The Prudential Regulation Authority (PRA) published its much-anticipated consultation paper, CP 19/23, on its proposed reforms to the Matching Adjustment (MA) framework on Thursday 28 September. 

The overall scope and shape of these proposals had been extensively trailed by the PRA, and those who kept abreast of the output of the PRA / ABI Subject Expert Groups on MA reforms will not be surprised by the PRA’s proposed directions of travel in most aspects of the reforms. However, there is a substantial amount of specific and detailed proposals, and there will be plenty for firms and other interested stakeholders to respond to in the consultation process. 

Below we set out a few quick initial observations on aspects of the reform proposals that immediately caught our eye. We focus on two of the most important elements of the MA reform agenda: investment flexibility and MA attestation.

Investment flexibility

The proposed eligibility criteria for assets with highly predictable (HP) cashflows, the cap on how much of them can be held in MA portfolios, and the new matching tests for assessing their potential implications for cashflow matching are all broadly in line with high-level expectations. Similarly, few will be surprised by the PRA’s proposed overarching principle that the part of an asset’s credit spread that arises from a lack of cashflow fixity should be included in the fundamental spread (FS). 

Firms will welcome that the PRA has grasped the nettle of proposing a standardised methodology for the assessment of fundamental spread additions for the risks associated with non-fixity of cashflows. The proposed methodology will produce materially different fundamental spread additions for different types of HP assets. We will be analysing what the proposed standardised methodology implies for a range of potential HP asset types over the coming weeks.

The proposed minimum ten basis points allowance in HP Fundamental Spread additions for the rebalancing / reinvestment costs generated by non-fixity is one of the more eye-catching elements of the investment flexibility proposals – both for its non-trivial size and for the lack of a quantitative rationale for this proposed sizing.

Whilst there are no proposals to change the criteria for what constitutes an asset with fixed cashflows for the purposes of the MA, the HP proposals may have some interesting implications for the treatment of current MA securitisations. In particular, firms would be required to determine if the underlying assets of existing securitisations meet the HP criteria, and if they do, the MA benefit generated by the fixed cashflows of the securitised notes should not exceed the MA benefit that would be generated by the HP treatment of those underlying assets if held directly in un-securitised form. This could imply a new form of cap on the MA benefits produced by some (existing and future) securitisations.

MA attestation

The proposed MA attestation wording does not include any reference to the ‘liquidity premium’ wording that featured in the HMT November 2022 response. As we discussed in our June blog, we view this as a sensible step, as that wording is very difficult to reconcile with HMT’s final position on the FS calibration.

The proposed MA benefit attestation wording instead requires that ‘the MA can be earned with a high degree of confidence’. The consultation states this ‘would require the MA to be materially more certain than a 50th percentile or best estimate basis’. 

The consultation recognises the significant role of judgment in approaches to justifying the attestation. Taken most literally, the proposed MA attestation wording focuses attention on the probability distribution of long-term realised returns produced by MA assets. The consultation intends to focus the attestation on where MA assets have materially different features to the corporate bonds that have been used in the calibration of the published FS parameters. 

However, the firm’s intended rebalancing strategy for MA assets would also play a meaningful role in determining whether the MA will be earned with a high degree of confidence. For example, the consultation suggests that the standard FS treatment of vanilla corporate bonds should not result in difficulties for the attestation or the need for a voluntary FS addition. But the requirement for the MA to be materially more certain than a 50th percentile would not necessarily be met if the firm’s rebalancing strategy for those bonds is the same as the annual rebalancing that is assumed in the FS calculation. The quantification of the impact of firm’s specific rebalancing strategies on the earned MA, and how this rebalancing varies by MA asset type, could play an important role in this form of attestation. 

Next steps 

The consultation period closes on Friday 5 January and we will be developing our fully considered response to the consultation over the coming weeks and months. We also look forward to working with clients to support their thinking and analysis in this critical area of regulatory reform for the UK life and pensions sectors.

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