30 June 2024 – an important date
30 June was important in BPA insurance terms as it signalled the introduction of the PRA’s new rules on Matching Adjustments for long-term insurers. A Matching Adjustment is a permitted addition to the discount rate used by an insurer to value certain long-term insurance liabilities where they are backed by investments that generate very closely matched cash flows. Theoretically the changes will allow a broader range of assets to qualify for the adjustment, reducing insurers’ liabilities and potentially even allowing releases of capital.
It might not seem that earth-shattering, however when you consider that only one of the nine insurers writing BPA business at the start of this year would have had sufficient assets to meet their Solvency Capital Requirement if the Matching Adjustment were removed, you can see that the Adjustment, and changes to it, are potentially a big deal.
What are the changes?
The changes were introduced as part of the UK’s ‘Solvency UK’ regime – the latest UK-specific application of the Solvency II methodology. To date assets qualifying for Matching Adjustment credit have tended to be residential Lifetime Mortgages (see separate article), commercial mortgages and long-dated private lending. Held to maturity and with cash flow profiles that more closely matched the policy liabilities they backed, the illiquidity of these assets helped BPA insurers generate extra returns ie an ‘illiquidity premium’. (How closely some of these asset classes match liabilities in practice is worthy of another article.)
To qualify for Matching Adjustment credit, these investments previously had to be investment grade and generate “fixed” cash flows to maturity. Assets that did not inherently generate qualifying fixed cash flows, such as Lifetime Mortgages, could be packaged up via securitisations into Matching Adjustment-eligible investment grade tranches with fixed cash flows, and ineligible, sub-investment grade mezzanine and equity tranches with less certain cash flows.
The recent changes now allow the Matching Adjustment portfolio to include a proportion of assets with “highly predictable” rather than necessarily fixed cash flows to qualify, as well as watering down the credit quality requirements. The new rules have also broadened the range of liabilities that might qualify for Matching Adjustment credit.
Overall the changes could allow insurers to start holding a broader range of infrastructure and ‘green’ investments. For example the definition of “highly predictable” cash flows would potentially allow the Matching Adjustment portfolio to include infrastructure assets with an initial construction phase, generally characterised by more flexible cash flow profiles. Changes to the restrictions on sub-investment grade assets may also encourage investment in ‘green’ or environmental financing assets, while improved recognition for internally-rated assets might also be expected to further increase insurers’ appetite for private credit.
Should the pensions industry be concerned?
Although the range of investments in which BPA insurers can invest has now widened and could potentially include riskier assets as well as a greater proportion of internally-rated investments, we believe the overall impact on BPA insurers’ balance sheets probably will be relatively muted:
- 10% limit: the benefit from these new assets is restricted to 10% of the Matching Adjustment credit from the whole of an insurer’s assets
- Fundamental Spread: this is the deemed risk component in the return from an asset. The greater the deemed risk the less of the return can be allowed for in the Matching Adjustment. Increases to this de-facto risk charge are required to accommodate the greater uncertainly associated with assets with only “Highly Predictable” cash flows, which are likely to reduce the effective Matching Adjustment credit for, and thereby deter, more aggressive asset allocations
- Attestation: there is a new “attestation” requirement whereby a designated senior manager at the insurer must attest at least annually that the Matching Adjustment can be earned with a high degree of confidence
- Other: additional stress testing requirements will effectively highlight those insurers with higher risk asset strategies
What should trustees and employers be doing?
Matching Adjustments can have a material bearing on an insurer’s solvency. While we do not anticipate the changes will have a material balance sheet impact on the industry as a whole, it nevertheless underscores the need for trustees and employers to be aware of the investment risks in their chosen insurer(s). Specialist independent assistance may be needed to assess this risk and ensure that trustees and employers are comfortable with the risk profile of an insurer prior to transacting.
For further information, contact:
Richard Hall
rhall@argyllcovenant.com
+44 (0)118 334 5801
+44 (0)7718 543168
