Sathish Umapathy explains why the matching adjustment is a vital measure for life insurance companies under Solvency II
A number of insurers have already transitioned their asset portfolios to comply with matching adjustment (MA) rules, while others have opted out owing to the practical difficulties associated with managing matching adjustment portfolios. In this article, we share our insights on what it takes to build and manage these portfolios. Under the Solvency II framework, insurers value their liabilities using the risk-free interest rate.
This is derived from the market swap rates for the liquid part of the curve, extrapolated thereafter to a long-term equilibrium rate.
The matching adjustment (MA) is an adjustment made to the risk-free interest rate when the insurer sets aside a portfolio of assets to back a predictable portion of their liabilities. It is based on the yield spread over the risk-free rate credit spread of the assigned portfolio of matching assets, minus a fundamental spread that accounts for expected default and downgrade risk. It is designed to reflect the fact that long-term, buy-and-hold investors only bear downgrade and default risks as they seek to hold assets to maturity, and allows them to capture other aspects of the spread such as the liquidity premium (see feature).
The benefits of MA are twofold. It increases the numerator of the Solvency II ratio (own funds) by reducing the value of their liabilities and at the same time decreases the denominator (the capital requirement). Thus one might ask why many insurers have not opted for the matching adjustment.
But, as quoted by many actuaries: "with the great capital benefits come the great approval requirements".
Within the UK, the Prudential Regulation Authority (PRA) has set quantitative and qualitative requirements for a matching adjustment-compliant portfolio. These requirements range from the quality and the nature of the assets to liquidity planning for future cash outflows. A key challenge for an insurer is to identify eligible assets. They must have a fixed set of cashflows, thereby ruling out bonds with embedded options or floating interest rates that make their cashflows unpredictable. Standard databases employed by investment and asset liability management teams cannot usually be considered sufficiently reliable or granular for this exercise; going back to the prospectus is necessary for each and every bond issue in the fixed income universe to identify acceptable levels of make-whole provisions, call optionality, or hidden clauses that would make it unsuitable.
The quality of cashflow matching is another area where the PRA has defined tests that seek to evidence that the asset portfolio produces sufficient cashflows (net of default and downgrade haircuts) to back the liabilities:
- Test 1 - discounted accumulated cashflow must not exceed 3% of liabilities in any year
- Test 2 - residual interest rate, inflation and currency risks are measured with a 99.5th percentile value-at-risk metric
- Test 3 - notional swap test requires that sufficient assets are allocated to back the liabilities.
Constructing a matching adjustment portfolio is an onerous task with various constraints in play. Insurers can seek a portfolio with the maximum MA level achievable or can compromise some level of MA for a reduced turnover or a higher average rating. One could see the portfolio construction as a constrained optimisation problem aimed at maximising the MA level from an investment universe of fixed income assets with appropriate credit fundamentals, subject to compliance with the cashflow tests, the investment guidelines and the spread capital charge limit.
As part of portfolio construction, one must ensure appropriate resilience of cashflow tests against interest rate stress scenarios.
To illustrate this, consider the cashflow profile in figure 1a (above), which passes test 1. However, under a humped risk-free curve, the shortfalls are magnified, resulting in a 135% increase in the maximum shortfall (see figure 1b).
A key residual risk in MA portfolios is the potential for credit deterioration. While one could argue that MA portfolios are not directly exposed to credit-spread movements, credit-spread widening tends to increase the likelihood of downgrades and defaults and higher corresponding haircuts.
Credit rating downgrades impact MA portfolios in two ways:
- Higher haircuts and cash injection: rating downgrades give rise to higher haircuts applied to the asset cashflows and, in turn, require additional cash to bring the shortfall to the level before rating downgrade
- Cost of downgrade adjustment (CoD): rating downgrades increase the CoD, thereby increasing the fundamental spread and reducing the MA.
Monitoring and mitigating rating transition risk is vital for MA portfolios. The credit profile of each bond may be monitored according to a number of metrics based on fundamental credit analysis.
Combining fundamental views with a quantitative downgrade analysis of the MA provides a powerful tool to manage downgrade risk.
The overall exposure of the MA portfolio to rating downgrade is quantified by applying 'parallel' rating shocks (for example, all A- bonds are downgraded to BBB+) and calculating the impact on the Solvency II ratio under these scenarios. Applying these shocks to different maturity segments informs the insurer about priority risk management areas (see figure 2a and 2b). This analysis may inform investment guideline limits and ongoing portfolio risk management action.
Foreign currency investments
The limited liquidity and diversity of the sterling corporate bond market has led a number of annuity writers to consider investments in US dollar credit hedged to sterling. Currency hedging raises a number of challenges for a MA portfolio, including the design of an appropriate hedging strategy (for example, cross-currency swaps) and liquidity planning to manage collateral calls in a way that respects cashflow matching constraints. The framework presented above incorporates these aspects at two levels:
1. Liquidity levels required to support potential collateral calls are incorporated as constraints in the portfolio construction phase, striking an appropriate trade-off between the increased yield and diversity introduced by foreign currency credit with the cost of hedging and opportunity cost associated with liquidity buffers; and
2. Stress testing of the matching and liquidity position under adverse FX and interest rate scenarios.
The application of the matching adjustment has the potential to support the level and the stability of an insurer's solvency position by increasing their own funds, reducing required capital, and aligning the market sensitivity of the liability and asset portfolios. However, implementing such portfolios is not straightforward. If one overcomes the obstacles in defining the eligible asset universe, constructing an efficient portfolio and managing it on an ongoing basis, the benefit is there to be reaped. I think it is worth the effort.