Insurers to repackage assets for matching adjustment

Repackaging assets that fail to meet the criteria for Solvency II’s matching adjustment could be one way for insurers to secure capital relief and hold on to attractive yields. Rob Mannix reports on the structures being considered and the alternative options available

As the finer details of Solvency II become more clear, insurers are puzzling over what to do about parts of the regulation where the final rules fall short of what they hoped for. One such area is the matching adjustment, a rule that allows insurers to discount liabilities more favourably if they hold assets that match directly with corresponding liabilities.

The adjustment is one of several amendments to Solvency II that have been strongly contested by insurers over several years, right up until the past few months. Insurers have wanted to ensure that certain assets would qualify for use in the adjustment. Now it seems they will be disappointed.

Says Emily Penn, London-based head of UK asset liability management for Royal Bank of Scotland (RBS): “Six months ago insurers were lobbying in relation to specific products, living in the hope that those products would be made eligible in their raw format for the matching adjustment.” More recently they have realised that in some instances the fight has been lost, she says. “Now they are asking what to do about the assets that will fail to qualify.”

For assets to be eligible for the matching adjustment insurers must show that the cashflows from the assets correspond to cashflows on the relevant liabilities. At the same time, based on the text of the Omnibus II directive that was approved by the European parliament in March, the cashflows in question cannot be subject to change by issuers or anyone else (see box, below, Matching or not?).

In practice this means assets with an element of optionality (for example, where the counterparty can prepay the principal of a loan) will fail to qualify. This includes callable bonds and any loans that lack features to compensate for prepayment – for example, many commercial mortgages as well as equity-release mortgages, of which insurers such as Partnership and Just Retirement in the UK are significant holders.  

The problem is not limited to legacy assets but also includes new investments, an area of special concern as insurers become increasingly active buyers of corporate and infrastructure loans. Depending on how these investments are structured, they could also be ineligible for the matching adjustment. This would render them less attractive to writers of long-term annuities in particular, who should be natural buyers for such assets.  

Says Jeff Davies, actuarial insurance leader at consultancy EY in London: “Lots of assets carry optionality that you need somehow to remove in order for the asset to qualify for matching adjustment.” Insurers are becoming more active in areas such as small business loans, infrastructure, renewable energy loans and whole loan mortgages, he points out. All of these include a degree of prepayment risk.

In the past, the embedded optionality in these products has made them more suited to bank balance sheets. More recently, as banks have reduced parts of their lending activity in response to regulatory pressure to reduce leverage (see Insurance Risk, May 2013), insurers have seen an opportunity to invest. Insurers are also being encouraged by governments to act as providers of long-term financing to the real economy (see Insurance Risk, February 2014).

Tough choices
Looking ahead, firms that want to hold assets of this type but also benefit from the matching adjustment have a number of options, though none of them ideal. These range from simply foregoing the benefit of the matching adjustment and the capital relief it brings to selling problem assets and buying others that do meet the relevant criteria.

Firms that are worried mainly about legacy assets have the option to use Solvency II’s transitional measures to continue valuing liabilities using their current approach. Doing so would allow them to transition to the less favourable discounting of Solvency II over a period of years. However, it would also impose on firms an additional reporting burden that will, in some instances, make using the transitional measures an unwelcome choice (see box 2, below, What insurers can do).

Choosing to forego the adjustment is an option practicable only for firms with smaller liabilities. It is hard to generalise about the financial impact to larger firms. But the energy devoted to lobbying for the inclusion of the adjustment in Solvency II is an indication of how costly giving up the capital relief would be. 

At the same time, selling problematic assets would mean losing the attractive yields that made investors buy in the first place. Interest rates on equity-release mortgages at the end of 2013, for example, were as high as 2% over rates on BBB-rated corporate debt, according to a paper by consultancy EY, published in early 2014.

This has led insurers to consider the more radical option of transforming the ineligible assets into instruments that will qualify for the matching adjustment. Banks and consultancies report a growing number of enquiries from insurers considering this option, with particular attention focused on portfolios of equity-release mortgages, an especially troublesome asset under the matching adjustment criteria (see box 3, below, Out in the cold).

Michael Rallings, director of capital management at Partnership, which holds about £700 million of equity-release mortgages, says the firm is still optimistic that lobbying might result in a better outcome for equity release under matching adjustment, but adds that Partnership is also looking at contingency plans for what to do if that turns out not to be the case.

“Quite a few in the industry are aware of and investigating the idea of packaging up equity-release assets into a special purpose vehicle (SPV) that would then issue bonds back to the insurance company structured so as to comply with the matching adjustment rules,” he says.

“The complicated part is to make sure the cashflows on the notes are sufficiently secure to be regarded as fixed.” Banks and consultancies are working with insurance companies to formulate structures that might work, he says.

The expectation is that the yield on the notes issued from the SPV would be lower than the return on the assets to create a cushion for default risk and so protect the cashflows on the bonds. The residual risk, held as equity, could remain with the insurer, most probably held within shareholders’ funds.

Transferable technology
RBS has been talking to several insurers about their options and, in particular, about repackaging equity-release assets. Penn says: “From a matching adjustment perspective, the cashflow profile for equity-release mortgages is uncertain due to mortality and morbidity risk, prepayment risk and the no-negative equity guarantee. These features will need to be factored into any restructuring solution.”

This implies some degree of hedging. Prepayment risk, for example, might be hedged using a combination of cashflow modelling and interest rate swaps and swaptions and drawing on models of prepayment behaviour based on historical experience.

Penn says the technology being considered for equity-release mortgages could be applied to other asset types. “The technology in these transactions is straightforward,” she says. “The main asset feature that needs to be addressed is prepayment risk, although the features will differ between different assets such as callable bonds or small business loans.”

There is little indication so far of how regulators will react to insurers’ plans, although practitioners are confident the structures being considered would meet regulatory approval.

“Companies have been quite circumspect taking much to regulators at this stage,” says EY’s Davies. “They want to know their position. They want to have their story straight. Understandably, it is hard to get an opinion from the regulator when the rules are changing. Also you want to know what the final rules will look like [before you make an approach].”

At the same time, the UK’s Prudential Regulation Authority is understood to be aware of insurers’ thinking and has yet to say anything publicly to discourage them.
In addition to regulatory approvals, insurers will have also to consider the legal and administrative costs of setting up SPVs as well as the costs of hedging prepayment and other risks to the extent that doing so is needed.   

Several structuring alternatives are being considered. For example, firms might use an internal group subsidiary rather than an SPV for the restructuring or seek to regulate cashflows using lapse and longevity swaps, but without transferring the assets off their balance sheets.

Using an internal subsidiary has the advantage of saving the administrative and legal costs of creating an SPV, but is likely to be realistic only for large group structures, according to consultants. A synthetic transaction using swaps, meanwhile, is an idea met with scepticism by some market participants, who say it could be difficult to secure regulatory approval for such an approach.

Straightforward approaches are expected to be more common. “Most companies would prefer to go for simplicity and certainty of regulatory, accounting and tax treatment in their solution,” says Davies. “Some will take a conservative view and won’t invest in anything that potentially wouldn’t qualify. Possibly they will try to divest. Others will feel they can find solutions that make them reasonably comfortable buying assets that don’t immediately qualify.”

Better terms
At the same time, insurers might find the simplest option is to focus on the terms of new investments. Their objective would be to negotiate terms that fit more comfortably with the matching adjustment criteria. Indeed there are signs this is happening already. Changes in the terms of some lending agreements might indicate a shift in favour of insurers. This, in turn,  reflects their increasing importance as a source of funding for borrowers.

Says one fixed income banker at an investment bank in London: “If an insurance company is looking to buy a new type of asset, it needs to be attractive from a regulatory point of view. Prepayment optionality invalidates the asset from a matching adjustment perspective from the outset.”

The natural response, he says, is to invest only in loans structured to protect the investor against early payment. Several bankers report a higher frequency of loan agreements involving insurers that include a so-called “make-whole” or “Spens” clause. These clauses require the borrower to compensate the lender for prepayment at a rate based on the value of discounted future cashflows.

Changes in market behaviour hold more promise for insurers than do any last minute amendments in the remaining Solvency II rulemaking. Although Solvency II delegated acts and implementing technical standards are still being worked on, there is little expectation of meaningful change in the criteria for the matching adjustment.

Janine Hawes, a director at consultancy KPMG, based in London, says: “The reasons for moving the matching adjustment into the Omnibus II text was to get political certainty. We have clear rules in the directive on the conditions that are required.” The layered approach to EU law-making means the delegated acts now under discussion cannot contradict Omnibus II and, if they did, the directive would take precedent, she says.

Meanwhile, a release from Eiopa on April 1 on the matching adjustment makes clear that the time available for firms to prepare is short. In its consultation on the first set of the Solvency II implementing technical standards, Eiopa says firms must base applications for the matching adjustment on how they manage the relevant portfolios at the point of applying rather than how they intend to manage portfolios in future.

This means firms wishing to restructure asset portfolios must do so before making an application. The release also indicates that national regulators will have up to six months to approve applications, with the implication that firms should submit applications before July 2015 at the latest.

Says Penn at RBS: “We understand the approval process opens on April 1, 2015, and firms will want to target this end of the window. In practice, where more complex structures are used they will want to start some regulatory discussions ahead of this to be confident of getting the structures approved.”

Box 1: Matching or not?
The matching adjustment exists so that firms holding assets to maturity to back long-term liabilities such as annuities are protected from the effects of short-term asset price volatility on their balance sheet.

Insurers discount their liabilities under Solvency II using a risk-free rate but mark their assets to market. As a result, volatility in asset prices could lead to volatility in the balance sheet that would arguably give an unfair view of a firm’s solvency.
To prevent this, the matching adjustment allows firms that directly match assets and liabilities to adjust the rate at which they discount those liabilities. The outcome is that falling asset values, at least for the portfolios in question, are matched by a lower figure for liabilities on the Solvency II balance sheet.

The precise adjustment to the discount rate reflects the spread of the matching assets over the un-adjusted rate minus a part of that spread deemed to reflect the default risk of the assets. UK and Spanish insurers, in particular, lobbied hard for the matching adjustment to be included in Solvency II. 

However, for assets to be included in the matching adjustment they must meet criteria set down in the Omnibus II directive. This requires assets to be managed separately and to have predictable cash-flows that cannot be changed by the insurer or by third parties.

Box 2: What insurers can do
In broad terms, the choices for insurers with assets that are ineligible for the matching adjustment are to do nothing, sell the assets and replace them with assets that are eligible, repackage the assets or transfer the risk of the assets to a third party. The best option for any one insurer will depend on many considerations, with opinion also split on whether some options will be practicable at all.

Says EY’s actuarial insurance leader Jeff Davies: “The situation differs for every company depending on structure, ownership, regulatory appetite and appetite for risk and complexity. Companies also have different views of different solutions. Some prefer something that looks more like a derivatives-based solution. Others prefer something that looks more like a reinsurance solution.”

For once, doing nothing is an option. Solvency II’s transitional rules allow insurers to continue to use existing approaches to liability discounting and move progressively to the new requirements over a period of 16 years. However, there are drawbacks to taking this approach.

Firms will require regulatory approval to use the transitional and this will most likely lead to a more onerous reporting burden, says Partnership’s director of capital management, Michael Rallings. “Although you will get the balance sheet benefit, it does potentially make the reporting burden more onerous and not everyone is going to want that.”

Meanwhile, it is not always possible to use transitional rules alongside measures such as the matching adjustment. For these reasons, certain transitional measures
might be unattractive or impossible for some firms to apply. 

Box 3: Out in the cold
Equity release mortgages allow policyholders to extract value from their homes, often to pay for elderly care. Policyholders either receive single or regular payments or have the capacity to draw down funds in increments over time. The loan is repaid using proceeds from the sale of the property when the policyholder moves into full-time care or dies.

The mortgages also often include a ‘no-negative equity’ guarantee to protect borrowers should the equity value of their property fall below the amount due at the termination of the loan. The UK equity release market is worth an estimated £9 billion and growing at about £1 billion of new premiums a year.