Clifford Chance
Countdown to Solvency UK - Solvency UK and the Matching Adjustment: A Closer Look
The Prudential Regulation Authority (PRA) has introduced significant changes to the Matching Adjustment (MA) framework in an update to Supervisory Statement SS7/18. Effective from 30 June 2024, the changes precede other Solvency UK reforms being implemented at the end of this year. The PRA has stated that the changes aim to provide firms with greater clarity and certainty regarding their investment strategies, fostering an environment where they can effectively manage their portfolios while ensuring the integrity and resilience of the MA framework.
By expanding the range of eligible assets and liabilities for the MA, although perhaps not to the extent hoped for by firms, the PRA hopes to encourage firms to innovate in their investment approaches while adhering to robust risk management practices.
Key changes to the MA framework include:
- Widened Asset Eligibility: MA portfolio eligibility criteria now include assets with highly predictable (HP) cash flows.
- Liability Eligibility: the scope of eligible liabilities has been widened to include recovery time risk and the guaranteed element of with-profits annuities.
- Investment in SIGs: the MA cap on sub-investment grade (SIG) assets has been removed and it is now for firms to determine appropriate prudent levels.
- Enhanced Attestation Requirements: annual attestations must be given for each MA portfolio within the firm.
- Updated Reporting Requirements: an annual Matching Adjustment Asset and Liability Information Return (MALIR) is to be completed.
- Streamlined Application Approach: a more efficient MA application process has been introduced.
- Proportionate Response to Non-Compliance: the cliff-edge withdrawal of MA approval for breaches not rectified within two months has been removed.
For further information on MA reforms, please refer to our briefing here.
(1) Asset Eligibility
Prior to the changes, in order to be eligible for inclusion in an MA portfolio, cash flows of the relevant portfolio of assets had to be fixed and not capable of being changed by issuers of the assets or any third parties.
Now, assets with cash flows that can be changed by issuers or third parties can be eligible if they have "highly predictable" (HP) cash flows. To qualify as HP assets, the cash flows must be subject to "contractual bounding", which means setting finite ranges for cash flow timings and amounts due under the legal documentation. The MA asset eligibility conditions, therefore, include a requirement that such asset cash flows must pay contractual sums with a bounded range of variability over both amounts due and the timing of payments.
Despite some respondents to the MA consultation paper (CP 19/23) finding the contractual bounding requirement to be too strict, suggesting it should be "bounded" rather than "contractually bounded", or that junior notes from internal securitisations and unrestructured asset portfolios should be allowed with notional restructuring or cash flow haircuts, the PRA has maintained its position and stressed in its response in PS10/24 that without contractual bounding, the cash flow profile could change, compromising the recognition of the credit spread as loss-absorbing capital resources.
The PRA still expects firms to consider the risks to the quality of matching even though the asset cash flows are contractually bound and firms should satisfy themselves that such risks are not material. In line with the prudent person principle (PPP), firms should consider whether the limited range of the bounded cash flows paid on the assets makes them suitable to match the nature of the liabilities in the MA portfolio.
The MA benefit on an MA portfolio from assets with HP cash flows is limited to a maximum of 10%, ensuring most assets in MA portfolios will continue to have fixed cash flows, thereby limiting risks to matching quality. Existing assets meeting eligibility requirements are not included in the 10% limit and remain characterised as fixed.
Firms with MA permissions can switch between treating assets as having fixed cash flows or HP cash flows, provided they, amongst other things, manage assets in accordance with their MA permissions, apply Fundamental Spread (FS) additions and establish an appropriate governance structure. However, frequent changes in treatment will require justification, and the PRA will monitor the inclusion of assets with HP cash flows and may set further expectations based on observed practices.
Restructurings
Firms have been able to undertake risk transformation transactions to achieve a portfolio of MA eligible assets, such as securitisation transactions or hedging arrangements.
Generally, the PRA now expects that firms will include MA eligible assets, whether with fixed or HP cash flows, in MA portfolios without restructuring. Where a firm does restructure MA eligible assets, and subsequently applies to include eligible note(s) from such a restructure in an MA portfolio, the firm will need to explain the reasons for the restructure and how it is satisfied that the level of MA benefit is appropriate. Firms must also demonstrate that they have sufficient data to model the exposure to the cash flow variability risks so that any notes issued by the restructuring arrangement can be relied on as having fixed cash flows. The aggregate value of a restructuring arrangement would not generally exceed the value that would result from including the assets directly in the MA portfolio. Where value has been created by restructuring, the firm must explain how this has arisen and demonstrate that any value enhancement has been created on an arm's-length basis. It is important that any restructure is appropriately recognised within the firm and its group, including any resulting changes in risk profile.
However, the PRA will not consider MA eligibility conditions to have been met where a firm proposes to define a notional part or fraction of the cash flows of an asset to match liabilities within the MA portfolio (and in the calculation of the MA). Notional, non-contractual identification of cash flows will also be unlikely to be consistent with the requirement to maintain the relevant portfolio of assets over the lifetime of the insurance obligations under the Insurance and Reinsurance Undertakings (Prudential Requirements) Regulations 2023 (IRPR Regulations). As a result, where firms are planning on using restructuring arrangements, these should be legally contractually executed and any resulting bond or loan to be included in the MA portfolio must meet the MA asset eligibility conditions.
(2) Liability Eligibility
The PRA has expanded the types of insurance liabilities that may benefit from MA. The changes mean that a guaranteed component of a with-profits annuity contract may be eligible for inclusion in an MA portfolio, provided that the component is (i) legally established and separately identifiable as guaranteed within an insurance contract; (ii) capable of being organised and managed separately in accordance with regulation 4(6) of the IRPR Regulations; and (iii) otherwise meets the MA eligibility conditions. For such components within an MA portfolio, the PRA expects firms to provide a detailed assessment, showing that the only elements of the liabilities included are contractually guaranteed and not dependent on future premiums or investment performance. The firm should also have a clear policy regarding the addition of future attaching bonuses in the MA portfolio or elsewhere.
Permitted underwriting risks connected to the portfolio of liabilities may now also include recovery time risk, namely the risk that policyholders receiving income protection payments take longer than expected to recover from illness. As such, "eligible elements" now include in-payment elements of income protection contracts and in-payment annuities under group policies provided death-in-service dependant annuities, where they are capable of being organised and managed separately. The PRA does not consider that the inclusion of recovery time as an underwriting risk should lead to types of liabilities other than income protection claims in payment being included in MA portfolios.
In-payment annuities under group policies providing death-in-service dependant annuities are now also eligible for inclusion in MA portfolios, where they also meet the same criteria, and are not subject to future premiums.
(3) Investment in SIG Assets
The limit on the amount of MA benefit that may be derived from SIG assets has been removed. This is particularly relevant to assets that are close to and below the boundary between investment grade and SIG (known as the "BBB cliff"). However, the PRA still expects firms to keep holdings of SIGs to prudent levels, considering the extent to which their other asset classes could be downgraded in deteriorating market conditions.
As SIG exposures can give rise to increased and a greater breadth of risks due to their lower credit quality, the PRA expects firms to take this into account, alongside any potential concentrations of SIG or near-SIG exposures when setting their investment strategy and limits, as part of their ongoing risk monitoring and when assessing the alignment of their approach to managing assets in a MA portfolio with the PPP.
(4) MA Adjustment Attestation
Firms must now provide annual attestations, timed to coincide with the Solvency and Financial Condition Report (SFCR), confirming that their MA portfolios meet regulatory requirements, ensuring assets and liabilities are appropriately matched and the FS is accurate and reflective of underlying risks. These new requirements require careful consideration from firms, as they will require firms to develop and maintain a policy for these attestations, which should be backed by robust internal processes and controls. The first required attestation for firms with MA permission will be in respect of their first financial year-end after 31 December 2024.
In summary, within their attestation policy, the PRA expects firms to include details of:
- how it has determined the PRA senior management function holder who is responsible for the attestation;
- triggers that may result in a material change in the firm's risk profile for an out-of-cycle attestation;
- the process by which the attestor should review the FS and MA (including any criteria for subjecting assets to a more detailed review); and
- how to determine the amount of any addition to the FS.
The senior manager responsible for the production and integrity of the firm's financial information and its regulatory reporting is also responsible for the attestation and will be required to certify to the PRA that the firm's financial statements are both adequate and of high quality.
Firms are expected to adopt a systemic approach to reviewing evidence for the attestation, which should include an assessment of whether the MA portfolio has a risk profile consistent with the underlying MA assumptions. Firms are also expected to consider the FS and MA on an asset-by-asset basis, rather than assuming that prudence for one asset can be offset against an insufficient FS for another, for example.
Although the attestation requirement may result in firms making voluntary additions to the FS as they take greater accountability for the level of MA applied in the valuation of their liabilities, the PRA does not expect this to result in a general increase in the level of FS applied to all assets, but instead provide greater insight into the drivers of variation in MA and improved management of risks identified. The PRA expects that a voluntary FS addition applied by a firm would not automatically result in a reduction to its SCR.
(5) Updated Reporting Requirements
Another key change is the requirement for firms to submit an annual return assessing portfolio changes over time. Firms with permission to apply the MA are expected to complete the MALIR on an annual basis for each MA portfolio, with the first return due in 2025, 130 business days after a firm's financial year ending on or after 31 December 2024. In light of concerns about operational burdens on smaller firms, and that certain sections of the MALIR may not be applicable, a waiver process is open to firms where the burden associated with the MALIR is considered disproportionate. Waiver applications will be considered on a case-by-case basis, factoring in portfolio materiality, firm size and asset holdings. Firms should properly justify their waiver requests to ensure the statutory requirements are met. There is no transition period as the PRA notes that firms should already be familiar with the process.
(6) Streamlined MA Application Approach
In response to requests for a more streamlined process for granting MA permissions, the PRA has made certain changes to enable a more efficient MA application review process. These include, amongst other things, a triage process to make an initial assessment of the scope and completeness of applications before they are allocated to a streamlined review path.
There will be a reduction in documentary evidence required for MA applications. Instead, there will be a greater reliance placed on a firm's written confirmation that the credit quality of the assets is capable of being assessed through a credit rating or an internal assessment of a comparable standard.
Whilst the PRA has maintained its overall approach to MA applications, it has indicated that it is open to developing the MA application process to better support long-term investments that align with its goals.
(7) Proportionate Response to Non-Compliance
The PRA has removed the cliff-edge withdrawal of MA approval where a breach of conditions is not rectified within two months. Instead, there will be an automatic reduction of the amount of MA in a staggered fashion, starting with 10% of the MA and increasing by an additional 10% for each further month when the firm is not in compliance.
The PRA believes that this staggered approach provides a more proportionate mechanism for addressing breaches while maintaining incentives for firms to restore compliance promptly. The reduction is meant to be dynamic, based on the current MA level, and the PRA retains the discretion to adjust the reduction rate depending on the circumstances, potentially increasing or reducing the impact. Reductions should cease once compliance is restored, with firms expected to liaise with their PRA supervisory contact to confirm the resolution of breaches.
Looking ahead
The PRA's adjustments to the MA framework mark an evolution rather than a step change in the post-Brexit regulatory landscape, providing firms with some enhanced flexibility regarding asset and liability eligibility. The extent to which they will allow improved capital efficiency in practice remains to be seen. As these changes have already come into effect on 30 June 2024, firms should have already started an assessment of their internal processes, ensuring alignment with the new requirements. This could include adapting governance structures, revising investment strategies, and developing robust policies for annual attestations and MALIR submissions.
