Who is this blog for?

Senior executives and actuaries in the UK and elsewhere, who work on balance sheet management, pricing, reporting, capital optimisation and risk.

At a glance:

  • Reforms to the Fundamental Spread (FS) are set out in the UK Government’s consultation on Solvency II, and the PRA’s Discussion Paper (DP), including a technical Annex which was released on 28 April 2022. The Government and PRA are seeking responses by 21 July 2022.
  • The reforms include an additional Credit Risk Premium (CRP) to the Fundamental Spread to capture the uncertainty around the expected loss within the FS. The PRA suggest the CRP should be calibrated to at least 35% of credit spreads on average through the cycle. This is expected to result in a general decrease to the Matching Adjustment (MA) and thus an increase in reserves and capital requirements.
  • The Government and PRA are requesting feedback on these reforms to help shape the calibration of the FS. The PRA will then follow up with a more detailed consultation later in the year.
  • This is the second blog in a two-part series looking in detail at the Solvency II reforms. In this blog, we consider the revised framework for the FS and its impact on the MA and Solvency Capital Requirements (SCR).
  • The first blog in this two-part series considered the changes to the Risk Margin (RM), MA asset and liability eligibility criteria and other aspects of the MA. See The UK Government's consultation on Solvency II: Part 1 – Risk Margin and Matching Adjustment eligibility impacts.

Reading time: 8 minutes

Executive Summary

Our interpretation of the consultation, in summary, is detailed below:

  • The overall impact of the consultation is currently uncertain. The ambiguity surrounding aspects of the designs, particularly in the reforms to the FS, means that it is difficult to ascertain the likelihood that the reforms will achieve the anticipated capital releases and benefits expected by the Government
  • The proposals are expected to reduce the base MA and increase its volatility to spread changes. The PRA’s proposal that the CRP should be calibrated to at least 35% of credit spreads on average through the cycle will address the PRA’s concern that the FS is too low and so generally increases the FS across all assets.
  • The CRP would take account of the average spread for a comparator index, and the spread for assets in excess of the comparator index.
  • The introduction of a shorter (than 30-year term) averaging window from which to calculate the average comparator index will introduce volatility. The length of the averaging window will be a key point of debate.
  • Volatility may also be introduced where the comparator index is not representative of the underlying assets which may well be the case for newer and more innovative asset classes.
  • There are other areas of uncertainty around the practical application of using a comparator index and whether this would be a single index or multiple indices for different assets. Using corporate bond indices is likely to be the simplest option for the PRA to pursue, given the availability of data. However, this may not meet the PRA’s signaled intention of differentiating the FS by asset class.
  • The impact on firms’ internal models and SCR is yet to be quantified from these proposals although the PRA maintains it expects no material changes in the level of firms’ SCR.
  • Increases in SCR may be expected to arise from a lower discount rate arising from a lower base MA, changes to the calibration of the credit risk SCR, and any additional risks arising from new asset classes that may now be MA eligible. These increases may be partially offset by greater benefits from management actions if proposals to allow a longer time than the current 2-month period for breaches in MA to be rectified, are implemented.

Proposed reforms to the FS

The proposed FS

The Government and PRA have long stated that, in their view, the current calibration of the FS does not allow explicitly and fully for uncertainty around credit risk, resulting in an FS which is too low. They argue that this is more pronounced for illiquid assets and, as holdings in illiquid assets increase industry-wide, the significance of any misstatement increases.

In addition, the PRA has acknowledged that the FS does not differentiate between assets of different currencies, sectors and credit quality steps (CQS) and does not adjust to reflect structural shifts in the credit environment over time, where a default or downgrade has not occurred.

This is demonstrated by the fact that in the current calculation of the FS (demonstrated below), the Long Term Average Spread (LTAS) floor tends to bite across most ratings and terms.

Consequently, the Government and PRA propose the following FS calculation:


EL is the expected loss, determined by the historic profile of defaults and recovery rates associated with assets of a certain credit rating (consistent with the probability of default in the current FS calibration), and

CRP is the credit risk premium based on market measures of the asset spread. The PRA view the CRP as the uncertainty around the EL for which a willing arm’s length third party would demand a premium for taking on the risk.

The CRP is calculated as:

        X ∙ (average spread for comparator index over n-years)

         + Z ∙ (difference between the spread of an asset and that of the comparator index)


X is a parameter calibrated to deliver the preferred degree of sensitivity to changes in the medium-term average spread for assets of a given credit rating; and

Z is a parameter calibrated to deliver the preferred degree of sensitivity to changes in the difference between the spread of an asset and that of the comparator index.

We consider each of the components in turn below.

Comparator index

Neither the consultation or discussion paper proposes a specific comparator index, and the PRA invites views on potential comparator indices. It is unclear whether different comparator indices for different asset classes, or one index for all assets is being considered. Corporate bond indices are one possible index, as used under the current FS calibration, and would likely differentiate by credit rating, and financial or non-financial status.

The below table summarises the pros and cons of using single versus multiple indices for different asset types.

 Choice of the averaging window - n

The n-term is likely to be hotly debated within the industry as firms are likely to want as long a term as possible to avoid volatility, whilst the PRA wants a term short enough to ensure that the FS remains sensitive to structural shifts in credit conditions.  The choice of n will be a trade-off between increased sensitivity using shorter terms versus decreased volatility for longer terms.

The PRA considers 5 years to be a reasonable period over which to average, as, in their view, this balances the need for the CRP to be responsive to sustained changes in the level of spreads whilst not over-reacting to short-term changes. However, 5 years is unlikely to be long enough to fully capture the effects of the credit cycle, and so will not reflect a through-the-cycle view of credit risk.  

The below graph discusses the choice of n at different durations.

We have calculated the rolling average spread for n = 5, 10 and 20 years using the ICE BofA 10-15 Year Sterling Corporate Index, which covers both financial and non-financial bonds, to demonstrate the sensitivity of the average spreads to the value of n. As expected the larger the n, the less volatile the average spread for all CQSs. The 5 year average spread in particular demonstrates significant historical volatility, with a sharp peak in 2012.

Source: ICE BofA 10-15 Year Sterling Corporate Index

X term

The PRA proposes that the X term would be restricted through the use of a cap and floor. However, too narrow a band in the X term where either the cap or floor bites may miss structural changes in credit conditions (a key issue of the current methodology for the PRA). In some market conditions, a cap may even conflict with the PRA’s proposed calibration of a CRP equivalent to at least 35% of credit spreads through the cycle.

Our assessment is that the use of such caps and floors to the X term is likely to be more appropriate where a short averaging window is used, as average credit spreads are likely to fluctuate more in this case, and caps and floors could be used to dampen the more extreme fluctuations.

In addition, the use of caps and floors may be more relevant (and beneficial), in our view, in the SCR calculation. For example, a cap could be set such that it is only likely to bite in a stressed scenario and therefore it would not impact the movements in the FS day-to-day but would limit the extent of any increase in FS in a stressed scenario. The consultations remain largely silent on how the FS under stress would be expected to change but we explore this further below.

Z term

The Z term of the CRP is designed to:

  • capture the basis risk or idiosyncratic risk between the individual asset and the comparator index, and
  • address the issue that, currently, investors are incentivized to invest in assets with high spreads for a given rating; instead, the higher the spread relative to an index spread, the higher the Z term contributing to the FS.

The PRA’s Annex states that the “Z term is intended to remain stable unless the idiosyncratic risks on a specific asset move differently to an appropriate reference index”. The ‘appropriateness’ of the index is key to ensuring this term acts as intended. For example, suppose a single corporate bond index is used as the comparator index. For an infrastructure asset, say, whose spread would be expected to be fairly stable, a reduction in the index without a change to the infrastructure spread would result in an increase in the FS, even though there had been no change in the idiosyncratic risk of the asset. This not only introduces volatility into the FS but may not represent the underlying risk of the asset.

Values of X and Z

The PRA believes that a CRP equivalent to at least 35% of credit spreads through the cycle is appropriate and indicates the value of X would be at least 35%, but could vary depending on the value of Z.

One factor the PRA may wish to consider is whether to vary the value of X and Z for different asset classes, particularly if only one reference index is used. In addition, varying the value of X and Z to be lower for specific asset classes is also a potential mechanism to support the Government’s objective of encouraging investment in long-term assets.

Justification of the level of CRP

The PRA’s justification of the CRP level is partly based on academic research that suggests that a CRP between 35% and 55% of the spread is supportable for corporate bond assets. It is also based on looking at transfer values of long-term life-insurance business. In particular, when reviewing transfer values, it is the combination of both a CRP calibrated to at least 35% of credit spreads and a risk margin (RM) reduction of 60-70% that results in annuity technical provisions that are within a ‘plausible’ range of market inferred values according to the PRA’s analysis.

The Government, in contrast, is asking for views on the impact of a CRP of 25%, 35% or 45%. However, given the evidence presented by the PRA, it appears unlikely that the PRA would settle for a lower value than 35% without, at the very least, a smaller reduction in the risk margin.

Overall impact on MA

In the current methodology, the LTAS floor of 35% typically bites whereas in the methodology within the consultation, the 35% of credit spread calibration reflects just the minimum CRP; the addition of the EL on top of that will result in a general strengthening of the FS, and hence a decrease in the MA.

The PRA analysed firms’ submissions as at year-end 2020 and compared the FS under the existing methodology with an FS calculated as CRP of 35% of spreads. The CRP of 35% of spreads methodology resulted in FS that increased by at least a third, with the exact increases differing by credit quality step.

While we know that the MA will be smaller in general, the extent of the decrease for a firm will depend firstly on the firm’s particular portfolios and asset-matching strategies, and secondly the PRA’s calibration of the X-, Z-, and n-parameters, and choice of comparator index (or indices).

Impact on SCR

The consultation and DP continue to remain largely silent on the impact on the SCR of these changes. The PRA state that they do not expect firms’ SCR to materially change as a result of the FS changes but point to a further exercise later this year to collect data on SCR impacts.

The PRA also hints that a move to a new calculation mechanism may be phased in over a period of time – giving firms and the PRA more time to reflect any required changes within the Internal Model.

The PRA will also want to give consideration to how the value of comparator indices should change under a credit stress. For Internal Model firms, it is likely that individual firms will need to assess whether the current credit stresses are aligned to the comparator indices or whether work is required to derive stresses for these indices.

Also, what was once discouraged as a purely mechanistic approach to FS under stress may now, given the nature of the proposed calibration, be less objectionable to the PRA. No firm statements have been made but indications suggest the PRA’s attitude to this approach may be softening.

Although the impact on SCR will be firm specific, we expect the following impacts from the reforms will be likely:

  • Increased Longevity SCR, owing to a lower discount rate due to the lower base MA;
  • Increased Credit SCR, owing to the FS being more sensitive to the level of credit spreads which have a higher correlation to wider markets compared to transitions and defaults (which is currently the more widely used mechanism by large IM firms with large MA portfolios) which will give less diversification benefit to credit risk after allowing for the MA with other risks;
  • Additional risks may have to be included in the SCR, to the extent that new asset classes are brought into MA asset portfolios by these changes; and
  • Greater benefits from management actions, particularly if the 2-month timeframe to rectify MA breaches is removed.

The overall impact on the SCR, combining all the direct and second-order impacts, remains to be quantified.

Overall impact of RM and MA reforms 

The PRA has estimated the proposed changes to RM and MA within the plausible range discussed above would result in a release of 10-15% of Own Funds, assuming the full run-off of TMTP. Therefore, the release of such levels of capital are not going to be available to be fully redeployed until 2032 once the TMTP has run off. The investment in long-term and green assets that the Government is keen to champion may yet be in for a longer wait than originally anticipated, unless the FS methodology is calibrated such that there is increased financial incentives to invest in these assets relative to other fixed interest assets. Furthermore, the absence of quantifiable impacts of the FS changes on the Solvency Capital Requirement remains a significant uncertainty that will continue to unsettle the industry.

See Part 1 of the blog for consideration of all other changes to the MA and RM changes.

For consideration of how the reforms may meet the Government’s objectives of enabling long-term investment while enhancing the overall competitiveness of the UK insurance industry see The UK Government's consultation on Solvency II: A green and competitive future, Linda Hedqvist (deloitte.com).