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Completing the Solvency UK puzzle: the final rules are here

At a glance
 

  • The final Solvency UK (SUK) rules on the Matching Adjustment (MA) remain largely unchanged following the initial consultation, but the PRA has provided several clarifications and targeted amendments that we expect will be helpful to life insurers. The changes to the regime are complex and material. Life insurers have their work cut out for them to ensure a smooth transition.
  • With the final rules now out, insurers can start the detailed implementation, particularly given the tight deadlines for many of the reforms. This includes forming a view of which elements are the most pressing to complete and considering the need for resources and expertise carefully.
  • From a strategic perspective firms may see opportunities in applying the rules early for example around investment flexibility. In a highly competitive market even if investment flexibility only provides a small benefit, it will likely be worth having. Firms should also consider how future transactions (bulk purchase annuity buy-outs) will interact with the attestation process and possibly trigger out-of-cycle attestations or make the year-end attestation more complex than expected (for example a transaction completed in November 24 would bring in the acquired MA portfolio under the scope of the year end attestation).
  • The PRA has taken on board industry feedback in several areas. These include: not going ahead with additional conditions for fixed assets that could have resulted in reclassifications of previously-approved assets; widening the MA liability eligibility criteria to Group Dependant Annuities (GDAs) and confirming group income protection policies are included; adopting a more pragmatic approach to the attestation requirements (assessing assets by homogeneous risk group); and removing some documentation requirements in the MA application process.
  • The industry had proposed the concept of sandboxes to create a more agile approach to investment flexibility and to overcome the issue of lack of availability of investments that meet the eligibility conditions. The PRA acknowledges the work done in this area but has not incorporated any of these ideas into rules. The work in this area will continue through Subject Expert Groups (SEGs). Any proposal to introduce sandboxes would be subject to a formal consultation process.


This insight is for: 
Board members, senior executives and actuaries of UK insurers with approvals to use the MA or considering doing so,  who work on balance sheet management, pricing, reporting, capital optimisation, risk, finance, and compliance.
 

On 6 June, the PRA published PS10/24 - Review of Solvency II: Reform of the Matching adjustment (‘final rules’) following CP19/23 (see our previous blog outlining the main aspects of the proposals). The final rules are among the most keenly awaited elements of the SUK reform. Overall, the final rules differ little from the proposals in the PRA’s original consultation, with some targeted modifications and clarifications that provide some helpful guidance as insurers press ahead with implementation.

In this blog, we outline: the expected impact on firms of the final rules, where we are in the overall SUK reform process and the more material changes included in the final rules since consultation

1. Impact on firms

 

The PRA has taken on board some industry feedback in relation to several of its original proposals. For example, the PRA has decided not to carry forward certain changes – including those that could have resulted in the reclassification of current MA portfolio assets considered fixed into the Highly Predictable (HP) category. In certain cases, the PRA has gone even further than originally anticipated by, for example, removing some documentation requirements in the MA application process and widening the liability eligibility criteria to ensure in-payment GDAs are MA‑eligible and clarifying that all in-payment group income protection business is also MA‑eligible. Firms will welcome a slightly more pragmatic approach to the attestation requirements, allowing them to carry out a top-down analysis by Homogeneous Risk Groups (HRGs) and to rely on the basic Fundamental Spread (FS) for corporate bonds subject to certain conditions. Despite this pragmatism, it is clear the PRA expects firms to determine if FS additions are required for assets such as illiquids, internally rated assets and Equity Release Mortgages (the PRA clarified that its published Expected Value Test parameters should be applied as a minimum).

With clarity on the final rules and timelines, MA firms can start the detailed implementation. Given the short timelines, life insurers need to determine which elements of the reforms to prioritise. We expect that the outputs required for year-end 2024 (e.g., the attestation) will require firms’ immediate attention. Adopting the requirements for the investment flexibility reforms (which come into force by the end of June) will depend on firms’ appetite for investing in HP assets but making an early start to this might provide a commercial advantage and should be a strategic decision.

Firms will also need to consider the impact of the reforms on their future acquisitions and other significant transactions as they may materially affect the year-end attestation process (for example a transaction completed in November 24 would bring in the acquired MA portfolio under the scope of the year end attestation), or trigger an out-of-cycle attestation (from 1 January 2025). Depending on each firm’s major model change policies, approach to notching and sub-investment grade (SIG) investments, there might be changes required to internal model processes, permissions and applications. We discuss this in more detail here.

Firms should also prepare to engage bilaterally with the PRA in some areas – for example in relation to fixed asset conditions and assumptions on timing of cashflows and ratings of assets. The PRA has also indicated that it will keep the new MA framework under review, and that further changes are possible (through sandboxes and SEGs). It will be important for firms to continue to raise issues and come up with suggestions on how to improve the regime over time.

2. Completing the SUK puzzle
 

PS10/24 completes a first batch of SUK final rules (PS2/24 and PS3/24) published earlier this year. One last Policy Statement to transfer retained EU laws into the Rulebook is still expected from the PRA in Q3 2024. Most of the new SUK rules will apply from 31 December 2024, but some MA provisions will be effective from 30 June 2024.

Implementation timeline of the Matching Adjustment (MA) reforms

Some aspects of the reform are being implemented on a voluntary basis from 30 June to 31 December 2024:

3. Key clarifications and modifications since consultation

 

A. Improving MA investment flexibility

The PRA is introducing more flexibility around MA investments, particularly by allowing insurers to include assets with ‘highly predicable cashflows’ (HP assets). The PRA will allow a limited proportion of HP assets (10% of the MA benefit) to be included in the MA portfolio provided they meet a set of strict criteria and appropriate controls are in place.

What has changed since the consultation?

  • Current fixed assets will remain so: following industry feedback the PRA has decided not to carry forward changes that would have resulted in the reclassification of current assets considered fixed into the HP category. This move will be welcomed by the industry with the PRA clearly stating that: ’the proposed policy should not act as a trigger for firms to reclassify assets previously considered to be fixed’.
  • PRA to engage bilaterally with firms on fixed assets conditions: since the PRA has decided not to carry forward the additional criteria for fixed assets, it will instead conduct work with firms to ensure consistent market interpretation around fixed asset conditions, assumptions on timing of cashflows and ratings of assets and explore concentration risk driven by build-up of exposures to individual counterparties.
  • Contractually bounded: the PRA has added some examples and clarification of expectations around what it means for an asset to be contractually bound, but the criteria remain unchanged.
  • HP vs fixed asset boundaries: the PRA confirms it is open to firms moving assets between HP and fixed MA portfolios subject to having the right permissions, FS additions, and adequate governance and oversight. In feedback, firms stressed that, without flexibility to move assets, they would need to target a limit in HP assets lower than the 10% proposed. The PRA has acknowledged this challenge by confirming that switching assets between HP and fixed portfolios would be permissible with justification.
  • Asset restructuring: the PRA’s expectation is that assets will generally be included without restructuring. PRA also confirms that if restructuring creates additional value, firms will be expected to explain how such value arose and why it is reasonable.
  • Controls on the quality of matching:
    • Additional matching tests 4 and 5 do not apply to fixed assets.
    • Limit of 10% of MA benefit generated by HP assets remains.
    • Current MA assets that meet HP conditions can remain as ‘fixed treatment assets’ and will not count towards the 10% limit.
    • The calibration of the additional matching tests (4 and 5) for HP assets has been changed, moving the thresholds from 3% to 5% - this is likely to be welcomed by the industry as some respondents felt the 3% threshold was a more significant biting constraint to the amount of HP assets that can be invested in than the 10% overall limit.
       

B. MA attestation

The MA attestation requirement was one of the most controversial areas of reform, and this is reflected strongly in industry feedback. Below we outline the key changes, but also some issues on which the PRA has stood its ground in the face of pushback:

  • Granularity: the PRA still expects firms to carry out the attestation analysis and FS addition determinations on an asset-by-asset basis. However, following feedback outlining the challenges of such an approach it has now clarified that the initial analysis can be performed by HRGs. These have to be granular enough to ensure the type and level of risks are sufficiently similar within a group. Firms should then analyse the need for further FS additions for specific assets where necessary. The PRA decided against allowing firms to ‘assume that prudence for one asset can be offset against an insufficient FS for another’ (this was the ‘over-unders’ debate). However, allowing firms to carry out their initial analysis by HRGs might help firms benefit from some diversification through random fluctuation in asset experience within each HRG.
  • Treatment of corporate bonds: the PRA has amended SS7/18 to clarify that where a firm’s corporate bond portfolio broadly reflects the portfolio used to calibrate the FS and has up-to-date and accurate credit ratings, then it can generally rely on the basic FS. 
  • Effective Value Test (EVT) for Equity Release Mortgages (ERMs) in attestation: the PRA has clarified that firms are expected to use parameters that are appropriate for the attestation when valuing ERMs, but these should not fall below the PRA’s published minimum parameters where the EVT is used. Therefore, FS additions may arise to the extent that the parameters used for the attestation need to be more prudent than those currently used in the EVT.
  • Audit scope: the PRA has clarified that there will be no change to the scope of external audit arising from either the attestation requirement or the option for firms to apply voluntary FS additions. Both the attestation and FS additions therefore remain out of scope of external audit. The ICAEW is assessing the impact of the reforms in different areas of the audit of regulatory returns and might update guidance in this area in the coming months.
  • Attestation frequency and transitional: the PRA has introduced an amendment in the final rules to include a six-month transitional period. Firms will be required to provide an annual or out-of-cycle attestation with an attestation reference date from 31 December 2024 (voluntary from 30 June 2024 as a result of the transitional arrangement). The PRA has not changed its position that a material change in risk profile would trigger an out-of-cycle attestation. Examples include: a large transaction that changes the risk profile of assets held, a merger of MA portfolios and a material change in outlook for a significant portion of MA portfolio assets.
     

C. Liability eligibility

The PRA has confirmed the expansion of the liabilities allowed in the MA portfolio to include the guaranteed benefits of with-profits annuities and in-payment income protection liabilities. Following industry feedback, the PRA has made changes from the consultation to allow the inclusion of in-payment GDAs in MA portfolios. It has also clarified that it is the policy intent to allow in-payment individual and group income protection liabilities in the MA portfolio. Firms will welcome the clarification and expansion, in particular to group policies, which are a significant part of the market for income protection.
 

D. MA operation

In its original consultation the PRA proposed reforms to improve the overall MA operation. This included creating a streamlined MA application approach and introducing a new annual reporting requirement for firms to provide detailed metrics and information on the assets and liabilities held in MA portfolios as a form of safeguard against widening eligibility criteria. While the PRA for the most part has taken industry feedback on board, there are a few areas where it has also introduced new elements, including notably the Application Readiness Assessment Process (ARAP), which may come as a surprise to some firms.

 

What has changed since the consultation?
 

  • Application documentation: the PRA will now require less information in a firm’s MA application. Applications no longer need to include a comprehensive assessment of the risks associated with the exercise of surrender options, nor some of the previously required quantitative information (including a breakdown of the number and value of each type of insurance contract, and an assessment of market risks arising from any cash flow mismatch). The PRA notes that it can still request this information from firms where it is deemed necessary.
  • Pre-application: the PRA is introducing an ARAP to assess firms’ readiness to initiate a full MA application, with firms strongly encouraged to participate. For changes to an MA portfolio, the ARAP should cover details of what is changing and why the firm considers that a new MA application is required. It is unclear how long the ARAP will take. This additional process within the MA framework will create some uncertainty for firms as we will not know its impact until it is put into practice.
  • MALIR: the PRA is introducing changes to clarify its expectations (including some definitions) and, to some extent, make it easier for firms to complete the MALIR. It has removed the requirement for firms to submit cash flows extending beyond 50 years, and amended the MALIR template to be more consistent with the Quantitative Reporting Templates (QRTs). The PRA also confirmed that the MALIR will not be subject to audit. These changes should, in theory, provide some relief for firms when it comes to MA reporting, although it is likely to be marginal.
     

4. Conclusion

 

The final rules are the last material piece in the SUK puzzle and provide much needed clarity for firms to focus on implementation. Overall, the clarifications and modifications the PRA has carried through to the final rules will be welcomed by the industry. Firms need to consider their implementation plans and resources for the next six to nine months carefully to ensure they will be on time for the submission of the first attestation. Considering this is a very active market with many more material transactions expected in the next months, firms will also need to consider carefully the impact of the new rules on the ease of merging new portfolios of assets into their MA portfolios and the impact on both annual and out-of-cycle attestations. Firms also need to decide whether and, if so, how quickly to move into HP asset investment, as increased demand for HP assets will have commercial and competitive implications. The final rules open a new chapter in the prudential regime for UK insurers, offering opportunities for firms to invest in a wider range of assets but also bringing in the need to demonstrate the insurer’s ability to earn its MA benefit with a high degree of confidence. The next few months will be challenging for insurers navigating these new risks and opportunities.


[1] Extended implementation timeline compared to CP19/23.

[2] For FS additions, the PRA notes that firms are likely to carry out their attestation processes first, which means that firms are unlikely to be in a position to apply any voluntary FS additions to the 30 June 2024 balance sheet.