Michael Henderson contributed to the writing of this blog post.
Christmas; a time for loving, laughing, giving and, for 2014 only, a frantic attempt to finish your Matching Adjustment pre-application.
The Prudential Regulation Authority (PRA) issued two documents relevant to the Matching Adjustment on 15 October 2014. The first, CP23/14, covers Solvency II approvals and provides details of the Matching Adjustment pre-application process. The second, a letter from Paul Fisher entitled Solvency II: matching adjustment, attempts to provide answers to some of the outstanding questions ahead of the SII conference to be held on 17 October 2014. It also gives feedback on the dry run applications that it received during the trial MA submission exercise run over the summer.
The pre-application process will allow the PRA to feedback on whether a firm’s draft application is likely to be sufficient for approval and to allow those developing an internal model to understand as early as possible if the PRA would be minded to reject the MA application in its current form.
The PRA say that although it is not mandatory to enter the pre-application process in order to submit a formal application, firms are strongly encouraged to participate. To enter, firms must produce a near-final submission and submit this to the PRA between 1 December 2014 and 6 January 2015.
CP23/14 also promises an application checklist for MA to be issued by the end of November 2014. Clearly, it is expected that the pre-application submission will tick all the boxes on this checklist.
In the PRA’s typical style, the Fisher letter does set out a lot of opinions and views but doesn’t quite give full clarity on the specific questions that firms have. Whilst we can hope for some further insight at the conference, it is likely that these specific questions will only be answered during the pre-application process.
The first half of the document generally gives some high-level principles, namely:
- assets can be paired or grouped to meet eligibility criteria
- cashflows that are dependent on the realisable value of property are not 'fixed'
- redemption clauses in bonds can be ignored if they are event dependent and not controlled by the issuer
- assets with redemption clauses can be included if appropriate make-whole clauses exist and can be proved to be robust
- reinsurance assets can be included
- firms should look through any collective investment schemes
- deferred annuity contracts with guaranteed cash options are not necessarily disqualified
- demonstrating matching should include annual cashflow projections and SCR-like stress tests
- clear segregation of the portfolio in terms of accounting systems, investment policy, governance, MI needs to be demonstrated but ineligible and eligible assets and liabilities can be administered together
- applications must describe the process by which they will maintain the MA portfolio on an ongoing basis
- fundamental spreads used must be those specified by the European Insurance and Occupational Pensions Authority (EIOPA)
The second half of the letter gives feedback on the applications seen during the trial submission. The major weaknesses identified were in connection to how firms would calculate the MA, how they would manage the MA portfolio and the liquidity plan.
There is a strong message that applications need to demonstrate that assets will be managed in line with the buy-and-hold principle, although assets can be traded for 'risk management purposes'. There should also be regular (monthly is suggested) processes in place to ensure cash flow matching and that a comparison of the best estimate of the MA liabilities to the assigned assets is conducted quarterly.
These regular processes need to allow for new business written, implying that firms will not need to re-apply in respect of new business.
Two examples of how the calculation of the MA can be performed are also given:
- Identifying assets held which best match the liability cashflows (or provide the greatest illiquidity premium); and
- Taking a slice of the assets held which results in a value equal to the that of the liability (called a 'notional swap' approach).
The PRA does not have a preference 'at this stage' on which method firms should use. Both require sufficient information to be provided in the application to enable the calculation to be verified. Firms can choose their own method for applying the fundamental spread and cap on the MA benefit for sub-investment grade assets, but the method needs to be justified, with detailed calculations provided.
There was clearly some disappointment regarding the liquidity plan details contained in the trial submission responses. It gives examples of best practice, including specific management of liquidity risk in relation to the MA portfolio requirements and how this fits within the wider business. Some firms were expecting to be able to sell assets in their MA portfolios in order to generate liquidity; the PRA view this approach as unsatisfactory.
The PRA also tried to give further clarity about what would be acceptable and examples of best practice. Key messages include:
- detailed information on the optionality within assets is needed
- further statement that the majority of equity release assets are unlikely to be eligible
- granular information on liabilities, including options, is required
- need to demonstrate compliance with the mortality risk threshold
- when assessing surrender risk, need to consider historic experience and the likelihood/drivers of peaks or troughs
- very long tail liabilities must still be cashflow matched
We await any further developments at the PRA conference tomorrow. However, these communications have made it clear that firms wishing to apply for the MA to be used from 1 January 2016 will need to use the pre-application process and hence the timescales for this significant exercise have dramatically shortened.