06 October 2014

Risk.net: Watered-down matching adjustment would be ‘utterly worthless'

Certain UK insurers are reconsidering whether to apply for the Solvency II matching adjustment (MA) as regulatory communications suggest the benefits of the measure could be significantly watered down.

The latest communication from the European Insurance and Occupational Pensions Authority (Eiopa) states that insurers participating in Euope-wide stress tests will have to account for credit risk in the risk margin calculated for MA portfolios, significantly boosting the value of technical provisions and eating away at the capital relief the adjustment was designed to offer.

"If this watering down were to occur, we estimate that this could offset around two-thirds of the reserving benefit from the matching adjustment, although this would vary from company to company. This would be a disastrous eleventh-hour blow to the UK industry, which has already been made to work very hard to motivate, justify and quantify the matching adjustment," says Stephen Makin, senior insurance consultant at Hymans Robertson in London.

The risk margin is added to an insurer's best estimate of liabilities to make up its total technical provisions. This margin is defined as the difference between the best estimate and the amount a reference undertaking would have to be paid to take on the liabilities of the insurer on an ongoing basis. A firm calculates the risk margin by projecting its solvency capital requirement (SCR) for non-hedgeable risks (such as underwriting risk and operational risk) for every year of run-off and applying a cost-of-capital charge of 6% per annum to account for the reference undertaking's expenses in financing the book of business.

In this hypothetical transfer scenario, an insurer is assumed to liquidate all its assets and replace them with risk-free instruments prior to the handover in order to minimise credit risk to the reference undertaking. However, on June 25, Eiopa issued responses to questions received on the technical specifications for the Solvency II preparatory phase, one of which explained that insurers "should assume that the assets eligible to the matching adjustment are transferred to the reference undertaking, giving rise to a material market risk".

Put simply, this means insurers would have to factor in credit risk when projecting the SCR for the risk margin in these portfolios. While Eiopa explains that this approach is for the purposes of the stress test, it has still thrown the UK market into confusion. The final calibration of the matching adjustment, and other long-term measures, will be laid down in the Solvency II, level 2 text, also known as delegated acts, which were expected to be published by the end of September. It is not certain when these will now be released.

Opinion is split on whether Eiopa's response signals a wholesale change in approach to the MA or a temporary deviation for the purposes of the stress tests. Mark Laidlaw, chief actuary at LV= in Bournemouth, says the June 25 interpretation may be here to stay. "This is the logical conclusion of the MA approach. There are a lot of rules around defining a ring-fenced matching portfolio, to the point that it's effectively a standalone element in a company. If you've created a ring-fenced fund, logically the rules suggest a separate calculation of the risk margin and a loss of diversification benefit."

But others believe this logic cuts two ways. Scott Eason, head of insurance consulting at Barnett Waddingham in London, says: "In a transfer scenario, I can see how it makes sense that your risk margin for an MA portfolio should assume the assets don't get switched into risk-free. However, we believe there is an argument that those buying a matching adjustment portfolio could switch the assets into illiquid, credit-risk-free instruments and therefore the current owner should not have to allow for credit risk in the risk margin calculation."

All agree that the uncertainty is of concern to the life industry. AT LV= Laidlaw goes so far as to suggest it is diminishing the attractiveness of the adjustment to undertakings. "No-one's come out and made a final decision yet. We're reviewing it very carefully. A company that is not in the annuity market might ignore the MA and rely on transitional measures instead."

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