Solvency II: the principles behind, and implications of using the matching adjustment (MA)
We outline the principles behind the MA, assess valuing liabilities using the MA under Solvency II, and highlight some key implications. We note that accounting standards follow different valuation rules that are not considered in this article.
Since 1 January 2016, UK insurers have been regulated under the Solvency II framework, which requires insurers to produce a market-consistent balance sheet with valuations of assets and liabilities (technical provisions). In addition, they are required to hold capital – the solvency capital requirement (SCR) – sufficient to ensure that assets exceed liabilities with a confidence level of at least 99.5% over a one-year period. As there is no observable market price for an insurance liability, insurers must calculate it.
A key assumption in this calculation is the discount rate. Under Solvency II, liabilities are typically discounted using a risk-free interest rate curve. For certain liabilities, typically annuities, insurers are permitted to apply a spread to the discount curve – known as a matching adjustment (MA) – based on the assets held to back them, which reduces the present value of liabilities.
Harnessing a risk premium from credit
Corporate bonds, and credit assets generally, typically yield more than comparable government bonds, the yield differential being termed the credit spread. The credit spread can be broken down into components:
- compensation for expected losses, arising from holding corporate bonds, over and above government bonds (eg, due to expected default rates); and
- a risk premium, reflecting uncertainty of losses (eg, defaults may be more or less than expected), and illiquidity relative to government bonds.
Under Solvency II, insurers are permitted to apply an MA to the discount curve, reducing the present value of liabilities, where they can identify liabilities:
- such as annuities (fixed regular cashflows, with a fairly high degree of predictability);
- whose cashflows can be matched by corporate bond cashflows (meeting particular criteria) less expected losses; and which meet various other conditions.
This MA can be very broadly defined as the credit spread on the corporate bonds less compensation for expected losses, allowing insurers to capitalise the risk premium from holding such bonds to maturity. The precise calculation of the MA depends on multiple factors, such as the difference between risk-free and government bond yields.
A practical example
Suppose an insurer has a known liability of £100 in one year. If the insurer backed this with a government bond paying exactly £100 in one year, with a yield of 0.70%, the present value of the liability would be £100/(1+0.70%), or £99.30. If, however, the insurer chose to back the same liability with a one-year corporate bond yielding 1.70%, and expected losses of 0.40%, the present value of the liability would be £100/(1+1.70%-0.40%), or £98.72.
As set out in the breakdown of credit spreads, there is also uncertainty around losses on corporate bonds, which may be more or less than expected. This is not reflected in the MA itself, or the value of liabilities. However, as part of their SCR, insurers are required to hold capital against adverse scenarios, including greater-than-expected losses on corporate bonds.
Effectively, the insurer’s investment strategy is designed to meet expected liability outflows with expected asset inflows. If the insurer can meet its liabilities using more efficient investments, holding them to maturity to capture the risk premium, the value of liabilities can be reduced and capital held against uncertainty of losses.
Impact on balance sheet volatility and SCR
Besides the impact on liability valuations on day one, the MA also has implications for the volatility of insurers’ balance sheets over time and the amount of capital insurers must hold. Suppose our insurer has chosen to back its £100 liability with the corporate bond yielding 1.70%. Let’s say that the yield on the corporate bond then rises to 2.10%, with government bond yields unchanged. If there were no MA, then the impact on the balance sheet would be the change in value of the corporate bond, £100/(1+2.10%) - £100/ (1+1.70%) , or -£0.39. However, the MA means there is also an impact on the value of liabilities. If the 0.40% allowance for expected losses remains unchanged, then the change in liability valuation would be £0.39, offsetting the change in the value of assets.
If, however, expected losses also increased (eg, due to bond downgrades or worsening economic conditions), there would be a net impact on the balance sheet. The MA typically means insurers are less exposed to changes in credit spreads than would otherwise be the case, due to this effect. However, they are still exposed to changes in expected losses.
Implications of the MA
The MA has far-reaching implications for UK insurers, consumers and the broader economy. We consider these across investment strategy and pricing.
The MA encourages insurers to match liabilities using credit assets of similar maturities, reducing the risk of cashflow mismatches and increasing potential returns for insurers. Without it, Solvency II arguably encourages insurers to invest in government bonds instead, or shorter-dated assets that match liabilities less well.
On the other hand, strict rules constrain the assets that insurers can invest in if they are to take advantage of the MA. In particular, assets with relatively predictable but contractually uncertain cashflows, including many mortgages, cannot typically be held. This leads to a risk that insurers’ portfolios become skewed towards assets which meet the MA criteria. Additionally, insurers investing in non-sterling assets would typically need to use long-dated derivatives to hedge asset cashflows back to sterling, leading to counterparty risk.
For purchasers of annuities (such as retirees), the MA helps ensure they maximise their income, since the insurer providing the annuity can discount its liability at a higher rate. The higher income is typically earned by the insurer through investing in a diversified portfolio of credit (eg, corporate bonds) rather than government bonds. While this, and discounting liabilities using the MA leads to higher risk than investing in government bonds, the insurer is nevertheless required to hold capital against uncertainty of losses.
A similar phenomenon occurs on a larger scale when insurers ‘buy out’ legacy pension scheme annuity liabilities from companies seeking to de-risk. From the perspective of the overall economy, the MA increases the affordability of annuities, reducing the amount of funds that need to be set aside, and ensuring the funds that insurers hold can be lent back into the economy, rather than invested in government bonds.
The MA results in a lower liability valuation than might otherwise be the case. Nevertheless, insurers are required to hold capital against adverse scenarios, including losses from any credit they are using to back liabilities. It should also be noted that even if the MA were removed from Solvency II, annuities would still not be risk free; for instance, in the event of a longevity stress that exceeded the 99.5th percentile confidence level over one year. The risk arising from MA needs to be weighed against the benefits of improved pricing, which arises as insurers share the benefit of investing in credit with their customers.
About the authors
William Gibbons, Director, PwC UK and Shazia Azim, Partner, PwC UK