PRA Statement on Application of Matching Adjustment Amid Crisis
PRA published a statement to insurers that clarifies the approach to application of the matching adjustment during COVID-19 crisis. PRA considers that the matching adjustment has functioned as intended thus far. Nevertheless, it has identified some areas where it may be useful to provide clarifications to ensure consistency in firms’ interpretation of the PRA policy. The key areas covered in the clarifications are management of matching adjustment portfolio, eligibility related to matching adjustment, calculation of matching adjustment, and reflection of matching adjustment in the Solvency Capital Requirement. The statement should be read in conjunction with the PRA expectations set out in the supervisory statements on illiquid and unrated assets (SS3/17), matching adjustment (SS7/18), modeling of the matching adjustment (SS8/18), and prudent person principle (SS1/20) under Solvency II.
Management of Matching Adjustment Portfolio
PRA is aware that, in their matching adjustment applications, some firms indicated that their approach to managing the matching adjustment portfolio would include occasionally removing certain assets despite their continued eligibility. PRA recognizes that, within what the legal framework allows, firms may wish to change their approach to managing the matching adjustment portfolio in light of the financial turbulence caused by COVID-19. Firms should discuss their intentions with the supervisors and note whether the changed risk profile is consistent with the assumptions underlying their calculation of the Solvency Capital Requirement, for example, in their internal model specification. Consistent with the paragraph 9.4 of SS7/18, PRA expects that any material change to the management or scope of matching adjustment portfolio after approval has been granted will require a new application for approval.
Eligibility Related to Matching Adjustment
The statement notes that following requests for, and granting of, a payment holiday or loan modification amid COVID-19, insurers are expected to review the rating assigned to such a loan. In reviewing the rating assigned to these loans, firms should take a measured approach that makes use of all information available to assess borrowers for indicators of deterioration in credit quality, taking into consideration the underlying cause of any financial difficulty and whether it is likely to be temporary, as a result of COVID-19, or longer term. PRA encourages firms to make well-balanced and consistent decisions that take into account the information they have regarding the borrower, the potential impact of COVID-19, and the unprecedented level of support provided by governments and central banks domestically and internationally to protect the economy.
Consistent with SS3/17, PRA would expect ratings to be updated to reflect changes to market-related or issuer-specific credit factors. However, PRA understands that firms may wish to consider the currently uncertain risk outlook when deciding on the pace of rating revisions. Consistent with the paragraph 4.13 of SS7/18, PRA expects firms to have a policy that sets out their definition of default events and processes to identify different types of default events or the severity of distress and likelihood of recovery for an individual asset. Where these assets are held in a matching adjustment portfolio, firms should assess the consequences of different types of default events, including the implications for the matching adjustment portfolio. PRA expects that firms will continue to monitor their matched position against the approaches specified in their matching adjustment applications. A firm may adopt an alternative approach to demonstrate cash flow matching. However, it must explain why its current approach is no longer appropriate and justify the suitability of its alternative approach.
Calculation of Matching Adjustment
PRA reminds firms that there is no requirement or expectation that equity release mortgages necessarily be restructured if a firm is unable to meet the Effective Value Test. Given the disruption in the property market caused by COVID-19, some firms have identified difficulties in obtaining reliable property valuations and determining appropriate approaches to suspended or unreliable house price indices. Where a house price index used in the calculation of the cost of "no negative equity guarantees" is unavailable or unreliable, a firm may use the most recently available reliable house price index until the point at which the house price index becomes available and reliable again. PRA would not expect firms to use the out-of-date index for more than two quarters. Firms should notify the supervisor and provide evidence that an house price index has become unavailable or unreliable before changing its approach. PRA will keep this guidance under review. In cases where only part of an asset’s cash flows are taken into account for demonstrating cash flow matching, firms should attribute the full market value of the asset to a matching portfolio and take the full asset value into account when calculating the matching adjustment, as set out in the paragraph 2.16 of SS7/18
Reflection of Matching Adjustment in the Solvency Capital Requirement
PRA is also aware that internal model firms may use limits or caps within their calculations of the matching adjustment in the Solvency Capital Requirement. Firms are always welcome to discuss improvements to their models with their supervisors, but such changes cannot be considered in isolation, and PRA will need to reconsider the firm’s detailed modeling work to determine whether it is warranted to revisit any limits or caps present in the model.
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Keywords: Europe, UK, Insurance, COVID-19, Matching Adjustments, Solvency II, SCR, Regulatory Capital, Internal model, Payment Holiday, Effective Value Set, Equity Release Mortgage, PRA
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