The Fundamental
Spread and the PRA's
new supervisory tools

June 20, 2023  |  Spotlight on risk transfer and insurance series  |  Part 1

Reforming the UK’s implementation of Solvency II into a tailored solvency UK system is now underway. This is likely to have significant implications for many aspects of UK life firms’ regulatory solvency framework, such as the calculation of the Risk Margin, the approval of internal models and regulatory reporting requirements.

However, it’s the Matching Adjustment (MA) elements of the reforms that generated the most industry engagement in the first half of 2023. This was particularly demonstrated by the three MA-focused subject expert groups that were established by the PRA and ABI at the start of the year1.

Reform of the MA framework and its Fundamental Spread

A year ago, public signals2 from the PRA suggested that reform of the calibration of the Fundamental Spread (FS) would be one of the key pillars of Solvency UK’s MA reforms. However, the HM Treasury (HMT) consultation response in November 2022 made clear that there would be no change to the existing FS calibration. Nonetheless, the outcome of the Government’s decision has important implications for other aspects of the MA reforms. 

Let’s re-cap the key public developments related to reform of the MA framework and its Fundamental Spread last year:

May 2022

The PRA publishes discussion paper 22/023 

  • Reaffirmed that the technical provisions produced by the MA should be aligned to liability transfer values.
  • Argued that the MA discount rate should not include the credit risk premia (CRP) that is expected to be earned by the MA asset portfolio, and hence this CRP should be included in the MA Fundamental Spread (whereas it’s currently not). 

November 2022

HMT publishes its Solvency II Consultation Response4

  • Stated that the Government has decided to leave the calibration and design of the Fundamental Spread as it stands today.
  • The PRA will be given the power to require senior managers of annuity firms to formally attest that the “matching adjustment reflects only liquidity premium”. 
  • Firms will be given the ability to increase the FS where they consider it appropriate.
     

February 2023

Sam Woods, the PRA CEO, makes a speech to the ABI, ‘Fundamental Spreads’5

  • Mr Woods states that the PRA will not use the new supervisory tools such as the attestation described above to reverse-engineer the FS calibration changes they argued for in the Discussion Paper in May 2022, which were rejected by the Government in November 2022.

Attesting to the MA discount rate 

These developments pose a challenge for MA firms. 

The Government has adopted two positions in the HMT consultation response:

  • An ongoing commitment to the current FS calibration, which results in the MA discount rate including (at least some of) the credit risk premia embedded in the MA asset portfolio’s yield; and
  • that senior managers of MA firms should formally attest that the MA is only liquidity premium, which implies it does not include credit risk premia. 

These appear contradictory – it’s very difficult to see how firms can make this attestation whilst simultaneously using the current FS calibration.
 

How can firms look to resolve this?

It could be argued that firms will be able to resolve this by opting to hold the FS add-ons that remove the CRP component from the MA discount rate that arises under the current FS calibration. However, this would imply increases to the FS of all credit-risky MA assets, including the most plain-vanilla corporate bonds. 

It would effectively entail using the new supervisory tool of attestation to deliver the proposed PRA FS calibration reforms. As noted above, the PRA has already publicly ruled this out. 
 

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Nuancing the proposed attestation

The lack of any mention of the attestation in the draft statutory instruments6 published on 20 June by HM Treasury suggests that the resolution of this puzzle will be left in the hands of the PRA. 

The discussion paper of May 2022 highlighted that the PRA is particularly concerned about the MA treatment of “high spread-for-rating assets”. This could point towards an attestation that the credit risk premium component of the MA discount rate produced by such assets is no greater than the credit risk premium component in the MA discount rates produced by vanilla corporate bonds. Something along those lines would still be challenging for firms to evidence and validate, but it would at least have a logical basis that is aligned to the use of the current FS calibration for vanilla assets.

Alternatively, and perhaps more usefully, the attestation could move away from the MA discount rate altogether, and instead operate at a higher level. For example, senior managers could attest on the overall adequacy of the total asset requirement (i.e. technical provisions plus solvency capital requirement) that has been produced by the MA reserving / capital framework. 

 

Validating the total asset requirements
produced for MA liabilities

The HMT Consultation Response outlines a second new supervisory tool that will be introduced by the MA reforms.

Stress tests

The PRA will be given powers to require firms to perform stress tests on their MA portfolios, and results may be published by the PRA.

The PRA has yet to provide public guidance on the design of these tests. For example, will they be firm-specific tests or a single ‘universal’ scenario akin to the PRA’s existing Life Insurance Stress Testing (LIST) framework? Will the tests have a short or long-term projection horizon? Will the stress tests focus on the behaviour of regulatory solvency metrics, or on the more fundamental ability of the asset portfolio to meet liability cashflows as they fall due?

How could stress tests be useful?

Irrespective of the stress tests’ design specifics, the PRA’s use of this supervisory tool may be constrained by the Government’s decision on the FS calibration. If the stress testing analysis leads the PRA to the conclusion that the MA framework is producing inappropriately high MA benefits across the industry, there’s likely to be a limit to what the PRA can do with that view before it is open to the challenge that it is attempting to implement by the back door the MA reform views that have already been rejected by the Government.

The HMT consultation response also suggests these stress testing results may have a role to play in informing firms’ attestations that their MA is only reflective of (il)liquidity premia. Future PRA consultations may explore how this could work in practice, but it seems more intuitive that stress testing could provide a useful form of independent validation of the adequacy of the overall asset requirements produced by the MA framework. Stress testing could therefore be an important element of the work that would support an attestation to this effect.

For stress testing to perform this role most effectively, the test should focus on metrics that are independent of the existing MA framework. This points towards an approach that focuses on the long-term funding of liability cashflows rather than on the short-term resilience of the balance sheet to MA capital metrics. If stress tests are to be used to inform a firm’s attestation, it would seem most natural for the tests to be designed to provide the firm-specific insights that senior managers have determined most useful in informing their attestations.

Conclusion

To normal people, and indeed actuaries, last year's fundamental spread calibration debate might have semeed like actuarial geekery. However, when we take a step back from CRPs, CoDs and LTASs, we can see we are living in interesting times.

The prudential regulator has publicly expressed concerns about the current MA system, and in particular the FS calibration, and has sought reforms that would address those concerns.

The Government has rejected those concerns and has instead focused on liberalising reforms that might be expected to be a cause of further consternation for the regulator. In an apparent peace offering, the Government has proposed the PRA should have some new supervisory tools that they can deploy to ensure the outcome of the Government decisions won’t have any negative consequences for policyholder security.

However, the most prominent of these new tools - a requirement for firms’ senior managers to make an attestation as to what is (and isn’t) in the MA discount rate - requires attesting to a property that will not be present even for the most vanilla credit-risky MA assets under the current Fundamental Spread calibration that the Government has decided should remain in place.

 

When considering how these new supervisory tools could be made more effective, it's useful to note that the overall MA reserving / capital framework is very complicated.

There are several important elements to the reserving and capital requirement calculations beyond the Fundamental Spread calibration, including asset eligibility rules, matching tests, the hypothecation of assets amongst MA portfolio components, the risk margin and internal models that produce one-year joint probability distributions for asset portfolio values and Fundamental Spreads.

Rather than focusing the new supervisory tools on one internal element of the MA reserving calculation, attestation and stress testing could be more usefully employed as higher-level independent validation tools. This could provide further assurance that the total asset requirement produced by the complicated MA framework is behaving appropriately.

 

 

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References

1  |  Solvency UK: PRA/ABI Insurer Engagement | Bank of England.

2 - Four Rs: Creating the conditions for long-term sustainable growth in the life annuity sector – speech by Charlotte Gerken | Bank of England

3 - DP2/22 – Potential Reforms to Risk Margin and Matching Adjustment within Solvency II | Bank of England

4 - Consultation Response - Review of Solvency II (publishing.service.gov.uk)

5 - Fundamental Spreads − speech by Sam Woods | Bank of England

6 - Draft Insurance and Reinsurance Undertakings (Prudential Requirements) Regulations - GOV.UK (www.gov.uk)

Reform of the MA framework and its Fundamental Spread

Let’s re-cap the key public developments related to reform of the MA framework and its Fundamental Spread last year:

May 2022

The PRA publishes discussion paper 22/023 

  • Reaffirmed that the technical provisions from the MA should be aligned to liability transfer values.
  • Argued that the MA discount rate should not include the credit risk premia (CRP) that is expected to be earned by the MA asset portfolio, and hence this CRP should be included in the MA Fundamental Spread (whereas it’s currently not). 
     

November 2022

HMT publishes its Solvency II Consultation Response5 

  • Stated that the Government has decided to leave the calibration and design of the Fundamental Spread as it stands today.
  • The PRA will be given the power to require senior managers of annuity firms to formally attest that the “matching adjustment reflects only liquidity premium”. 
  • Firms will be given the ability to increase the FS where they consider it appropriate.
     

February 2022

Sam Woods, the PRA CEO, makes a speech to the ABI, ‘Fundamental Spreads’6

  • Mr Woods states that the PRA will not use the new supervisory tools such as the attestation described above to reverse-engineer the FS calibration changes they argued for in the Discussion Paper in May 2022, which were rejected by the Government in November 2022.
     

The PRA publishes discussion paper 22/023 

  • Reaffirmed that the technical provisions from the MA should be aligned to liability transfer values.
  • Argued that the MA discount rate should not include the credit risk premia (CRP) that is expected to be earned by the MA asset portfolio, and hence this CRP should be included in the MA Fundamental Spread (whereas it’s currently not). 

3 - DP2/22 – Potential Reforms to Risk Margin and Matching Adjustment within Solvency II | Bank of England

HMT publishes its Solvency II Consultation Response5 

  • Stated that the Government has decided to leave the calibration and design of the Fundamental Spread as it stands today.
  • The PRA will be given the power to require senior managers of annuity firms to formally attest that the “matching adjustment reflects only liquidity premium”. 
  • Firms will be given the ability to increase the FS where they consider it appropriate.

5 - Consultation Response - Review of Solvency II (publishing.service.gov.uk)

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Sam Woods, the PRA CEO, makes a speech to the ABI, ‘Fundamental Spreads’6

  • Mr Woods states that the PRA will not use the new supervisory tools such as the attestation described above to reverse-engineer the FS calibration changes they argued for in the Discussion Paper in May 2022, which were rejected by the Government in November 2022.
     

6 - Fundamental Spreads − speech by Sam Woods | Bank of England

A year ago, public signals2 from the PRA suggested that reform of the calibration of the Fundamental Spread (FS) would be one of the key pillars of Solvency UK’s MA reforms. However, the HM Treasury (HMT) consultation response in November 2022 made clear that there would be no change to the existing FS calibration. Nonetheless, the outcome of the Government’s decision has important implications for other aspects of the MA reforms. 

I discuss how the Government’s proposals for new PRA supervisory tools, particularly the new attestation requirements, could be made more effective by using them as higher-level independent validations of the overall asset requirements produced by the complicated MA framework, rather than focusing on one internal element of the MA calculations.

2 - Four Rs: Creating the conditions for long-term sustainable growth in the life annuity sector – speech by Charlotte Gerken | Bank of England

3 - DP2/22 – Potential Reforms to Risk Margin and Matching Adjustment within Solvency II | Bank of England

5 - Consultation Response - Review of Solvency II (publishing.service.gov.uk)

6 - Fundamental Spreads − speech by Sam Woods | Bank of England