13 April 2014

Risk.net: Insurers to repackage assets for matching adjustment

Repackaging assets that fail to meet the criteria for Solvency II’s matching adjustment could be one way for insurers to secure capital relief and hold on to attractive yields. This article reports on the structures being considered and the alternative options available.

The adjustment is one of several amendments to Solvency II that have been strongly contested by insurers over several years, right up until the past few months. Insurers have wanted to ensure that certain assets would qualify for use in the adjustment. Now it seems they will be disappointed.

Emily Penn, London-based head of UK asset liability management for Royal Bank of Scotland (RBS) said: "Six months ago insurers were lobbying in relation to specific products, living in the hope that those products would be made eligible in their raw format for the matching adjustment." More recently they have realised that in some instances the fight has been lost, she said. "Now they are asking what to do about the assets that will fail to qualify."

For assets to be eligible for the matching adjustment insurers must show that the cashflows from the assets correspond to cashflows on the relevant liabilities. At the same time, based on the text of the Omnibus II directive that was approved by the European parliament in March, the cashflows in question cannot be subject to change by issuers or anyone else.

In practice this means assets with an element of optionality will fail to qualify. This includes callable bonds and any loans that lack features to compensate for prepayment – for example, many commercial mortgages as well as equity-release mortgages, of which insurers such as Partnership and Just Retirement in the UK are significant holders. 

The problem is not limited to legacy assets but also includes new investments, an area of special concern as insurers become increasingly active buyers of corporate and infrastructure loans. Depending on how these investments are structured, they could also be ineligible for the matching adjustment. This would render them less attractive to writers of long-term annuities in particular, who should be natural buyers for such assets. 

Jeff Davies, actuarial insurance leader at consultancy EY in London commented: "Lots of assets carry optionality that you need somehow to remove in order for the asset to qualify for matching adjustment." Insurers are becoming more active in areas such as small business loans, infrastructure, renewable energy loans and whole loan mortgages, he points out. All of these include a degree of prepayment risk.

In the past, the embedded optionality in these products has made them more suited to bank balance sheets. More recently, as banks have reduced parts of their lending activity in response to regulatory pressure to reduce leverage, insurers have seen an opportunity to invest. Insurers are also being encouraged by governments to act as providers of long-term financing to the real economy.

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