Game, set & Matching Adjustment

Siân Barton takes the temperature of the industry ahead of new Solvency UK changes due to be published in the coming months that could alter investments.

New II Orange #EC652F 1200 (13) @Pixabay.
What will Solvency UK mean for insurers?

Policy changes with regard to the Solvency regime in the UK are set to be published on 30 June 2024 and the new regime is expected to come into effect from December 2024.

The Solvency rules were one of the first EU-led regulatory frameworks to be reassessed following the Brexit vote in 2016. Insurers, the Prudential Regulation Authority (PRA), and other stakeholders have been thrashing out the terms of the new regime since June 2020 when the government announced that Solvency II would be reviewed, with consultation documents first published in April 2022.

The proposals were:

          ·        Releasing capital by changing the calculation of the risk margin and cutting the risk margin substantially, including by 60-70% for long-term life insurers in recent economic conditions;

          ·        Reforming the fundamental spread of the matching adjustment;

          ·        Unblocking long-term productive investment by making it easier to include a wider range of assets in matching adjustment portfolios; and

          ·        Reforming reporting and administrative requirements to reduce EU-derived burdens.

The regime is being re-worked because, according to the government, the “UK’s financial services regulatory framework must adapt to the UK’s new position outside of the European Union.”

What will this mean for insurers’ investment portfolios?

At the time of writing the near-final rules remained under consultation but key changes will allow insurers to invest more widely. Under Solvency II insurers had to invest in assets with fixed cashflows. Under the new rules, this will be expanded to include “highly predictable” cashflows.

“The reforms make it easier for insurers to include assets
in the Matching Adjustment."

As Hugh Savill, a Senior Adviser at compliance experts Sicsic Advisory, summarised: “The bottom line is that it expands the range of assets you can include in a Matching Adjustment compliant portfolio and that should ultimately improve the yield for any returns.”

Most experts flagged the matching adjustment requirements as the main development for insurance investors.

“The reforms make it easier for insurers to include assets in the Matching Adjustment, which is a cheap way of holding assets and it reduces the regulatory capital required for holding those assets,” Savill said.

According to WTW’s Anthony Plotnek, leader of the Private Assets and Capital Management team, the changes to, and the details around the matching adjustment have been a “bone of contention” throughout the consultation period.

His colleague, Director, Muhammad Amjad, explains how the instrument works: “Matching adjustment is a concept within the European insurance industry, which allows insurance firms to capitalise some of the returns that they will be earning on investment, fixed income investment assets, and to discount their liabilities.

“It stems from the idea that because firms are not going to be selling, or firms are going to be holding these assets to maturity, that if these assets do not default, they will get whatever the promised cashflows were and will not be prone to price changes and the risks arising from the price changes between the purchase of the asset and maturity," he said. "That is what we call risk premium in technical speak."

“Because insurance companies buy to hold these assets to maturity they are not exposed to these risks and can take credit for them," Amjad. "For the spread that is attributable to that, you know, let's say illiquidity to be able to discount the liabilities at a higher rate.”

The rule was originally introduced, primarily for the UK and, ostensibly, to benefit annuity writers when the rules around fair valuation of assets were brought in under Solvency II.

“It's a large component of the balance sheet, especially as [investors] moved
more and more into high yielding private assets or liquid assets."

Currently, under Solvency II, the matching adjustment is applied as an increase to the liability discount rate; it is calculated by deducting the fundamental spread from the credit spread on the assets backing matching adjustment liabilities.

Plotnek said changes to how companies are investing following the 2016 introduction of Solvency II meant it was necessary to re-evaluate the rules:

“It's a large component of the balance sheet, especially as [investors] moved more and more into high yielding private assets or liquid assets. The regulator has some concerns around the fact that the Matching Adjustment was conceived in 2015/16, a time when insurers had had much more vanilla asset portfolios than they do today.”

Portfolio management set to change

The changes coming in as a result of Solvency UK place a lot of focus on the composition of asset portfolios and the justification of those portfolios. Experts reiterated the change has created a new investment category with “highly predictable” cashflows meaning insurers can expand what they can invest in.

The Association of British Insurers (ABI) has welcomed the developments David Otudeko, ABI’s Head of Prudential Regulation, said: “Proposals for Solvency UK are a step in the right direction and will allow the UK insurance and long-term savings industry to play an even greater role in supporting the levelling up agenda and the transition to Net Zero.

“The current rules restrict firms to investing in a relatively narrow set of asset classes. Through Solvency UK, the industry will be able to further expand investments into ‘green and good’ projects which benefit both the environment and the economy.”


This could open the floodgates for insurers to plough money into new areas: Savill said: “The objective should be to allow a lot more investment in things like infrastructure, green assets required for the net zero economy and so on.

“We need vast amounts of capital for the net zero for infrastructure, so this will contribute to that.”

Plotnek agreed and said the change opening the door to allow some extra assets into the portfolio. "So, things like construction phases of infrastructure projects. Firms may have looked at that before, but it may not have been economically attractive to put it into the Matching Adjustment portfolio with very prudent assumptions.”

Otudeko detailed this further and said that following the introduction of the reforms, the industry has committed to channel £100 billion into UK productive assets. "Through our Investment Delivery Forum, we’re working with the industry and other connected stakeholders to ensure that these regulations, when enacted and coupled with future supporting developments and initiatives from on-going dialogue with the PRA, will see insurers in the best possible place to deploy significant investment.”

However, there remains a lack of clarity as to how far the rules will allow asset classes to open up. “At the moment, it is not clear to firms what all the potential asset classes are that could benefit from that flexibility," Amjad said.

What’s more clear is that firms will have to satisfy the PRA their investments are robust and, at the moment a voluntary attestation process is likely. The PRA wants insurer CFOs to personally sign these attestations.

“It’s not clear where the industry as a whole is going to land in terms of the
ability to invest in all these various asset classes."

Savill explained that at the earlier stages of the consultation, the regulator was concerned about the impact of loosening the terms and the new formula used to calculate matching adjustment underestimated the credit risk that insurers were carrying, precisely the fundamental spread. “What CFOs are going to have to do is to sign an attestation that they have made proper allowances for the credit risk in their bond portfolio and the fundamental spread is adequate to reflect the real risk in there,” he predicts.

As it is not completely clear what this might look like, experts are alive to the possibility it may have a dulling effect on the loosening of the rules, especially given the time and expertise burden the attestations could place on insurers. “It’s conceivable that in a year or two, when the industry has developed a process for complying with the requirements of Solvency UK that some asset classes that might be currently attractive, may have started looking less attractive.”

“It’s not clear where the industry as a whole is going to land in terms of the ability to invest in all these various asset classes,” Amjad said.

The experts suggest it’s too early today the impact these changes will have on cash-in-hand and balance sheets, partly because of other external levers which affect investments.

“It’s too difficult to tell,” Savill said. “Because these rule changes don’t happen in a vacuum. The future path of interest rates matters.”

On cash-in-hand, it’s likely to be a ‘horses for courses’ scenario. Amjad points out: “The impact on individual firms depends on what their starting point was - if a firm had a relatively vanilla, prudent philosophy around investments, then they may not be negatively impacted by these changes, but if there are firms who were at the more racy end of the spectrum, they might find when going through the certification process, that they have to offer up voluntarily some reductions in capital via add-on.”

Ultimately, it’s a positive for insurers, said Savill who framed it as a "good news story".

"You've sensibly expanded the things that insurers can invest in into long range investments that are suitable for insurers to invest in because they've got such long-term balance sheets," he said.

“I use this term a lot but there's going to be a Goldilocks type company,
which is there in just the right position for investment.”

Time will tell the real impact of these changes but for now, as Savill considers, Solvency UK could well be “the poster child for the Brexit dividend”.

What about the impact of investment in UK insurance?

Dan Kaine, of risk adviser Inherent Risks, believes the rules could both help and hinder companies. “The new kind of Solvency requirements can be looked at as a pro or a con, depending on the type of company.

“I use this term a lot but there's going to be a Goldilocks type company, which is there in just the right position for investment.”

Smaller insurers may struggle and that could lead private investors to move in via the broker space.

They may also find themselves in hot water: “If they are in the start-up phase, or they're in the scale-up phase, to suddenly be hit with a new solvency capital requirement can be devastating,” Kaine said.

On the flip side, this may lead to more investment into the UK insurance sector, particularly from large, privately-backed brokers. Kaine believes: “It will really push these companies to focus on M&A with regard to these smaller insurers.”