Solvency II's Matching Adjustment (MA) provisions give insurers relief for holding certain long-term assets which match the cash flows of a designated portfolio of life or annuity insurance and reinsurance obligations.
It does so by allowing an adjustment to the discount rate at which the firm is required to value the cash flows of its (re)insurance obligations in order to determine the amount of the technical provisions it is required to hold to cover them. This briefing explains Solvency II technical provisions and the effect of the MA on their valuation. We also discuss the PRA's guidance to date on the use of the MA, and the eligibility of assets and liabilities for inclusion in the MA portfolio. References to "insurers" and "insurance obligations" include reinsurers and reinsurance obligations.
Current status of the MA for UK insurers
On 21 November 2014, the PRA published the application checklist (the Application Checklist) for UK insurance firms wishing to use the MA as provided by Article 77b of the Solvency II Directive 2009/138/EC (Solvency II) as amended by Directive 2014/51/EU (Omnibus II). The MA is part of the so-called "long¬term guarantees package" (LTGP), agreed by the Trilogue of the EU in November 2013 and finalised in Omnibus II, which sets out the quantitative rules for the treatment of long-term insurance products. The aim of the LTGP was to introduce regulatory measures designed to avoid undesirable impacts on the balance-sheet of insurance products which include long-term guarantees to policyholders. One of those impacts is the effect of short-term volatility on the valuation of an insurer's technical provisions (see below), and the MA seeks to address this.
The LTGP agreement also enabled the European Commission to finalise level two Solvency II implementing measures in the form of delegated acts which were adopted by Commission Regulation in October 2014 (the Delegated Acts).
The MA is available only to firms who have received permission from their supervisor to use it. Formal applications to use the MA will be possible from 1 April 2015, and the PRA will notify the applicant within 30 days confirming whether the application is complete. The PRA has a maximum of six months in which to make a decision on a complete application, although if the application is considered incomplete, the six-month period will be paused while the additional information requested is supplied. As Solvency II will come into force on 1 January 2016, this means that firms wishing to apply the MA from that date will need to have submitted their applications at the latest by 1 July 2015.
Between 1 December 2014 and 6 January 2015, the PRA accepted submissions from firms as part of a pre-application process under which firms could obtain feedback on the likely success of their application. The PRA has indicated that it will supply this feedback by 31 March 2015, ahead of the start of the live application process.
Technical provisions under Solvency II
Under Article 76 of Solvency II, insurers must hold technical provisions in an amount equal to what they would have to pay to a third party insurer in order to transfer their insurance obligations to that third party. Technical provisions are calculated under Articles 77 to 86, principally as the sum of the following two elements:
- the "best estimate" – which represents the present value of the expected future cash flows of the insurance obligations, discounted using the "relevant risk-free interest rate term structure" – i.e. a discount rate set under Article 77a by the European Insurance and Occupational Pensions Authority (EIOPA) on a periodic basis, based on the prevailing swap rate for the relevant currency and maturity (the Risk Free Discount Rate); and
- the "risk margin", which represents the margin that would be charged by the acquiring insurance company (reflecting cost of capital).
These technical provisions are intended to cover the expected cash flows of the insurer. However, they also impact the valuation of the "Own Funds" held by an insurer, as Basic Own Funds (described below) include the value of the insurer's assets over its liabilities, valued at market value (rather than book value).
The Matching Adjustment
Article 77b of Solvency II allows insurers to use the MA, with approval from their supervisor, if they assign and manage separately a portfolio of bonds or assets with similar cash flow characteristics (MA Assets) to a portfolio of insurance obligations (MA Liabilities) and together with the MA Assets, the MA Portfolio and maintain that assignment over the life of the MA Liabilities. The MA allows an insurer calculating the best estimate component of the technical provisions to adjust the Risk Free Discount Rate by the difference between:
- the annual effective single discount rate which when applied to the cash flows of the MA Liabilities would give the present value of the MA Assets; and
- the annual effective single discount rate which, when applied to the cash flows of the MA Liabilities, would result in the value of the best estimate arrived at using the Risk Free Discount Rate.
This difference is then reduced by an EIOPA-prescribed haircut representing the "fundamental spread" for the MA Assets – i.e. the credit spread representing: (i) the probability of default; and (ii) the risk of downgrade. Under Article 53 of the Delegated Acts, the haircut for fundamental spread must be applied by first adjusting the cash flows of the MA Assets to allow for the probability of default of the asset before calculating the MA, and then deducting the remainder of the fundamental spread (i.e. the portion of the fundamental spread representing downgrade risk) from the amount of the MA once calculated.
This adjustment to the Risk Free Discount Rate effected by the MA reflects the fact that exposure to volatility in asset spreads could lead to volatility in the balance sheet which could give a false impression of the firm's solvency. To avoid this, firms which match assets and liabilities in an MA Portfolio are permitted to peg the rate at which they discount the MA Liabilities to movements in asset prices, so that falling MA Asset values will be matched by a reduction in the value of MA Liabilities on the balance sheet. Note that the MA only represents an adjustment for spread volatility – the insurer must continue to recognise risk of default in the MA Assets it holds by applying the haircut to the MA represented by the fundamental spread. Note also, however, that the MA can turn negative when spreads are generally low, and in those cases the amount of required technical provisions would be increased by the application of the MA, as once an insurer uses the MA for an MA Portfolio, it cannot revert to an approach which does not use it. If the MA Portfolio ceases to comply with the eligibility requirements and compliance cannot be restored promptly, the insurer will be prevented from using the MA for a period of two years.
| The MA and the Solvency Capital Requirement |
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| Insurance companies must hold eligible Own Funds equal to the Solvency Capital Requirement (SCR) to cover the amount of unexpected losses arising both from their underwriting business and the assets in which they invest. These Own Funds are separated into "Basic Own Funds", being: (i) the excess of the market value of the insurer's assets over its liabilities; and (ii) subordinated liabilities, and "Ancillary Own Funds", which include other items which can be called up to absorb losses (such as unpaid share capital). Own Funds are further classified into tiers, according to their loss-absorbing capability, and there are limits on the amount of each tier that can be used to meet the SCR. The SCR comprises a "Basic SCR" plus a capital requirement for operational risk and an adjustment for the possible loss-absorbing capacity of technical provisions and deferred taxes. To determine the Basic SCR, the balance sheet is divided into five "Risk Modules". Each of the five risk modules involves a calculation resulting in the capital requirement for that module, and the five are input into the calculation of the SCR. The capital charge for each module can be calculated using an insurer's own internal model if approved by its supervisor, but in the absence of such approval, Solvency II sets out standardised formulae for calculation of capital requirements. The SCR calculation is not a simple aggregate of capital charges for each risk module, but instead assesses the distribution of risk across the whole of the insurer's risk portfolio. However, the Delegated Acts provide that where insurers use MA Portfolios, they must calculate an SCR for each MA Portfolio as though it were a separate insurance undertaking and no credit is available for diversification of risk between the MA Portfolio and the rest of the insurance undertaking, or between separate MA Portfolios. Thus, although the MA creates a potential benefit for insurers in their calculation of technical provisions, and potentially an increase in Basic Own Funds, there may be other capital consequences of its use. |
Eligibility of assets for the MA Portfolio
The expected cash flows from the MA Assets must replicate each of the expected cash flows of the MA Liabilities in the same currency, they must be fixed and cannot be changed by the issuer or any third party (although they may be inflation-linked if the relevant insurance obligations are also inflation-linked) and there must be no mismatch giving rise to material risks. This means that bonds with issuer redemption options and step-up clauses cannot be included in the MA Assets. However, the PRA has indicated that issuer redemption or alteration of the cash flows with an accompanying Spens or similar make-whole clause will be permissible, subject to meeting criteria to ensure sufficiency of the compensation, as will bonds with market standard redemption clauses for events beyond the control of the issuer. If the insurer holds units in collective investment schemes in the MA Assets, the PRA will expect the firm to "look-through" to the underlying assets and ensure that they would qualify for the MA on their own merit, and the fund must be prohibited from investing in assets which do not qualify for the MA. Asset cash flows dependent on longevity, morbidity, the realisable value of property, and exposure to pre-payment risk (such as many equity-release mortgages) are unlikely to qualify for the MA.
No separate special purpose vehicle (SPV) is required to hold eligible assets, but they must be identified and managed separately from other assets of the insurer and cannot be used to cover other losses arising elsewhere in the insurer's business. The only assets in the MA Portfolio should be MA-eligible assets.
Repackaging of ineligible assets to achieve eligibility
Insurers may wish to consider restructuring portfolios of assets or undertaking risk transformation or repackaging transactions to achieve eligibility or cash flow matching. The PRA has indicated that it expects firms carefully to consider the behaviour of these arrangements under stress and whether the
associated risks are well understood and managed, and to consider any new risk created thereby, such as exposure to the credit risk of any counterparty to the transaction.
Repackaging of assets to transform cash flows or other contractual features can be achieved in a number of ways. Typically, however, the underlying instrument (in this case the ineligible asset) is transferred (either physically or economically) into a SPV, which finances the acquisition through the issue of debt. The SPV may enter into derivatives to convert the cash flows and/or transfer risks, or issue different classes of debt, or a combination of these methods, to create a class of instrument whose cash flows and features qualify such instrument for inclusion in the MA Assets. Residual cash flows and risks can be hived off into a separate class of debt or equity. The diagram below shows a very generalised basic form of repackaging of assets.
The SPV is used here to isolate the ineligible cash flows and risks, and effectively transform the underlying assets into assets complying with the applicable requirements.
Variations can include the addition of credit enhancement to mitigate counterparty risk, the inclusion of a liquidity facility to avoid unexpected cash flow shortfalls, and the appointment of a portfolio manager to make changes to the pool by adding, removing or substituting assets. There is a significant amount of flexibility and customisation that can be achieved through this technique, although insurers would need to ensure that the PRA's concerns are satisfactorily addressed, and also consider the impact of any potential classification of the resulting assets as securitisations.
Eligibility of liabilities for the MA Portfolio
The insurance obligations in the MA Portfolio must not give rise to any future premium payments, and the risks underwritten must be longevity and mortality risks (with mortality risk being subject to a threshold five per cent impact on the best estimate when stress-tested). The only options permitted for the insured person should be a surrender option limited to the value of the assets backing the obligation. The PRA has indicated that provisions permitting the adjustment of the initial premium will not necessarily exclude policies from eligibility, but policies which include provision for deferred premiums will be seen as splitting the insurance obligation into two parts, which is not permitted in the MA Portfolio.
PRA feedback on trial submissions for MA approval
In June 2014, the PRA invited firms to make trial submissions of the evidence required in applications for approval of use of the MA, based on EIOPA's draft Implementing Technical Standards on the procedures to be followed for the approval of a matching adjustment (the MA ITS) published on 1 April 2014. In October 2014, the PRA gave feedback on this exercise. As well as clarifying its views on the interpretation of certain of the criteria, the PRA noted that the best submissions made by firms gave detailed evidence as to the degree of matching between the MA assets and the MA Liabilities. The PRA's pre-application now requires this evidence to be in a specified format, as described below.
Applications for approval to use the MA
The Application Checklist follows the format of the MA ITS but, following the feedback from the June trial submissions, for the purpose of pre-application submissions, the Application Checklist was accompanied by an annex specifying in more detail the information required from insurers to demonstrate the matching of cash flows. The annex required insurers to undertake three separate financial tests on the proposed MA Portfolio and to report the results.
To perform the tests, firms were first asked to categorise the MA Assets into three components – A, B and C, as follows:
- component A – assets whose cash flows replicate the expected liability cash flows (after being adjusted for the component of the fundamental spread that corresponds to the probability of default, as described above);
- component B – additional assets that, when added to component A, result in a value equal to the best estimate of the MA Liabilities; and
- component C – further assets that are deemed "surplus" for the purpose of covering the MA Liabilities, but which may or may not still be needed to demonstrate compliance with the other MA requirements.
In other words, the PRA asked firms to identify, within the whole portfolio of assets which meet the MA eligibility criteria, i.e. specific MA Assets (Component A) which replicate cash flows on the MA Liabilities, and separate those out for the purpose of performing the tests. Firms are then required to perform the following three tests on the MA Assets:
- A "Discounted Cashflow Shortfall" Test on the assets in component A – to show the present value of projected future cashflow shortfalls, assuming that any surplus cash can be used to meet accumulated shortfalls from previous years (or reinvested to reduce subsequent shortfalls);
- a "99.5th Percentile Value-at-Risk Test" to show the market risk of the MA Portfolio for each of interest rate, inflation and currency risk, and calculate a capital requirement for each such risk as a ratio of the best estimate of the MA Liabilities. This test is to be performed on assets in Components A and B; and
- a "Notional Swap Test" to find how much the MA would change if any shortfall (or surplus) in the asset versus liability cash flows could be eliminated – by notionally scaling the market value and cash flows of the Component A assets up or down until the asset and liability cash flows are perfectly matched using Component A assets only.
These three tests are designed to provide information as to how precisely the asset and liability cash flows in the MA Portfolio are matched. The PRA recognises that, for the purpose of Article 77(1)(b) of Solvency II, firms are permitted to submit evidence in any form they choose, but in standardising these tests the PRA is expecting to be able to compare results from different firms consistently, and come to a view as to the level of closeness of matching which will be required. It remains to be seen whether the PRA's feedback, due in March 2015, will require similar tests to be conducted as part of the live submission process.
Conclusion
With the closing of the pre-application submission window, the timetable for live applications to apply a Matching Adjustment is now looming. There has been a notable proliferation of official publications and guidance by the EU and the PRA in recent months in readiness for implementation of Solvency II, and the Matching Adjustment provisions are a core part of their focus.
The market is clearly into novel territory with the Matching Adjustment provisions, and the interpretation of the detailed requirements is challenging. Careful analysis and structuring will be required in order to take advantage of the relief offered. The PRA has also placed emphasis on a clear analysis of the rights and features of underlying documentation in order to evidence eligibility.
For legal advice and assistance with any aspects of the Matching Adjustment, including assistance with the analysis of underlying documentation, or restructuring or repackaging assets to achieve eligibility or matching cash flows, please get in touch with any of the contacts below or your usual Ashurst contact.
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