In limbo: insurers await PRA views on matching adjustment

The list of questions gets longer, and the time left for answers gets shorter. The UK industry can only wait as regulators prepare a final position on details of the Solvency II matching adjustment.

UK firms are counting down to the implementation of Solvency II, but their regulators refuse to be rushed on details of how a critical part – the matching adjustment – will apply. There have been two letters from the Prudential Regulation Authority (PRA) to the industry, a summit, trial submissions, and a pre-application process is now under way, but still insurers don't know exactly what to expect. The delay is creating confusion about how much benefit individual firms will get from the measure. Unfavourable decisions from the regulator could turn the planning of firms on its head, or even lead to forced sales of parts of their asset portfolios.

The PRA is the European supervisor furthest ahead in dealing with this part of the directive, which is expected to be widely used by UK annuity providers as well as Spanish insurers and some Dutch firms. The regulator's deliberations will be watched closely by other supervisors not least because the matching adjustment has been a contentious area. Some continental regulators think a lenient interpretation of the rule could give UK insurers an unfair advantage over foreign peers, allowing them, for example, to use their stronger capital position to fund acquisitions.

Firms in the UK filed pre-applications to use the matching adjustment with the PRA in early January, as part of a dry run ahead of official applications in April. The rule matters to UK annuity providers, in particular, because it allows them to discount liabilities at favourable rates if they hold assets that are closely matched. The proviso is that the assets are placed as buy-to-hold investments in a ring-fenced portfolio, and that cashflows are fixed and match the designated liabilities.

However, a long list of worries continues to trouble insurers as a result of these criteria, including how often firms can trade the matched portfolio, what diversification benefit they can claim, and how the adjustment might contribute to the calculation of group own funds (see box, Group discounts?). Insurers have been hoping for indications from the PRA of how it sees these issues. But the regulator will not give company-specific information ahead of simultaneous feedback to all pre-applicants, expected towards the end of the first quarter.

Patience might be a virtue, but it is hard to embrace when parts of your business hang in the balance. "Firms are still not sure what does or doesn't work and, to be honest, we won't know until March," says Paul Fulcher, managing director, ALM structuring, at Nomura in London. "We can see matching adjustment hell and matching adjustment heaven. At the moment we are in purgatory."

We can see matching adjustment hell and matching adjustment heaven. At the moment we are in purgatory.

Limbo

Jon deBeer, head of prudential regulation at industry group the Association of British Insurers (ABI), says: "Insurers are working hard to get ready for Solvency II and waiting for clarification from the PRA on a number of issues, including feedback on the matching adjustment. It is important this feedback is provided as soon as possible so that firms and the supervisor can ensure a smooth timeline for approval applications. The ABI and its members will continue to work closely with the PRA on this area." In practice, the timeline looks set to be anything but smooth.

A first item of concern for insurers is how far they will be able to restructure ineligible assets to fit the matching adjustment criteria. So far, the PRA has shown a willingness to be helpful on this point. In a letter to the industry in October last year, the authority opened the door to risk transformation transactions – welcome news for firms looking to reshape assets that include some form of optionality into assets that pass the matching adjustment test.

The assets being looked at include commercial loans with prepayment clauses, commercial mortgages or infrastructure investments. Equity-release mortgages, in particular, have been a source of contention. Sold to borrowers as a way to get cash from the equity value of their property, these redeem when the borrower dies or moves into long-term care. The loan is then repaid with interest from the proceeds of the sale of the property. A no-negative-equity guarantee means the lender pays the shortfall if the sale price of the house is below the value of the loan.

The mortgages catch in the teeth of the matching adjustment because of the complex matrix of risks they include: prepayment risk, morbidity and mortality risk, and property risk. UK insurers such as Partnership and Just Retirement are understood to hold extensive portfolios. And the PRA has made clear that, as they stand, these mortgages will not qualify.

Bankers and consultants propose a variety of fixes for problem assets, most of which follow a common theme. The idea would be to transfer ineligible assets to a vehicle that would issue fixed-rate bonds to the matching adjustment portfolio. The residual risk would then be passed either to another part of the group or to a third party.

Nomura's Fulcher explains: "You externalise the risk on a stochastic basis. So you are able to say, for example, that there is a BBB level of probability of getting the cashflows. You are turning ineligibility into default risk, and default risk is allowed in the matching adjustment." So far, so good. But the question remains, how much of the residual risk might insurers have to transfer to a third party.

Simeon Rudin, a partner at law firm Freshfields Bruckhaus Deringer in London, who has been advising several firms on the pre-application process, says the cost of transferring all the residual risk would kill most structures. "For one portfolio we looked at – a full third-party transaction where the third party took all the residual risk – the cost largely eliminated the matching adjustment benefits," he says. "It was a big number. That transaction would not have been worth doing."

The PRA's letter in October (and a previous letter in June) said little on the details of structuring. And some insurers are understood to have proposed structures in the pre-application with no risk transfer outside the group. Such an approach might mean, for example, transferring risk to the company's shareholder fund.

At Nomura, Fulcher says it is unclear whether the regulator will require some of the risk to be removed from the balance sheet entirely. "The shareholder fund is the capital of the entity that provides capital to the annuity fund. By transferring the risk to your own capital, you then reduce the amount of capital you need. The PRA might have issues with that," he says. "They could require insurers to externalise some of the risk. Maybe you can pass the risk outside of the annuity fund, pass some of it externally and then pass the residual bit somewhere else within the group. But no-one knows and no-one is going to know until March."

A second big concern relates to the matching adjustment's treatment of foreign exchange hedging programmes. Common practice among UK insurers is to hedge forex risk using rolling currency forwards, which is a more efficient approach than trading long-dated cross-currency swaps to match the relevant bonds. Long-dated swaps are costly, not least because of the capital that bank counterparties have to hold against them under Basel III liquidity rules.

Of course, the cashflows of these hedging programmes are not matched in the way the matching adjustment requires. A literal reading of the rule would force firms to hedge with cross-currency swaps or leave foreign currency investments out of the portfolio. Firms say, however, that banks would not provide liquidity at long-enough tenors to make hedging possible, even if insurers wanted.

Rather than turn to structuring options in this instance, some in the industry are understood to be lobbying to keep the status quo. The arguments are, broadly, that doing so achieves the risk mitigation required and, because short-term hedges are used, there is little credit or collateral risk.

An additional line of reasoning says that rolling currency forwards are a better hedge for the risk. A firm might, for example, trade a cross-currency swap that matched the notional of a portfolio of foreign currency bonds. If spreads subsequently widened, the foreign currency value of the bonds would fall, but the swap notional would remain the same. In such a case, the firm would be over-hedged going forward.

A third area of uncertainty is whether firms must hold collateral for their derivatives positions within the matching adjustment portfolio or whether they can source collateral from outside the ring-fenced fund. The adjustment says nothing either way on the subject, but some in the industry think regulators might expect collateral to be included.

The PRA's October letter contributes to this impression, according to Eric Viet, head of financial institution advisory at Societe Generale, based in London. The letter says that cash is an admissible asset in matching adjustment portfolios, he points out. But, why would insurers hold cash in the portfolio other than to post as collateral?

"Cash could not match any long-dated liability cashflows. But you need cash in the matching adjustment book if you are going to use derivative overlays, because you need to manage your collateral requirements," says Viet. It seems, perhaps, that the PRA is assuming collateral will be posted from within the portfolio. "The PRA said a weakness of the trial submission was that few insurance companies had a credible plan for how to manage liquidity requirements," adds Viet.

Whether or not firms hold collateral in the matching fund they will have to think about liquidity optimisation, says Andrew Kenyon, insurance ALM actuary at Royal Bank of Scotland in London, meaning ways to hold more credit (and fewer gilts) in the portfolio but knowing they have access to liquid collateral when they need it. "This is one of the areas where PRA feedback is vital," says Kenyon. "Firms should consider what contingent options are available to them and how their requirements might change under stressed conditions."

Other insurers believe that collateral can be sourced from outside the ring fence.

Jeff Davies, actuarial insurance leader at consultancy EY in London, says he has come across this argument. "One perspective we've seen is that the matching adjustment is about covering expected cashflows and that collateral is an entirely separate concept." In this view the matching adjustment simply has nothing to say about collateral or where it might come from, he explains, although he is unsure what the outcome of this discussion might be. "It remains to be seen whether this fits with the way the regulator thinks about the matching adjustment."

There might be implications even if regulators accept that collateral can be posted from outside the matching fund, according to Rudin at Freshfields. The PRA could take the view that an implicit guarantee is being provided to the ring-fenced fund. That view should have no impact on the matching adjustment part of the business, he says, but could influence the calculation of solvency capital requirements and own funds for the rest of the business.

"Is there anything that says you can't post collateral from outside the ring fence? No, so long as you continue to meet the requirement for the cashflows of the assets to be fixed and to match the specified liabilities. But that isn't the entire question. The question is: what are the consequences if you do." The management of collateral will also be structurally complicated, he points out, because collateral is posted on a market value, not on a cashflow basis.

Wait and hope

As the industry awaits judgment, it matters not only what regulators decide, but why. Returning to the issue of asset repackaging, EY's Davies explains. "If the PRA says ‘no' it depends why it says ‘no'. If it believes it is legally bound to an approach because of what the regulations say, it is more likely to offer the quasi external solution [with risk partly but not wholly transferred to a third party]."

Firms hope the PRA will be helpful both in its reading of the rules and how far they have to window-dress portfolios to meet those requirements. "No one in the industry wants structuring for the sake of it," says one risk manager at a UK insurance company. "If you can show that an intragroup transaction, for example, would remove from the portfolio any mismatch in cashflows, you shouldn't have to waste all the structuring costs in explicitly doing that." The UK regulator has shown lenience in this way in the past, granting waivers to firms that show they can satisfy its rules but not requiring them to make largely superficial changes

While the regulator is giving little away, it has made encouraging comments recently. In a speech earlier this month, for example, Paul Fisher, deputy head of the PRA, reminded the industry of the regulator's appreciation of the position of UK insurers. "The matching adjustment has been something the UK advocated strongly in the trilogue negotiations," he said. "We do recognise that certain annuity firms can afford to invest in less liquid assets."

For now, though, insurers can only wait. "The PRA has said it will give individual feedback simultaneously to everyone," explains Fulcher. "Even if a company has submitted something bulletproof they are not going to get an email until the end of March, the same as everyone else." The only individual communication that firms should expect from the PRA between now and then will be questions or requests for clarification about the firm's own submission.

The caginess is because PRA determinations on the matching adjustment can be expected to influence the market. Leaked information about a harsh line on the admissibility of some assets could cause shares in some firms to fall, as did leaked information about an annuity review from the UK's conduct regulator last year. The PRA has indicated, however, that it will make two more policy statements to the industry as a whole. These should draw attention to areas of common interest and are expected later in the first quarter.

When the complete feedback drops into inboxes in March, insurers will have just weeks to act on what they read. If they allow six months for regulatory approval, firms will have until the end of June to apply, in order to secure approval in time for Solvency II in 2016.

In those three months they will have to complete the documentation of new legal structures and adjust portfolios depending on what the PRA decides. Furthermore, insurers cannot submit on the basis of planned changes. The submission must be based on the firm's position at the time of application.

Above all, firms will need to analyse in detail the trade-offs between the benefit they will get from the matching adjustment and the costs of its use, including its impact on liquidity and tax. "Firms are on their toes and working out what they will do in each case," says the UK risk manager. "It makes sense to have the infrastructure in place to do something if need be. If the outcome is positive you just collapse the infrastructure. But the timeline is tight. Firms have to be on their feet and ready, and need to have worked through all the possible scenarios and be ready for each of them."

Most insurers anticipate the PRA ruling favourably. The consequences if it did not could be transformational. At Freshfields, partner George Swan says: "There are particular portfolios of assets where if the PRA takes a non-accommodating line those assets will disappear, with quite material social consequences that the PRA will be aware of. The expectation is that they will be accommodating. But of course they have Eiopa looking over their shoulder."

Having said that, the role of the European Insurance and Occupational Pensions Authority (Eiopa) in the process is largely reactive, leaving plenty of room for the PRA to make its interpretations. "We are in contact with the PRA but it is their decision," says Eiopa chairman Gabriel Bernardino. "It is up to the national authorities to decide on implementation. But I'm sure that, as time goes by, there will be a discussion within Eiopa to ensure we have consistent implementation in the different member states.

"In such a detailed exercise there will be areas where there will be divergences in implementation. We are here to make sure that if these are material we come up with a consistent and convergent approach."

With the PRA as the first mover in interpreting the matching adjustment rules, this is likely to mean others will follow the UK's lead. It is often said that patience is rewarded. Insurers are hoping that, on this occasion, the maxim will prove true.

 

Group discounts?

Insurers have been fretting over an apparent contradiction in the drafting of parts of the Solvency II legislation that would appear to take away the benefit of the matching adjustment at group level – rendering it all but pointless.

The Solvency II delegated acts say that when calculating own funds at group level, insurers must eliminate the effects of any intragroup transactions. The intention is to stop firms from effectively issuing capital to themselves, with one entity buying equity in another to boost own funds when calculated at group level. The accidental consequence, though, could be the effective unwinding of the matching adjustment at group level for firms using intragroup transactions to restructure ineligible assets.

UK firms have expressed worries about this part of the delegated acts, specifically at a meeting in October 2014 hosted by the PRA to discuss the results of the trial submission, among other topics. The PRA, for its part, has offered little clarification and talked at that time of Eiopa still consulting on the treatment of the matching adjustment at group level.

Optimism is now emerging, founded on two paragraphs in the annex of Eiopa guidelines on group solvency that were released at the end of last year. Explanatory notes to guideline 15 seem to resolve the issue, allowing intragroup transfers in matching adjustment portfolios to contribute to group own funds.

The notes say: "When calculating the restricted ring-fenced fund own funds… the ring-fenced fund assets and liabilities used to identify this restriction are also required to be gross of intra-group transactions." And later: "The restricted ring-fenced fund own funds calculated at group level is the same as the restricted ring-fenced fund own funds calculated at individual level."

Freshfields' Rudin says this would seem to clear up the controversy. "There were 20-odd documents released on November 27. This bit is not in the guideline itself, but in an explanation of the guideline," he says. "It is possible many people have still not waded through all the documents to focus on these particular two paragraphs."

"If you look at it the other way around, it would be pretty illogical to have the solvency capital requirement aggregated gross of intragroup transactions but own funds calculated net. That just could not be right. The guidelines could be clearer. But I think the answer is that intragroup transactions are included and, logically, that should be the answer."