Firms may have to review how they calculate credit risk capital requirements for matching adjustment (MA) portfolios, following a note published by the PRA.
In a Solvency II implementation note dated August 29th, the Prudential Regulation Authority (PRA) detailed its view on assessing credit risk for matching adjustment portfolios. "The amount of credit risk capital should not be dictated by the matching adjustment calibration that applies to the calculation of technical provisions," stated the supervisor.
The matching adjustment allows insurers to claim capital relief on certain policyholder obligations where the cashflows are closely matched by long-term assets, through the application of a parallel upward shift to the risk-free rate used to value the liabilities.
The amount of the benefit is defined as the spread on the matching assets minus the so-called fundamental spread, which is the part of the total spread attributable to the risk of default or downgrade on the assets.
The note states: "The PRA has not yet seen any evidence to demonstrate that a mechanistic re-application of the matching adjustment following a stress would meet the Solvency II requirements, including the requirement that the model allows for all quantifiable risk."
Industry sources suggest a "mechanistic re-application" means firms may have used how the matching adjustment behaves in normal market conditions to inform the solvency capital requirement (SCR) generated by their internal model.
In normal conditions, an increase in market spreads would almost always trigger an increase in the benefit provided by the matching adjustment, because the fundamental spread is based on long-term averages and widens gradually compared with other aspects of the spread. The result of following this approach in internal models would be to largely eliminate capital held against the credit stress.
The PRA note also suggests firms should consider the possibility that certain portfolios will be ineligible for the adjustment in a stress scenario as a result of breaches of the terms of its use. The supervisor highlights in the note that models should account for all quantifiable risks.
PRA Solvency II implementation note
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