An Oasis of Freedom or a Mirage of Flexibility? Deciphering the New UK MA Landscape

• In its latest consultation paper, the UK’s Prudential Regulation Authority (PRA) outlined significant changes to the matching adjustment (MA) mechanism. These changes could have a profound impact on UK life insurers’ investment and business strategies.

• We believe the reform is a positive development for UK life insurers. It allows the allocation of MA portfolios to assets with stable, highly predictable (but not fully fixed) cash flows, such as prepayable mortgage loans. The removal of the MA benefit cap from sub-investment-grade assets encourages a higher allocation to these assets.

• The notching of the fundamental spread improves the alignment between economic risk and regulatory capital requirements for credit investments.

• While the reform provides increased investment flexibility, it also required additional reporting and ongoing adherence to the Prudent Person Principle in setting investment limits and quantifying, monitoring, and managing investment risk.

On 28 September 2023, the Bank of England’s Prudential Regulation Authority (PRA) published its much-anticipated consultation paper CP19/23, which details the proposed reform of the matching adjustment (MA) mechanism. If enacted, the reform will significantly alter the business landscape for UK life insurers, with an expanded universe of MA-eligible assets and liabilities, additional flexibility to invest MA portfolios in assets with highly predictable (HP) cash flows, and no disincentives to investment in sub-investment-grade assets.

We believe the reform is a significant positive development for UK life insurers, giving them the flexibility to build more diversified and resilient portfolios, to seek better outcomes for policyholders and shareholders across a wider range of new and emerging productive assets, and to better align regulatory capital requirements with the economic risk of their investments.

Most importantly, the reform will allow insurers to allocate a proportion of their MA investments to HP assets, provided that:

• The MA benefit of HP assets is capped at 10% of the total MA benefit

• MA portfolios meet two new asset-liability matching tests

• Insurers establish internal safeguards in adherence with the Prudent Person Principle (PPP)

In the spirit of principles-based regulation, the reform imposes few overt quantitative restrictions on insurers’ investment in newly eligible assets. Rather than face numerous and potentially restrictive investment constraints, insurers must instead show evidence of adherence to the Prudent Person Principle, whether in developing cash flow assumptions for their asset portfolios, quantifying their capital requirements, setting limits on allocations to riskier assets, or applying internal ratings.

Navigating the expanded asset universe may require closer engagement with specialist asset managers who could help insurers understand, quantify, and monitor the risk of non-traditional investments and assist them in identifying, structuring, and executing on MA-eligible investment opportunities.

We provide an overview of the proposed reform package below before delving into asset-side reforms, with a particular emphasis on highly predictable cash flow assets.

The proposed reforms comprise:

• Expanded asset eligibility

  • MA portfolio eligibility for highly predictable cash flow assets (within an allocation limit determined by a 10% overall MA benefit cap)

  • Removed the MA benefit cap for sub-investment-grade assets, with no hard limit on sub-IG allocations (insurers will be required to keep sub-IG allocations at prudent levels)

• Expanded liability eligibility

  • Expand the underwriting risks allowed in MA portfolios to include recovery time risk and allow the guaranteed benefit component of eligible with-profits annuities to be included in the MA portfolio

• Mandatory use of credit quality notches for fundamental spread calculation

  • Insurers will be required to use notched fundamental spreads (interpolated between credit quality steps published by the PRA) for calculation of the MA benefit

  • Where applicable, insurers’ internal models should be enhanced to reflect credit quality notching

• Enhancements to internal models and internal credit assessment processes

  • Insurers’ internal models should reflect the removal of the MA benefit cap on sub-IG assets

  • New requirements for internal rating assessments (including demonstrable comparability with external credit ratings)

  • Requirements for internal credit assessments previously set out as PRA expectations in PRA Supervisory Statement SS3/17 will be enacted in the PRA Rulebook

• Changes to processes for MA approval, attestation, breach management, and rule changes

• New reporting requirements in the form of the Matching Adjustment Asset and Liability Information Return (MALIR) template

The matching adjustment benefit of highly predictable cash flow assets

The reform establishes a new category of MA-eligible assets with “highly predictable” – but not fully fixed – cash flows. Spreads on these assets will be subject to additional haircuts reflecting the reinvestment and liquidity risk posed by cash flow uncertainty. The determination of prudent haircuts will be at insurers’ discretion and should reflect their (or their investment manager’s) experience and expertise in managing the risk of these investments.

Rules for Highly Predictable vs. Fixed Cash Flow Assets

New opportunities in internal securitizations

Under the existing regime, insurers have used internal securitization mechanisms to create MA-eligible fixed cash flow instruments from pools of MA-ineligible assets. The PRA is proposing that when these underlying assets have highly predictable cash flows, they can be included in MA portfolios in unstructured form, subject to filing a new MA application. Insurers may also seek to include more cash flow from internal securitizations by including sub-investment-grade securitization tranches in the highly predictable component of the MA portfolio. To avoid arbitrage, the value from the securitization (including the MA benefit and the value of any residual interest) will be capped at the value of including the assets in the MA portfolio in unsecuritized form.

While internal securitizations have become a standard tool for UK matching adjustment insurers, the expanded eligibility of HP assets creates opportunities to structure third-party managed assets – including non-UK illiquid credit – into MA-eligible securitizations.

Portfolio limits on HP cash flow assets

The inclusion of non-fixed cash flows introduces reinvestment and liquidity risks to MA portfolios that are not well captured within the existing solvency capital models. To manage these risks, the PRA is proposing additional safeguards for MA portfolios containing HP assets:

• HP benefit cap. The MA benefit of HP assets will be capped at 10% of the total MA benefit. In the event of a breach, insurers will have two months to achieve compliance; following that, the PRA may apply a reduction in the MA benefit.

• Internal controls. To ensure compliance with the Prudent Person Principle, insurers should set internal exposure limits at an asset class or instrument level as part of their MA application. The PRA does not provide prescriptive guidance on the appropriate limits, noting that such limits should reflect individual insurers’ investment and risk management expertise and data availability. Establishing controls for new and non-traditional asset classes may require closer engagement with specialist asset managers.

Sub-investment-grade assets: no more MA benefit cap

The PRA is proposing to remove the cap on MA benefit for sub-investment-grade assets. Currently, the MA for sub-IG assets is capped so that it cannot exceed the MA for comparable investment-grade assets.

In the spirit of principle-based regulation, the PRA does not impose quantitative limits on insurers’ allocations to sub-IG assets. In line with the Prudent Person Principle (PPP), insurers are expected to maintain their sub-investment-grade investments at prudent levels, taking into account the uncertainty in cash flows due to higher default risk and the other risks of such assets.

To ensure compliance with the PPP, insurers are well advised to develop their sub-IG asset allocations in collaboration with asset managers with an established track record in credit risk management and distressed workouts.

Additional PRA matching tests for HP assets

The PRA is proposing changes to the existing asset-liability matching tests that will apply to all insurers. Insurers wishing to use HP assets in their MA portfolios will need to demonstrate ongoing compliance with two additional tests: an MA loss test and a cash flow shortfall test.

For externally managed HP assets, the new tests would require even closer collaboration between insurers and their asset managers to deliver timely and accurate cash flow reports and income projections.

Updates to PRA Asset-Liability Matching Tests