensuring the overall security, liquidity and profitability of the portfolio as a whole.