Prudential Regulation Authority Rulebook

2.1

Permission for use of the MA is subject to the MA eligibility conditions, including conditions for the assets and matching liabilities to which the MA is applied. This chapter sets out the PRA’s expectations in relation to those MA eligibility conditions that are applicable to assets in the MA portfolio (referred to in this chapter as ‘the MA asset eligibility conditions’).

2.2

The MA eligibility conditions define the features that the asset portfolio, and in some cases the individual assets within it, must have. These features, together with the ability to identify, measure and manage the risks of an individual asset, and of the MA portfolio, in accordance with the requirements of the PPP,^[19] determine eligibility, not the notional class to which the asset (or group of assets) belongs. For this reason, there is no prescribed ‘closed list’ of eligible assets for MA purposes. Instead, the PRA expects firms to be able to demonstrate at the point of application, and on a continuous basis, that their portfolios satisfy the MA asset eligibility conditions.

2.3

The PRA will review each asset portfolio on a case-by-case basis as part of the MA permission process, taking into account the evidence provided by the firm in its application.

2.4

For the purposes of demonstrating satisfaction of the MA asset eligibility conditions, the PRA expects a firm to consider all the features of the assets against all of the relevant MA asset eligibility conditions, not just the condition(s) that the firm considers to be most material.

2.5

The PRA expects firms to have a robust screening process in place to identify those asset features that could affect MA eligibility.

2.6

Firms should review the relevant terms and conditions or prospectuses. Where reliance is being placed on third-party data providers, firms should perform validation checks, for example by comparing against another set of external data or by examining a random sample of prospectuses.

2.7

[Deleted with the first sentence moved and modified to form part of paragraph 9.1A]

2.7A

The MA eligibility conditions include that the credit quality of the assets in an MA portfolio must be capable of being assessed through a credit rating^[20] or the undertaking’s internal credit assessment of a comparable standard. A firm should be able to demonstrate that the assets included in its MA portfolios meet with the relevant requirements of Chapter 7 of the Matching Adjustment Part and the expectations set out in SS3/17. Considering how internal credit assessments would compare against issue ratings that could have resulted from a credit rating agency (CRA),^[21] including appropriate independent external assurance, should act as a useful check and balance alongside the validation and assessment of the ongoing appropriateness of the internal credit assessment process.

2.7B

Matching Adjustment 2.2(6) sets out the MA eligibility condition that the relevant portfolio of assets, and each individual asset contained in it, must meet the requirements of the PPP. Firms are expected to assess their compliance with this eligibility condition having regard to the PRA’s expectations set out in SS1/20. In particular, a firm will need to determine if it can properly identify, measure and manage the risks on the assets in which it is invested or is considering investing in.

2.8

Regulation 4(7) of the IRPR regulations requires that the asset portfolio’s expected cash flows replicate each of the expected liability cash flows in the same currency. The PRA does not consider that this requires individual assets to be denominated in a particular currency, provided that replication can be demonstrated by considering the cash flows of assets in aggregate. The PRA’s view is that the requirement in regulation 4(3) of the IRPR regulations that the portfolio must consist of ‘bonds or other assets with similar cash flow characteristics’ could also be satisfied by considering relevant pairings or groupings of assets. For example, a foreign currency bond with an appropriate currency swap could be used in combination to generate a cash flow in the relevant currency of the liabilities.

2.9

In the case of pairings or groupings of assets, firms should consider carefully how any such arrangements satisfy all the relevant requirements, including whether the assets on a paired or grouped basis satisfy all the MA asset eligibility conditions and result in fixed cash flows, and whether such arrangements comply with the requirements on risk management and on the PPP. This includes considering the reliability and predictability of such arrangements under stressed conditions.

2.10

For example, for the purposes of assessing the eligibility of assets paired with derivatives, this would include firms identifying any break clauses that allow the counterparty to change the cash flows at its option and, if so, whether the terms provide sufficient compensation within the meaning of regulation 4(9)(c) of the IRPR regulations.

2.11

The PRA expects firms to consider carefully, and be able to justify, the method by which pairing or grouping arrangements have been reflected in the assessment of matching and the calculation of the MA. For example, firms should be able to explain whether all the individual elements of an arrangement have been de-risked and mapped to FSs separately, or whether instead the combined asset has been de-risked and mapped onto a single FS.

2.12

[Deleted]

2.12A

Chapter 5 of the Matching Adjustment Part (supplementing, in accordance with the IRPR regulations, the eligibility condition set out in regulation 4(9)(a) of the IRPR regulations) allows a limited exception from the requirement that the cash flows of the relevant portfolio of assets must be fixed and not capable of being changed by the issuers of the assets or any third parties. This exception is available where the risks to the quality of matching are not material, and provided that only a limited proportion of the relevant portfolio of assets (as the PRA may determine) is affected (see regulations 4(9)(a) and 7(b) of the IRPR regulations). The PRA considers that in order for firms to be able to demonstrate that the risks to the quality of matching are not material, the asset cash flows must at least be contractually bound. The MA asset eligibility conditions therefore include a requirement that such asset cash flows must pay contractual sums with a bounded range of variability over both amounts due, and the timing of payments (Matching Adjustment 5.3 and 5.4). The PRA considers that where asset cash flows are not fixed, contractual bounding is achieved where the legal documentation underlying a bond or loan sets out a finite range for the cash flow timings and amounts, for example:

• the cash flow profile (with the payment dates and amounts, or how the cash flow amounts are to be calculated);
• the situations where the cash flow profile may, or must, be varied by the issuer; and
• where the cash flows can be varied, the amount and timing of the varied cash flows.

2.12B

Firms, however, are still expected to consider the risks to the quality of matching even though the asset cash flows are contractually bound, and to be satisfied that such risks are not material. Consistent with the PPP, the PRA expects firms to consider whether the limited range of the bounded cash flows paid on the assets makes them suitable to match the nature of the liabilities in the MA portfolio. For example, an asset may meet the MA eligibility condition for bounded cash flows, but where very significant variations in cash flows are contractually permitted, the asset may not be suitable to match annuity liabilities.

2.12C

Some assets may incorporate contracts that do not specify upper bounds on the cash flow amounts, such as leases with upward-only rent increases. The PRA considers that the upper bounding of cash flow amounts for such assets may be demonstrated through the use of appropriate assumptions for the rate of any future escalation. For any such asset, where a firm assumes increases that are above the contractual minimum, the PRA expects the firm to assess the risks to the quality of matching, having regard to the economics of the asset.

2.12D

In this SS, the assets meeting the criteria referred to in paragraph 2.12A above (which firms can demonstrate do not present a material risk to the quality of matching (see Chapter 4 of this SS)) are referred to as assets with HP cash flows. The proportion of the portfolio with HP cash flows is limited in aggregate to creating 10% of the MA benefit for the MA portfolio, as set out in PRA rule Matching Adjustment 5.2, and may also be subject to additional safeguards in order to manage and mitigate the additional risks introduced into the MA portfolio (see paragraph 5.18 of this SS).

2.12E

The PRA is aware that some assets could either be considered to have HP cash flows, or could be considered to have fixed cash flows provided firms apply the expectations in the following sections, for example by partially recognising the assets’ cash flows, or by recognising the lowest amount and/or payment at the latest date. Where firms apply the expectations in the following sections and treat such assets as having fixed cash flows, these assets would not be considered to be part of the limited proportion of the portfolio with HP cash flows. The PRA considers that decomposing any asset within the MA portfolio into separate fixed and HP cash flow components would not be consistent with the MA eligibility conditions. In relation to the movement of assets between a fixed and an HP cash flow treatment the PRA considers that this may be reasonable where:

• the firm has permission to apply the new treatment for a particular asset;
• the firm manages the assets in line with its MA permission, including applying an FS addition (where moving from ‘fixed’ to HP) and considering the implications for the attestation;
• changes in treatment are subject to the firm’s policies on managing the MA portfolio such that they are subject to an appropriate level of governance and oversight;
• frequent changes in treatment for individual assets are subject to justification; and
• the firm carefully considers the operational implications before applying different treatments to holdings of the same asset.

2.13

Other than for the limited proportion of the portfolio of assets with HP cash flows, firms will need (in accordance with regulation 4(9) of the IRPR regulations) to be able to demonstrate that the overall cash flows from the remaining proportion of the portfolio are fixed in terms of timing and amount, and cannot be changed by the issuers of the assets or any third parties. For this purpose, it is not sufficient for a portfolio of assets to provide cash flows that are predictable in aggregate to a very high degree.

2.14

In addition to the limited exception for assets with HP cash flows, the MA eligibility conditions set out two exceptions to the requirement that the cash flows at the level of the portfolio be fixed. This is where firms have used:

• inflation-linked assets to match the cash flows of inflation-linked obligations in an MA portfolio (regulation 4(9)(b) of the IRPR regulations); or
• assets with cash flows that may be changed at the request of the issuer or a third party, provided that in such an event the firm receives sufficient compensation to allow it to obtain the same cash flows by re-investing in assets of an equivalent or better credit quality (regulation 4(9)(c) of the IRPR regulations).

2.15

For assets that produce both fixed and non-fixed cash flows, where a firm considers such an asset to have fixed (rather than HP) cash flows, the PRA considers that this would not necessarily be excluded under the MA asset eligibility conditions in cases where only the fixed cash flows are taken into account for the purpose of demonstrating cash flow matching. For example, firms may be able to demonstrate that the cash flows from callable bonds up to the first call date are fixed, thus allowing them to be recognised partially in the demonstration of cash flow matching (provided that the asset also meets the other MA asset eligibility conditions).

2.16

In cases where only part of an asset’s cash flows are taken into account for the purposes of demonstrating cash flow matching, firms should attribute the full market value of the asset to an MA portfolio, and take the full asset value into account when calculating the MA in accordance with Chapter 4 of the Matching Adjustment Part.

2.16A

Where firms include assets in the MA portfolio where the full investment is not made at the point of purchase, the PRA expects that the MA benefit on such assets will only be recognised where the MA portfolio includes a provision for the future investment sums, and these sums are considered in both the liquidity plan and in assessing risks to the quality of matching.

2.17

The PRA understands that many bonds (and other assets with similar cash flow characteristics) will be subject to terms and conditions that allow the issuer of the asset to redeem or terminate the contract prior to maturity.

2.18

The PRA considers that the requirement in regulation 4(9) of the IRPR regulations that ‘the cash flows of the assigned portfolio of assets must be fixed and not capable of being changed by the issuers of the assets or any third parties’ does not necessarily disqualify all assets that are subject to early redemption or termination rights at the option of the issuer or a third party.

2.19

Certain categories of early redemption or termination rights would clearly not meet the eligibility criterion for fixed cash flows in regulation 4(9) of the IRPR regulations, for example rights of redemption or termination that are entirely at the discretion of the issuer or third party (subject to the exception in regulation 4(9)(c) of the IRPR regulations).

2.20

However, there are other categories of rights of redemption or termination that the PRA considers are less likely to undermine the need for predictability of cash flows that underlies the requirement in regulation 4(9) of the IRPR regulations - in particular, rights of early redemption or termination at the option of the issuer that are only triggered by events that are outside the control of, and cannot be avoided by, the issuer, and where such events would arguably change the nature or substance of the underlying contract. For example, corporate bonds will typically be subject to early redemption at the option of the issuer in the event of a tax change that results in the issuer having to pay additional amounts under, or as a result of, the bond. It is also typical for index-linked bonds to contain early redemption rights at the option of the issuer where the relevant index is no longer available.

2.21

In light of the points above, when making arguments for the inclusion of an asset within an MA portfolio as an asset with fixed cash flows, the PRA expects firms to demonstrate that any right of redemption or termination is not at the unfettered discretion of the issuer or third party, but is triggered only by events that:

• are outside the issuer or third party’s control;
• cannot be avoided by the issuer or third party; and
• would otherwise materially change the nature or substance of the obligations of the issuer or counterparty under, or as a result of, the contract.

2.22

Further, the PRA expects firms to demonstrate that they have considered the extent of reinvestment or other risks posed by any such redemption or termination rights, and have considered whether and how these could be mitigated. Such consideration should form part of a firm’s own risk and solvency assessment (ORSA).

2.23

The PRA would expect the matters in paragraph 2.21 above also to be relevant in assessing the eligibility of assets with extension on default clauses, particularly with respect to the trigger for the extension of cash flows under such clauses.

2.24

The PRA considers that reinsurance assets may be included as assets with fixed cash flows in an MA portfolio without relying on the limited exception of assets with HP cash flows, provided that firms can demonstrate the following:

• any variation in timing, duration and/or quantum of cash flows from the reinsurance asset (that is not otherwise captured by the MA eligibility conditions) is solely attributable to, and reflects, the variation in the timing, duration and/or quantum of cash flows of the underlying (re)insurance obligations that are covered by the reinsurance asset;
• the cash flows of the reinsurance asset replicate the cash flows of the underlying (re)insurance obligations covered without giving rise to material mismatch risk;
• the insurance and/or reinsurance obligations that are covered under the reinsurance asset are properly included in an MA portfolio (ie they satisfy all the relevant MA eligibility conditions);
• the reinsurance asset satisfies all the other MA eligibility conditions (including that it is structured in such a way that it produces cash flows with similar characteristics to the cash flows of bonds); and
• the inclusion of the reinsurance asset in an MA portfolio is consistent with the assumptions underlying the MA as set out in Chapter 1A of this SS, in particular that it is consistent with the assumption that insurance and reinsurance undertakings will hold the matching assets to maturity.

2.25

The PRA expects that, as a minimum, firms would be able to provide a similar demonstration for any other asset where cash flows vary with the underwriting risks set out in the MA eligibility conditions.

2.26

For the purposes of calculating the MA and satisfying the MA eligibility conditions (including cash flow matching), firms should risk adjust the reinsurance cash flows on the basis of Technical Provisions 11.1. The adjustment made for the purposes of the MA calculation should be the same as that made for the purposes of calculating the value of the reinsurance recoverable. For the avoidance of doubt, the PRA does not expect firms to map the reinsurance to an FS.

2.27

Assets with cash flows that depend on risks that are not included in the underwriting risks referred to in the MA eligibility conditions are unlikely to be eligible for inclusion in the MA portfolio as assets with fixed cash flows; if a firm intends to include these in the limited proportion of assets with HP cash flows then they must meet the MA eligibility conditions that are applicable to assets with HP cash flows.

2.28

The PRA considers that the paired or grouped assets that result from using FX forwards to hedge non-sterling bond exposures do not provide fixed cash flows because, in their current form, the cash flows on these paired or grouped assets are only contractually fixed for a few months rather than over the full duration of the underlying bond. Therefore, they are unlikely to satisfy the MA eligibility conditions. Where short dated FX forwards are paired with maturity matched short-dated assets then they may meet the MA eligibility conditions.

2.29

The PRA does not consider that the rolling of the forwards on expiry, combined with the purchasing or selling of the underlying bonds (ie rebalancing), together produce fixed cash flows over the full duration of the bonds. Such an interpretation depends on two significant assumptions: regular rolling and rebalancing of an MA portfolio; and reliance on the firm’s continuing ability over a long time period to access the FX forward markets.

2.30

Relying on such assumptions is not consistent with the MA eligibility conditions for an MA portfolio of assets to have fixed cash flows. The relevant portfolio of assets may change only in limited circumstances that are out of the control of the firm (eg on early repayment of an asset where consistent with the MA eligibility conditions, or where expected liability cash flows have materially changed due to, say, changes in underlying longevity assumptions). The PRA considers that these circumstances do not encompass the use of assumed management actions or rebalancing on the potentially significant scale that would be needed to overcome the maturity mismatch between firms’ foreign currency bonds and the associated short-term forwards. The PRA also considers that a reliance on regular rolling of FX positions and continued access to FX forward markets is not consistent with either: (i) the contractual bounding requirement for assets with HP cash flows; or (ii) the requirement that assets with HP cash flows must not present a material risk to the quality of cash flow matching.

2.31

The PRA notes that some other strategies to hedge currency exposure, and specifically the use of significantly longer-dated cross-currency swaps, would be more consistent with the MA eligibility conditions. Firms seeking to include foreign currency assets in an MA portfolio should explore longer-dated cross-currency swaps or other approaches including potential portfolio restructures.

2.32

The PRA is aware that some assets will contain cash flows where the timing is uncertain but is bounded, for example final redemption payments on callable bonds, or bonds where the timing at which repayments start can vary within a contractually bounded period. The PRA will assess firms’ applications to include such assets as meeting the fixed cash flow requirement on a case-by-case basis. Firms could also consider whether the assets meet the criteria for HP cash flows as set out in paragraphs 2.12A and 2.12D above and, if so, include them in the MA portfolio as part of the limited proportion permitted for these assets.

2.33

The PRA’s view is that, in addition to recognition of cash flows up to the first call date (as set out in paragraph 2.15 above), firms may also be able to demonstrate that the redemption payment from a callable bond can be regarded as being fixed (provided that the asset also meets the other relevant MA eligibility conditions) if, for the purposes of demonstrating matching, it is only recognised at its final redemption date (and provided that such a fixed date is specified in the bond’s contractual terms).

2.34

For bonds where the start of repayments is uncertain but there is a fixed latest point (and provided that such latest date is specified in the bond’s contractual terms), for example bonds with an initial construction phase or sinking fund assets, then subject to other relevant MA eligibility conditions being met, firms may be able to demonstrate that cash flows are fixed for the purposes of matching liabilities, if the cash flows are recognised at their latest date. The fixed amounts should not include any amount contingent on the timing of the cash flows, ie cash flows must be certain to be available to meet the matched liabilities; for example, any additional interest payments that result from a later start date of repayment would not be considered to be ‘fixed’. Firms should also be able to demonstrate how cash flows received at an earlier date will be invested so that they will be available to meet the liability cash flows as assumed in the matching assessment.

2.35

In considering alternative treatments for assets with uncertain cash flow timing but included in the fixed cash flow part of the MA portfolio to that set out in this section and the section on partial recognition, for example a ‘yield to worst’ approach, a firm should note that where assumptions need to be made about the future cash flows it will receive on an asset, this may expose the firm to the risk of these assumptions changing over time and to the risk of actual cash flows being lower than assumed. The PRA considers that, unless properly managed, both of these risks would pose an obstacle to the firm being able to demonstrate that the asset should be considered as having fixed cash flows, in which case the additional controls for assets with HP cash flows as set out in Chapters 4 and 5 of this SS would need to be met in order for the asset to be included in the MA portfolio.

2.36

Where a cash flow is directly dependent on the realisable value of property or other asset(s), the PRA considers that such uncertain cash flows should not generally be regarded as presenting an immaterial risk to the quality of cash flow matching even where a firm proposes only to recognise a prudent estimate of the realisable value.

2.36A

For sub-investment grade exposures, firms should carefully consider whether the cash flows they expect to receive from these assets can be sufficiently relied upon for the purposes of cash flow matching. In doing this, the PRA expects firms to have regard to the higher expected level of defaults compared to investment grade assets and the consequent uncertainty in the cash flows as well as the other additional risks that may be associated with such assets. The PRA expects firms to take these considerations into account when determining whether inclusion of such assets in the MA portfolio is in line with the PPP.

2.37

For the purposes of the derogation in regulation 4(9)(c) of the IRPR regulations (mentioned in paragraph 2.14 above as the second exception), where firms are including assets as part of the fixed cash flows portion of the MA portfolio, they must be able to demonstrate clearly that the compensation they would receive in the event of a change in the cash flows would allow them to obtain the same cash flows by reinvesting in assets of equivalent or better credit quality. The PRA considers that firms may be able to satisfy this MA eligibility condition by being able to demonstrate that sufficient compensation will be received on the basis of an adequate contractual compensation clause. In assessing adequacy of compensation, the PRA expects firms to take into account whether relevant insurance or reinsurance obligation cash flows would continue to be matched out of assets acquired with the compensation payable.

2.38

Where firms rely on a compensation clause in the form of a standard^[22] Spens clause (or equivalent), the PRA expects firms to be able to demonstrate that the:

• reference gilt (or other suitable asset) used is suitable given, for example, the term to maturity of the asset in question; and/or
• remaining cash flows that are discounted correspond to those assumed in the demonstration of cash flow matching.

2.39

Where firms rely on modified Spens clauses (or equivalent), one method of assessing the impact of make-whole clauses on a firm’s assets would be for the firm to determine a maximum make-whole spread such that cash flows on assets with make-whole spreads in excess of this maximum would not be considered to be fixed for the purposes of cash flow matching.

2.40

The PRA expects firms to put in place robust governance arrangements around assessing the adequacy of compensation, including determining maximum make-whole spreads, and expects a firm to notify its supervision team of any changes to these sufficiency criteria.

2.41

The PRA’s view is that it may be possible for firms’ criteria for assessing ‘sufficient compensation’ to be devised by reference to the relevant MA liabilities being matched by the recognised asset cash flows, together with the ability to purchase an asset of at least as good quality as the original to replace these cash flows in the event they are changed by the issuer, ie to ensure that this matching continues. The PRA expects a firm to be able to demonstrate the same level of confidence in its ability to replace cash flows as in its assessment in paragraph 2.39 above. This may, in practice, mean that the firm would recognise part of the asset’s cash flows up to the level of contractual compensation payable, subject to the considerations relating to partial recognition set out in paragraphs 2.15 to 2.16A above.

2.42

The PRA expects firms to consider how their own criteria for assessing ‘sufficient compensation’ cater for foreseeable events such as an asset being upgraded. The PRA considers that in such upgrade events, a firm would not necessarily need to remove the asset from the MA portfolio, if its own criteria provide for this (and to the extent that those criteria were effective in assessing whether compensation would be sufficient, taking into account paragraph 2.37 above). For example, where sufficiency of compensation criteria follow the approach described in paragraph 2.41 above, the firm might continue to recognise the asset’s cash flows up to the level of the compensation payable, ie so that the asset’s compensation would remain sufficient to replace the cash flows needed to match relevant MA eligible liabilities.

2.43

In addition to being able to demonstrate the suitability of the reference gilt used in both standard and modified Spens clauses, firms should also be able to demonstrate that:

• The adequacy of the compensation clause or maximum make-whole spreads has been assessed at a suitable level of granularity. For example, an assessment only at the asset class level (as opposed to further subdivisions by rating and duration) should have strong justification. Where holdings of individual assets are material, firms should carry out this assessment at asset level.
• Explicit consideration has been given to the impact of asset spread narrowing and/or gilt spread widening scenarios on the sufficiency of the compensation. The scenarios considered should be extreme enough to allow the firm to be able to demonstrate that there is negligible risk of the modified Spens clause not providing sufficient compensation in the future.
• There is sufficient liquidity in the market (taking into account stressed conditions) to be able to buy an asset of the same class and credit quality with the compensation provided, or if not, that the compensation is otherwise sufficient (for example, it is sufficient to buy a corporate bond of the same or higher rating).

2.44

The PRA accepts that there is a range of possible approaches that can be used to calibrate the maximal spreads. The PRA considers that scenario testing would provide a useful sense check as well as a means of ensuring a consistent standard is applied across firms. For example, the PRA would expect firms to investigate a scenario where spreads return to historically low levels over the period for which spread data is readily available and appropriate to the exposures in question and consider whether compensation would be sufficient in that case. Firms should consider explicitly such a scenario test in arriving at their maximum make-whole clauses.

2.45

Firms should also take into account the following in calibrating the maximal spreads:

• where firms are using index data in their analysis it should be noted that while there is no requirement to replace cash flows using the ‘average’ bond that the index represents, equally firms should not rely on being able to replace cash flows with the cheapest bond in the index;
• in assessing whether sufficient replacement assets are available to replace cash flows, firms should confirm that the replacement assets under consideration would be MA eligible;
• the maximum make-whole clauses should be kept under active review to ensure that any new purchases of assets with prepayment options would provide adequate compensation; and
• firms should consider carefully the impact of extreme spread-narrowing scenarios beyond those considered in setting their maximum make-whole spreads. These scenarios should also involve consideration of wide-scale upgrading of asset ratings. The risk of mass early redemptions in such scenarios should be explicitly considered in firms’ ORSAs, along with their plans to manage or mitigate the risk in these extreme scenarios.

2.46

If there is no make-whole clause as described above, an alternative arrangement may be appropriate if it has an equivalent effect. However, firms should be able to demonstrate that the arrangements are effective and firms should also take account of the considerations set out above.

2.47

It is not possible to give a definitive view on the MA eligibility of ERMs as an asset type because of the wide variation in the features that such assets possess. However, some features are common to most investments in ERMs, such as cash flows that depend on longevity, morbidity, the realisable value of property (where the mortgage contains a No Negative Equity Guarantee (NNEG)) and exposure to prepayment risk. In the PRA’s view, an asset with this combination of features is unlikely to be compatible with the general requirement for fixed cash flows (regulation 4(9) of the IRPR regulations). The PRA expects firms to consider whether ERMs can meet the other MA eligibility conditions including the requirements for credit rating/credit assessment. Where firms take the view that ERMs are not compatible with the general requirement for cash flows to be fixed, firms should consider the additional requirements for assets with HP cash flows together with the materiality of the risk to the quality of matching from the ERM cash flows, and therefore whether such ERMs can be included in the MA portfolio under the limited proportion of assets with HP cash flows. Where this is not possible, the PRA expects that firms will need to undertake restructuring, pairing or grouping of assets to transform the cash flows of ERM assets into an eligible format. For the avoidance of doubt, the PRA does not have a preference for the way in which firms choose to restructure their ERM assets for the purposes of satisfying the MA eligibility criteria.

2.48

Although it may be possible to demonstrate that cash items are compatible with the MA eligibility conditions, the PRA does not consider that expected future cash interest can satisfy these eligibility conditions unless paired or grouped with a suitable contract. Future cash interest payments will depend on a number of variables, and the variability and uncertainty of future cash interest are likely to be incompatible with the requirement for cash flows to be fixed, and with the requirements for HP cash flows (including in particular that risks to the quality of matching are not material) (see regulations 4(7) and 4(9) of the IRPR regulations).

2.49

In considering whether to include cash items in an MA portfolio, firms should assess carefully and be able to demonstrate their compliance with all other relevant requirements, including the requirements for risk management and the PPP.

2.50

Where a firm proposes to include holdings in collective investment schemes or mutual funds within the relevant portfolio of assets, the PRA expects the firm to ‘look through’ to the underlying assets and be able to demonstrate that these meet all of the MA asset eligibility conditions.

2.51

Further, firms should be able to demonstrate that, notwithstanding that the assets are held within a collective investment scheme or mutual fund structure rather than held directly, this does not in any way compromise the firm’s ability to ensure that the underlying assets are managed in a way that satisfies the MA eligibility conditions. For example, the firm needs to be able to demonstrate that the collective investment scheme or mutual fund would not have discretion to invest in assets that are not eligible for the MA.

2.52

The PRA recognises firms may undertake certain risk transformation transactions in order to obtain a portfolio of MA eligible assets. In particular, firms may be entering into securitisation transactions or putting in place hedging arrangements, specifically to secure compliance with the MA eligibility conditions. A firm that engages in such restructuring, pairing or grouping of assets should discuss its plans with its supervisor at the earliest opportunity and should also be considering contingency options in case it is not possible to transform the asset cash flows in a way that meets the eligibility criteria.

2.52A

The PRA considers that the MA eligibility conditions will not be met where a firm proposes to define a notional part or fraction of the cash flows of an asset to match liabilities within the MA portfolio (and in the calculation of the MA). In particular, the credit quality of such cash flows is unlikely to be capable of being assessed through a credit rating or the undertaking’s internal credit assessment of a comparable standard. This is distinct to the guidance set out in paragraphs 2.15 and 2.16 above where a rating would be assessed for the full asset in the MA portfolio, but only a subset of (fixed) cash flows would be used to match liability cash flows. The PRA also considers that a notional, non-contractual identification of cash flows is unlikely to be consistent with the requirement to maintain the relevant portfolio of assets over the lifetime of the insurance obligations (regulation 4(5) of the IRPR regulations). Where firms are planning to use restructuring arrangements, these should therefore be legally contractually executed and any resulting bond or loan to be included in the MA portfolio must meet the MA asset eligibility conditions.

2.53

The PRA reminds firms that, as part of the MA eligibility conditions, they are required to demonstrate compliance with the PPP, and are also expected to assess carefully, and to be able to demonstrate, their compliance with the requirements for risk management. In particular, firms are expected to be able to identify, measure and manage risks within their asset portfolios, to invest in the best interest of all policyholders and beneficiaries, including managing potential conflicts of interest, and only to use derivative instruments where they genuinely contribute to a reduction in risk or facilitate efficient portfolio management.

2.54

The PRA expects firms to consider carefully the prudence of any transactions or arrangements they enter into for the purposes of the MA, including their behaviour under stress, and whether the associated risks are well understood and appropriately managed. Securitisation transactions, for example, can vary in their features, and firms should refer to initiatives of international bodies and evolving standards including in legislation to understand the features that underpin high-quality securitisations. Firms should also have considered any new risks generated by risk transformation arrangements, such as counterparty exposure, and how to account for these. In all considerations about asset eligibility, one of the key questions the PRA expects a firm to consider is whether it is exposed to the risk of changing spreads on the underlying asset, which would risk the firm being unable to employ a hold-to-maturity investment strategy thus running contrary to the assumptions underlying the MA.

2.55

Restructuring of assets through a subsidiary company set up for this purpose and wholly owned within the insurance group, ie a special purpose vehicle (SPV),^[23] may be acceptable, provided that proposals comply with applicable MA eligibility conditions. It is important, however, that the restructure is appropriately recognised within the firm and the group, including any changes in the risk profile of entities affected by the asset transformation. Given the additional complexity and consequential risks that restructuring gives rise to, the PRA’s expectation is that these arrangements will only be used in cases where firms have not been able to identify a viable alternative approach, for example pairing/grouping, or partial recognition of cash flows.

2.55A

The PRA considers that firms may create MA eligible mezzanine notes as part of a restructuring, where those notes have HP cash flows. Such notes would count towards the overall 10% of MA benefit limit for assets with HP cash flows. The PRA expects that the FS addition for such assets would normally be assessed using a more sophisticated approach that compares the asset to a fixed cash flow alternative.

2.55B

The PRA expects that firms will generally include MA eligible assets, whether with fixed or HP cash flows, in MA portfolios without restructuring. Where a firm restructures MA eligible assets, and then makes an application to include eligible note(s) from such a restructure in an MA portfolio, the PRA expects that the firm will additionally explain the reasons for the restructure and how it is satisfied that the level of MA benefit is appropriate. The PRA will consider these applications on a case-by-case basis. The firm will also need to be able to demonstrate that it has sufficient data to model the exposure to the cash flow variability risks so that the notes issued by the restructuring arrangement can be relied on as having fixed cash flows. The PRA expects that the aggregate value of a restructuring arrangement, including the MA benefit from the notes issued by the subsidiary company and the value of any residual interest in the company, would not generally exceed the value that would result from including the assets directly in the MA portfolio. Where the firm considers that value has been created by restructuring, the PRA expects it to be able to explain how this has arisen and to be able to demonstrate that any value enhancement has been created on an arm’s-length basis (and not, for example, from the use of a liquidity facility for which the SPV is paying below a market rate).

2.56

The extent to which transactions within the insurance group (including loans or derivatives) can be used to restructure assets in order to include them in the MA portfolio depends on whether the restructured assets thereby created can satisfy the MA eligibility conditions. The PRA expects firms to have regard to the underlying assets being restructured when they consider whether the MA eligibility conditions will be satisfied. The PRA would not expect firms to apply arrangements as set out in paragraph 2.55 above, or arrangements that in substance have that effect, to assets that, in unrestructured form, would in any event not meet all applicable Solvency II requirements, including those of the PPP. The PRA notes that some assets by their very nature may have characteristics that make it infeasible to restructure them as MA eligible assets, and expects firms to be able to demonstrate that sufficient reliance can be placed upon restructuring arrangements to ensure the continuing satisfaction of the MA eligibility conditions.

2.57

The PRA’s expectations set out in paragraph 2.9 above, in relation to the pairing or grouping of assets, apply equally to asset restructurings.

2.57A

Where assets are restructured, the PRA expects that any extension clauses would satisfy the PRA’s general expectations in paragraph 2.21 above (where applied to extension clauses instead of redemption or termination rights).

2.58

In assessing the suitability of arrangements set out in paragraphs 2.55 to 2.56 above in this context, the PRA expects firms first to consider whether the unrestructured asset is likely to remain appropriate over time, consistent with the duration of the restructuring arrangement, and as operating conditions might change. Examples of assets that may not be a suitable match for the liabilities of the MA portfolio include:

• ERMs with a NNEG with a high loan-to-value ratio, or written to younger age borrowers. These may be riskier assets, and over time may be more similar to a property investment than a bond, and therefore may not be a suitable match for the liabilities of the MA portfolio; and
• arrangements where an SPV does not have sufficient assets to meet future funding commitments to complete an investment that will be used to secure cash flows on the notes issued by the company.

The PRA expects that any subsequent deterioration in the quality of the underlying assets, for example following a stress event, should be reflected through the regular process of reviewing and updating the rating of the restructured asset. Firms would not be expected periodically to remove underlying assets from the structure.

2.59

For the purposes of demonstrating the reliability and efficacy of such arrangements, the PRA expects firms to be able to demonstrate (among other things):

• the arrangements will not give rise to conflicts of interest and will be subject to transparent and robust governance arrangements that afford sufficient certainty that the transaction will deliver the promised fixity of cash flows;
• there is a robust rating process of the SPV (or any notes issued by the SPV), including total return swaps (TRSs), to provide sufficient assurance that the required fixity of cash flows will be delivered and the rating is a factor in the MA benefit claimed; and
• the arrangement is in line with the relevant requirements on risk management and the associated requirements under the PPP.

2.60

For example, a TRS paired with a loan asset having variable cash flows could not be relied upon to ‘cure’ the failure of such an asset to satisfy the MA eligibility conditions relating to fixed cash flows unless the arrangement provides sufficient assurance that the promised fixity of cash flows will in fact be delivered. The PRA considers that a TRS transaction entered into with an unfunded, unrated and unregulated SPV would be unlikely to provide sufficient assurance as to the SPV’s sustained ability to satisfy its obligations to make fixed payments under the TRS on an ongoing basis for the purposes of MA eligibility.

2.61

In the case of a transaction with an intra-group SPV, the PRA would also expect that robust and transparent governance arrangements are in place and that the transaction is made on an arms-length basis so as to ensure that there is no impairment of the SPV’s ability to make the required payments to the firm. These transactions include the arrangement of liquidity facilities from another group entity and the extraction of assets from the SPV by the group.

2.61A

The PRA considers that where assets or pools of assets have previously been restructured to create an asset that met the ‘fixity’ requirement, firms may seek to include these in MA portfolios in an unrestructured form as assets with HP cash flows, where they meet the MA asset eligibility conditions. The PRA considers that this would require a new MA application.

2.62

Article 335(3) of the Commission Delegated Regulation (EU) 2015/35 requires group insurance and reinsurance undertakings to calculate the best estimates of liabilities (BEL) and consolidated group own funds net of any intra-group transactions. Where an asset portfolio has been restructured within an insurance group so that substantially all the risks and rewards of ownership of the asset receivables remain within the same entity within the group, this raises the question whether, in fact, there is an intra-group transaction that would be required to be netted out upon group consolidation. In the case of an asset portfolio that has been restructured through a form of securitisation using a subsidiary company specifically set up for this purpose within an insurance group, and where all tranches of cash flows and the equity in the subsidiary are held by the same insurance entity (albeit that junior tranches are held outside the associated MA portfolio), it is likely that the arrangement would not be recognised as an ‘intra-group’ transaction, with the result that there would be no intra-group transaction to be netted out at group level.

2.63

Any restructuring of the assets for the purposes of transforming the assets into MA eligible cash flows should be appropriately reflected in firms’ risk management frameworks. It is important that firms have in place, and are able to demonstrate, the necessary governance and expertise to manage any additional risks arising from the restructure, including the exposures to or within each of the SPV, the associated MA portfolio and the holder of the junior tranches and/or equity.

2.64

As noted in the SS on Solvency II approvals (SS15/15), as part of deriving the MA, it is anticipated that firms may seek to use internal credit assessments to assign a rating category. The PRA expects firms to be able to demonstrate that any internal credit assessment used meets the MA eligibility conditions and the expectations in SS3/17 as set out in paragraph 2.7A above.

2.65

Firms should take into account the Valuation Part of the PRA Rulebook and Chapter 7 of the Matching Adjustment Part and the PRA’s SSs on valuation risk for insurers (SS9/14) and on illiquid unrated assets (SS3/17) when valuing and rating the assets. In addition, a firm should recognise the risk of valuation uncertainty within its ORSA and, where appropriate, allow for this risk in determining its capital requirements.

2.66

If reliance is being placed on additional liquidity facilities to maintain the ability of the issuer to support the fixity of cash flows and the liquidity of the structure, the PRA expects a firm to be able to demonstrate, among other issues, that these facilities will be available over the expected lifetime of the SPV, as well as under stressed conditions. The PRA understands that in rating an SPV undertaking securitisations, external rating agencies would generally require liquidity providers for SPVs to be of high credit rating, with provisions for replacement on credit downgrade. Where the provider of the liquidity facility is internal and not externally rated, the PRA expects the firm to be able to explain and justify why any reliance on additional liquidity facilities is appropriate, including:

• stress testing of the availability of the liquidity facility to at least an equivalent degree to that which would be required of liquidity providers by rating agencies, including the likelihood of the liquidity facility no longer being available or being reduced;
• how the liquidity facility will operate in practice and, in particular, sufficient evidence that funds will be available if they are needed from an operational perspective; and
• how the liquidity facility will be managed so that it complies with the requirements (in regulation 4(6) of the IRPR regulations and Matching Adjustment 2.2(5)) for the MA portfolio to be separately organised and managed and not to be exposed to the risk of losses outside the MA portfolio (for example, if available liquidity were to be used to mitigate potential losses and therefore would not be available to support the fixed cash flows on notes issued by the SPV).

2.67

If firms intend using the structure to include new loans in the future (including incremental drawdown on existing loans), the application for MA permission should set out the process for doing so. This should include an assessment of the volume of additional loans that will need to be accumulated before further tranches of notes of sufficient quality can be issued.

2.68

Firms should identify the sources of funding for any additional loans for the interim period ahead of the issuance of further tranches of notes, and consider how this complies with the relevant liquidity management policies.

2.69

The PRA expects a firm to be able to demonstrate that any assumption that an MA portfolio will make an advance commitment to purchase additional tranches of senior notes is compliant with the asset and liability management (ALM) and liquidity policies of an MA portfolio, including potential scenarios of closure or material restriction in volumes of new annuity business, and/or increase in additional drawdowns on existing equity release policies. Firms should consider whether a commitment fee should be made for such a facility.

2.70

In cases where the restructure involves the pooling and transformation of cash flows from a defined set of underlying exposures into a series of ‘tranches’ of separate cash flows that are distinguished by an increasing scale of risk posed to the investor (from senior to junior tranche), the PRA considers that such a structure is, in substance, a securitisation. Following this approach, the calculation of the model-based capital requirements should consider the substance, rather than rely solely on the technical classification of the structure by product or securitisation type.

2.71

In the case of exposures to securitisation vehicles, firms proposing to use the standard formula to calculate the Solvency Capital Requirement (SCR) will need to treat the notes issued by the SPV as a Type 2 securitisation where they fail to satisfy the criteria for Type 1 securitisations (for example, where they are unrated).

2.72

The PRA anticipates that given the bespoke nature of the (restructured) ERM investment, firms using the standard formula may wish to develop a partial internal model (PIM) for this risk exposure. The PRA anticipates this would be a situation in which use of a PIM would be appropriate, provided firms satisfy the relevant requirements to use a PIM.

2.73

For firms applying for permission to use an internal model, the PRA expects the asset transformation as a result of the restructure to be reflected in the model. This will require a comprehensive consideration of the risks of asset transformation as well as the underlying ERMs and any diversification restrictions between the associated MA portfolio and the rest of the entity or group. The PRA expects models will also make allowance for default, spread and concentration risks arising from investment in the notes issued by the entity.

2.74

For structures that result in the creation of junior or equity tranches or exposures, the PRA expects firms to hold capital appropriate for the specific nature of the investment, noting the long tail and expected volatility of the risk exposure.