Prudential Regulation Authority Rulebook

1A.1

The MA is an adjustment to the discount rate used to value certain insurance liabilities that represents a proportion of the spread (above the relevant risk-free rate) that an insurer projects to earn over the future lifetime of the assets matching its MA liabilities. It effectively increases the capital resources of the insurer through the associated reduction in the valuation of the MA liabilities. The MA framework recognises that insurers with predictable liability cash flows that are closely matched by asset cash flows are not materially exposed to the risk of having to realise those matching assets in unfavourable circumstances. Consequently, the MA framework does not encourage procyclical behaviour.

1A.2

Under Conditions Governing Business 3.2(2), firms are required to assess the sensitivity of technical provisions and eligible own funds to the assumptions underlying the calculation of the MA (or equivalently ‘assumptions underlying the MA’). A firm should also assess the extent to which its risk profile is consistent with those assumptions. Deviations from those assumptions would create a risk that the MA applied does not reflect the proportion of the spread that the firm may expect to earn with high confidence given its actual risk profile. It is important that the firm assesses this risk when making its attestation (in line with the requirements of Chapter 9 of the Matching Adjustment Part) and when considering the need for any addition to the fundamental spread (FS) to allow that attestation to be made (as per regulation 6(9) of the IRPR regulations and Matching Adjustment 4.17).

1A.3

The PRA considers the key conceptual assumptions underlying the MA to be as follows:

• Firms that are suitably cash flow matched in respect of their assets and liabilities and adopt a hold-to-maturity investment strategy are not exposed to certain risks. Therefore, those firms may expect to earn, with high confidence, the portion of the credit spread on their assets that represents compensation for risks to which they are accordingly not exposed.^[7]
• The total credit spread can be separated into two components: the FS, which reflects compensation for the risks retained by the firm, and the MA, which is the residual spread reflecting an allowance for risks that are not retained by the firm.^[8] The FS covers (at least) an allowance for expected default and downgrade losses.^[9]
• The FS for the risks retained by the firm is calculated using a transparent, prudent, reliable and objective method, which is consistent over time and between assets of different currencies and countries.^[10]
• The FS applied to each asset is derived from historical, long-term data that is relevant for that asset’s duration, credit quality and asset class.^[11]
• The firm acts in accordance with effective risk management practices and, when implementing the hold-to-maturity investment strategy, replaces assets for the purpose of maintaining matching only where the expected asset and liability cash flows have materially changed.^[12]

1A.4

The PRA considers that the following are the technical assumptions, which are the key policy requirements in relation to the technical information published by the PRA for the calculation of the MA (ie inputs to the calculation of technical information for the FS):

• The outcome of credit rating processes, or equivalent credit assessment processes, on individual assets provide an objective and reliable measure of risk. These credit ratings are mapped to an FS that appropriately reflects the asset’s credit quality.^[13]
• For the purposes of calculating the credit spread corresponding to the probability of default and expected loss resulting from the downgrade of an asset, 30% of the asset’s market value can be considered recoverable on default.^[14]
• Expected downgrade losses are determined based on immediately replacing a downgraded asset with an asset of the same asset class, same cash flow profile and the same or higher credit quality. For the purpose of this calculation, downgrades are measured only in full Credit Quality Steps (CQSs).^[15]
• The FS is at least 35%, or in the case of UK government bonds 30%, of the 30-year average of the observable credit spreads on assets of the same duration, credit quality and asset class.^[16]

1A.5

In addition to the above, the PRA’s published technical information^[17] for non-government exposures is based on data for well-diversified portfolios of corporate bonds. Therefore, the technical information assumes that the risk profile of firms’ exposures is well represented by a well-diversified portfolio of externally rated and traded corporate bonds.

1A.6

Firms should take account of the assumptions set out in paragraphs 1A.3 to 1A.5 above when considering how they comply with technical provisions requirements (as set out in the Technical Provisions Part and the Matching Adjustment Part), investment requirements (as set out in the Investments Part) and governance requirements (as set out in the Conditions Governing Business Part). Specific examples of when the assumptions would be relevant include:

1. i. in respect of PRA rules that refer to the assumptions underlying the MA, such as the requirement for firms, as part of their risk management systems, to regularly assess the sensitivity of technical provisions and eligible own funds to the assumptions underlying the calculation of the MA, including the calculation of the FS, and the possible effect of a forced sale of assets;^[18]
2. ii. when determining whether a firm’s MA portfolio is invested and managed in line with the PPP (Chapters 2 and 3 of the Investments Part);
3. iii. as factors that the PRA expects firms to consider when determining any appropriate FS additions and safeguards in respect of assets with highly predictable (HP) cash flows (rule 4.16 and Chapter 8 of the Matching Adjustment Part);
4. iv. as factors that the PRA expects firms to consider as part of the attestation process (Matching Adjustment 9); and
5. v. as factors that the PRA expects firms to consider when determining if any additions in accordance with Matching Adjustment 4.17 (and regulation 6(9) of the IRPR regulations) are appropriate to ensure that the FS reflects risks retained by the firm.

1A.7

If a firm concludes that its MA portfolio has a risk profile that is not consistent with the assumptions set out in paragraphs 1A.3 to 1A.5 above, then the PRA expects it to take remedial action. This includes making additions to the FS (as noted above), making changes to the management and governance of the MA portfolio (eg changes to investment policies) and/or removal of certain assets from the portfolio. The actions that a firm chooses to take will depend on the specific reasons for the deviation.