DNB takes firm line on matching adjustment repacks

Structuring of assets must remove residual prepayment risk

The Dutch regulator is taking a strict line in its interpretation of Solvency II's matching adjustment rules according to the country's insurance industry association, a move that could trigger protests from local firms if other European supervisors are seen to be more lenient.

The Verbond van Verzekeraars (Dutch Association of Insurers) wrote to members last month to update them on how De Nederlandsche Bank (DNB) plans to apply the matching adjustment, based on the association's discussions with the regulator.

On the key question for Dutch insurers of whether they will be able to repackage mortgages that contain prepayment risk into assets that qualify for the matching adjustment, the association said the DNB would allow restructuring, but with the requirement that residual risk be transferred to a third party.

"It appears the DNB is taking quite a strict approach whereby they will apply a formal test to the existence of prepayment risk rather than a materiality test," says Neal Hegeman, Amsterdam-based director, institutional solutions and advisory, at Royal Bank of Scotland. "You will have to structurally remove all the prepayment risk," he says.

A spokesman for the association says: "DNB has indicated that they want to open dialogue with individual insurers on concrete cases, where each insurer should try to find a solution that is fitting in relation to its own mortgage portfolio. DNB will then judge each individual construction, on the basis of the relevant articles in directive and delegated acts, including the prudent person principle."

Structures using tranching and prepayment swaps are an "interesting" approach but would lead to less transparency and more complexity, said the spokesman.

It appears the DNB is taking quite a strict approach

The matching adjustment under Solvency II enables insurers to discount liabilities at a higher rate if they hold a ring-fenced portfolio of matching assets. The assets, though, must meet certain criteria, such as having fixed cashflows and being free from prepayment risk.

Dutch insurers could apply the adjustment to in-force group pension liabilities of which they hold about €44 billion, according to DNB figures for the end of 2014 (roughly 15% of all Dutch life insurance liabilities).

Bankers say the scale of appetite from Dutch firms has been higher than they expected, with at least two large insurers understood to be planning to use the measure.

Using residential mortgage portfolios for the matching adjustment would be highly attractive for insurers because Dutch residential mortgages are trading at spreads as high as 250 basis points over euro libor three-month swaps, but have proven to be a resilient investment, explains Eric Viet, head of financial institution advisory at Societe Generale in London.

Losses for Dutch mortgages were only 0.08% in 2013, he says, adding that "almost all Dutch insurers already have residential mortgages in excess of their matching adjustment-eligible liabilities".

However, particular features of Dutch mortgages create some difficulties.

Dutch regulation says borrowers are able to pay back 10% of principal on mortgages without penalty every year. Borrowers can usually also prepay the entire loan without penalty if they sell the underlying property. Mortgages, therefore, include in-built prepayment risk, meaning they have to be restructured to qualify for the adjustment. A similar issue arises in the UK in relation to equity-release mortgages.

The association letter says firms will be able to securitise pools of mortgages to create asset-backed notes where the risk of prepayment on eligible senior tranches is minimised. However, it says the DNB will require the residual prepayment risk in such structures to be hedged with a third party so there is no possibility of impairment to cashflows arising from higher-than-expected prepayment levels. This would add extra cost for insurers.

The letter goes on to say the DNB will not allow substitution of new mortgages into the asset pool to replace prepaid mortgages, because this would clash with the requirement for assets to be buy-and-hold under the matching adjustment.

Meanwhile, the DNB appears undecided still on which types of group pension contracts will qualify for the adjustment. The letter suggests that whether pension contracts are written with the employer or the employee as the insured party will influence whether they qualify or not. But the DNB is yet to reach a final decision on this point. "It surprises me that there is no clarity on this as yet," says Hegeman.

European firms are tracking the interpretation of the matching adjustment rules by different regulators, most notably the Dutch and UK supervisors, because the view of one could establish a precedent that influences others.

The adjustment has been an area of focus for UK annuity providers, which are expected to use it extensively, with the UK's Prudential Regulation Authority (PRA) currently running a pre-application process to help clarify how the rule will work in practice.

It is the responsibility of local supervisors to implement the matching adjustment following guidance from the European Insurance and Occupational Pensions Authority (Eiopa), but if material differences in implementation emerge it will be Eiopa's responsibility to resolve them.

So far, the PRA has been most active in working towards an interpretation of the matching adjustment, carrying out a trial submission process last year, issuing two letters to the industry on the topic and running the pre-application currently taking place among UK firms.

The PRA is expected to release the results of this towards the end of March, but has also flagged that it will publish information collectively to the industry in March on the treatment of equity-release mortgages in particular.