On 20 July 2021, the PRA launched its Solvency II Quantitative Impact Study (“QIS”). Amongst other topics, such as calculation of the Risk Margin, a key focus of the QIS is to test the impact of potential changes to the construction and calibration of the Fundamental Spread (“FS”) and hence the Matching Adjustment (“MA”).
The approach set out in the QIS decomposes the FS into the following four components, under two Scenarios, A and B:
Expected loss: This component resembles the current Probability of Default component within the current FS.
Adjustment for sovereigns: The methodology for calculating the FS for sovereigns is unchanged from the current methodology.
Credit risk premium (“CRP”): This is intended to capture the “unexpected defaults” component of the spread and replaces the existing Cost of Downgrade element (including the long-term average spread (LTAS) floor). The QIS defines this as “25% * current z-spread of the individual asset + 25% of a 5-year industry average spread”. The industry average spread in the latter component is prescribed in the QIS instructions and zeroised in Scenario B.
Valuation uncertainty (“VU”): This is a fixed basis points addition to the FS based on the credit quality step and IFRS fair value hierarchy levels of the asset. This hierarchy ranks assets by the valuation techniques used, the highest ranking given to assets using unadjusted quoted prices in active markets and the lowest ranking to assets using unobservable inputs in their valuation e.g. mark-to-model assets.
The PRA has been at pains to state that the scenarios set out in the QIS are not intended to represent reform proposals or decisions. Nevertheless, for the purposes of this blog, we discuss below our key observations on the implications for the MA and firms more generally if the FS approach set out in the QIS is introduced as part of the PRA’s package of reforms to the UK’s Solvency II regime.
How is the MA expected to change?
The use of current spreads and a shorter period for the average spread in the CRP (5 years, vs. 30 years in the current approach) will introduce more of the spread volatility into the FS, and MA, and therefore more volatility into the Solvency II surplus than under the current approach. If the FS set out in the QIS had been implemented prior to March 2020, the industry would have seen much greater volatility in firms’ Solvency II ratios than was observed in practice following the extreme market movements at the start of the Coronavirus pandemic.
The VU component directly addresses the inherent model risk associated with mark-to-model assets. Given the lack of an active market to price these assets there is a degree of judgement made in the valuation of these assets and therefore there is intrinsic uncertainty in the size of the implied spread. The VU component moves a fixed amount of that implied spread into the FS. This is intended to reduce the risk of inaccurate valuations artificially inflating the MA benefit allowed for in the Technical Provisions.
The Cost of Downgrade component of the original FS is a complex calculation that requires a full projection of the asset portfolio's cashflows and ratings. This model is not easily interpretable for all asset classes held in the MA e.g. illiquid assets being sold on downgrade and replaced with similar assets of the original rating is not a realistic scenario. A move to a more transparent design as set out in the QIS that is based on observable spread data and more easily interpretable for all assets is a positive move in our eyes; however, this more simplified FS design will also lead to a loss of granularity within the underlying calculations and potentially a reduction in accuracy which may adversely affect the FS for some assets.
What are the implications for the level of MA?
With the replacement of the Cost of Downgrade component and the LTAS floor with the CRP and VU, the expected impact on the FS is largely equal to the difference between 35% of the LTAS and 25% of the current spread + 25% of the 5-year average (for Scenario A), plus the Valuation Uncertainty for less liquid assets.
Our internal analysis shows that Scenario B can be less onerous than the current FS regime and that Scenario A will likely be more onerous. For example, on an A rated/CQS2 10 year non-financial bond, we would expect a 5bps higher MA on Scenario B compared to the current regime and up to 40bps lower MA under Scenario A.
What are the implications for firms’ MA processes & SCR models?
The increased level of granularity in the construction of the FS set out in the QIS, if adopted, would need to be matched by a significant increase in granularity of firms’ MA process in order to perform the asset by asset level calculations. Many firm’s processes and models have not been built with such granularity in mind and therefore the effort to address this could be substantial.
With regards to the SCR under the revised FS, the impacts are still unclear but developments to credit risk and MA under stress (”MAUS”) risk modules will be required.
Those firms whose credit risk modules have separate transition and default risks that directly influence the MA under stress (rather than a % of spread) are likely to be at the greatest disadvantage and may require the most substantial redesigns.
However, even for firms who have already adopted a % of spread approach to MAUS, we envisage the changes extending to calibrating stressed credit risk premia, stressed valuation uncertainties and introduction of interactions with the yield stresses to understand the stressed z-spreads within biting scenarios.
What are the implications for MA portfolios and investments?
The removal of the sub-investment grade cap will create new optimisation opportunities for MA portfolios.
The current cap means that MA portfolios are not rewarded for holding sub-investment grade debt as the MA is restricted to be no higher than the MA on investment grade (CQS 3) assets. The removal of the cap would allow firms holding such assets to crystalise the additional spread in the MA. However, this would be dampened somewhat should the FS be linked to the size of the spread (as is suggested in the QIS).
The impact of such changes on illiquids is currently unclear. Illiquids are likely to continue to provide a greater MA benefit compared to corporates but there is now an explicit component of the FS which is designed to capture the inherent uncertainty in the spread. How the FS will be modelled under stress will also have an impact on how favourable, or otherwise, the new regime will be to illiquids.
There is also uncertainty around how any changes to the FS will reconcile with the PRA’s desire to support investment in infrastructure and consistent with the Government’s climate change objectives.
As noted above, a move to the FS structure set out in the QIS will, by design, result in a more volatile balance sheet due to the MA absorbing less credit spread volatility than currently. Firms would need to consider not only how to manage this volatility but how to communicate and manage the messaging to shareholders.
The above implications do not take into account any other changes that the PRA may make to the MA process, application or eligibility rules. In his speech on 22 September 2021, PRA Director Gareth Truran indicated that the PRA is considering changes to both the MA application and MA eligibility criteria, in order to broaden the range of investments within the MA portfolio and reduce the time and effort required by firms prior to investment in new asset classes. This, combined with the broad range of questions from the PRA’s qualitative questionnaire, suggest changes to a suite of MA aspects may be on the table, but only time will tell as to what aspects they feel are most pertinent to address and what the impact of these changes, combined with the other alterations being considered by the PRA, will be on the balance sheets of the UK’s insurance companies.