Internal Securitisations
and Solvency UK

Opportunities and challenges

June 20, 2023  |  Spotlight on risk transfer and insurance series  |  Part 2

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Internal securitisations – where an insurance firm securitises a pool of investment assets and retains all the resultant securitised assets – could be regarded as an unintended consequence of the Matching Adjustment (MA) framework.

Today, UK MA portfolios include some £30bn of equity release mortgage (ERM) internal securitisations.1 

MA firms continue to originate and re-structure new ERMs, although future origination volumes may be lower than previously forecast given the current higher interest rate and its potential impact on consumer demand for ERMs.

An increasing range of property-backed loans and mortgages are using internal securitisation machinery for MA purposes.

Internal securitisations do not directly achieve much economically as the firm still owns the same assets after the securitisation as before. However, their implementation can incur substantial legal and regulatory-related costs.

Securitisations also add a layer of complexity that may create technical actuarial challenges, notably, ensuring the underlying mortgages and securitised notes are valued consistently over time and across different market conditions.

However, the re-structuring provides these assets with a means of meeting the current cashflow fixity requirements of the MA and thereby being made MA-eligible.

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Your questions

Will Solvency UK create a route to ‘de-securitisation’ of internally securitised assets? 

The key regulatory driver for internal securitisations – the MA’s ‘fixed cashflows’ asset requirement – is currently being reformed.

HM Treasury’s (HMT) November 2022 consultation response –  'Review of Solvency II: Consultation Response’ – opened the door to at least some assets in MA portfolios being subject to a less stringent ‘highly predictable’ standard of cashflow certainty2.  

This poses questions such as how much of the MA portfolio may qualify for this treatment? And what might the alternative treatment look like? This will become clearer later in the year when the PRA is expected to launch its consultation on how it proposes to revise its MA rules. 


Will the majority of MA assets continue to have fixed cashflows? 

The HMT Consultation Response sets the expectation that the vast majority of MA assets will continue to have fixed cashflows. 

The 'vast majority' wording did not feature in the draft statutory instruments published on 20 June, but it seems likely that the PRA's interpretation of high quality cashflow matching will necessitate a substantial majority of the MA asset portfolio's cashflows being fixed. 

The prospect of some MA cashflows being held to a lighter definition of contractual cashflow fixity opens the possibility of the underlying assets of internal securitisations being held directly in MA portfolios.

This could be a natural and welcome result of the Solvency UK reforms, as internal securitisations are a costly piece of regulatory compliance driven by the current cashflow fixity requirement.  

Challenges

There is likely to be some regulatory-driven obstacles to ‘de-securitising’ internal securitisations: 

The size of the ‘not fixed cashflows’ MA asset bucket is likely to be quite limited (recall the Consultation Response’s ‘vast majority’).  
 
Firms may prefer to use this bucket to pursue new asset opportunities that have not been accessible under today’s MA system and don’t fit well into the existing internal securitisation approach to creating fixed cashflows. 

If individual ERMs were to be held directly in MA portfolios, firms would need to demonstrate that they have a robust approach to mapping their internal credit assessments of individual ERMs to MA Credit Quality Steps (CQSs).  
 
The PRA’s expectations in this area are set out in its Supervisory Statement 3/173. Their key expectations are: 

  • That the CQS to which an internal credit assessment maps lies within the plausible range of CQSs that could have resulted from an issue rating given by an ECAI; and 
     
  • Firms should describe how they have maintained broad consistency between the CQSs resulting from their internal assessments and those which could have resulted from an issue rating given by an ECAI.

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Rating agencies don’t issue credit ratings on individual ERMs and as far as we are aware, have not published methodologies on how to do so. This may make it challenging for a firm to demonstrate how its mapping of an internal credit assessment for individual ERMs to CQSs complies with the Supervisory Statement.  

However, SS3/17 ‘Solvency II: Illiquid unrated assets’ recognises that a firm’s internal credit assessment methodology may be undertaken in circumstances where an ECAI has not published a credit rating methodology.  

Solutions and opportunities

So, how might a firm demonstrate compliance with the above expectations when there is no published ECAI credit rating methodology for the asset class? 

The CQS of an MA asset determines its Fundamental Spread (FS). The aim of the FS is to determine how much of the spread on an eligible asset should be taken to reflect the risks retained by the firm on the assumption that the asset is held to maturity.   

In a nutshell, the FS is calibrated to reflect the expected credit losses associated with holding the asset. The tables used in determining the applicable FS are calibrated to historical corporate bond default data by credit rating and the CQS is the way in which the MA system determines the expected credit loss that should be assumed for a given MA asset.  

This points to an interesting possibility for individual ERMs - firms that invest in ERMs already perform granular robust quantitative internal credit assessments of individual ERMs. These assessments are not currently made for the purposes of generating individual CQSs, but for the purposes of underwriting individual ERMs.  

When a firm decides what mortgage rate to offer when originating an ERM, it will consider how factors such as Loan-to-Value (LTV), age and property features impact the expected losses that arise from the no negative equity guarantee (NNEG) on the individual mortgage.  

Some firms may also have similarly granular quantitative modelling of their underlying ERM assets in the internal models that are used in the assessment of their solvency capital requirements.  

The answer to this is quite intuitive - according to the FS tables, the CQS that generates an expected loss equal to (or no less than) the firm’s assessed expected loss for a given ERM asset should be applied to that individual asset.  

This is consistent with ECAIs as the expected losses that result from these CQS mappings are consistent with the credit losses in the ECAI-rated corporate bond data that the FSs have been calibrated to.  

With this approach, when considering an individual corporate bond or an individual ERM, a given CQS denotes the same thing – the assets have been assessed to have the same expected loss (after making appropriate allowance for all the relevant features of each asset). 

This approach would make direct use of a firms’ existing assessments of individual ERMs, providing a more straightforward MA treatment of ERM’s credit (NNEG) risk than internal securitisations. Some work may be required to document and validate these individual credit assessment processes to a standard that is consistent with the expectations set out in SS3/17.  

Firms that write individual ERMs are already expected to be able to assess the expected losses associated with those individual mortgages. So why not make use of this capability for MA purposes?

Some form of FS add-on would likely be required to make allowance for the non-fixed nature of the de-securitised cashflows4. Further details on the treatment of non-fixity risks will emerge with the publication of the PRA’s consultation later in the year. The viability of the de-securitised approach may boil down to a comparison of the capital costs generated by this add-on with the legal and compliance costs associated with internal securitisations.

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"We are heading towards a new destination where Employer DNA will deliver sustainable, robust and innovative strategies."

I started by saying that “DNA is the very material that defines our uniqueness – the very substance that carries the information we need to survive and to thrive.” The same is true for Employer DNA. As you work your way up the rungs of the data analytics ladder, the closer you get to the top, the more you’ll realise that your Employer DNA really does contains the insights you need to both survive and to thrive. 

The HMT Consultation Response signalled that the ‘BBB cliff’ - where the MA benefit of sub-investment-grade assets is capped at the MA benefit of an otherwise-equivalent BBB asset – will be removed5. This may increase firms’ appetite for sub-investment grade (and BBB) assets in their MA portfolios. 

This could be reflected in the structuring of internal securitisations by re-structuring an existing equity tranche into sub-IG tranches and a (new, riskier) equity tranche.   

This is likely to be more relevant to the ‘second generation’ internal securitisations that feature underlying assets such as build-to-rent property assets, where the equity tranches tend to be material in size. The equity tranches of ERM internal securitisations tend to be very small, so there is less scope to carve material new sub-IG tranches out of them.  

Valuing Securitised Notes as Financial Derivatives 

For ERMs, improving the consistent valuation of underlying mortgages and securitised notes could be an area of future technical actuarial development.

The current issue here is that the underlying mortgages tend to be valued using stochastic methods, whilst the securitised notes use ratings-based valuation approaches. Forcing these two distinct valuation methods to work coherently across a range of economic conditions is difficult.

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The securitisation valuation methods tend to be ratings-based because that fits well with the MA framework. However, this approach can result in useful insight being lost – the securitised notes are effectively financial derivatives of the mortgage portfolio, and the stochastic methods that firms use to value the NNEGs in their mortgages simultaneously imply valuations for all the securitised notes (along with other assumptions about timing of surplus cash distributions to junior notes etc).

The implementation of these implied stochastic-based securitisation valuations can provide useful validation of existing securitisation valuations, and additional economic insights into the risk and return characteristics of alternative designs.

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Our author

Find out more about our insurance consulting services here, and if you would like
any further information on the above topic, please contact Craig Turnball.

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Craig Turnbull
Partner and Head of Regulatory Advisory,
Insurance Consulting

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References

1 - ERM asset values are disclosed in insurance firms’ Solvency Financial Condition Reports and the figure of £30bn is derived from the Year End 2022 SFCRs of the seven largest ERM-investing insurance firms.

2 - See paragraph 4.5 of Consultation Response-Review of Solvency II pdf (publishing.service.gov.uk)

3 - SS3/17 'Solvency II: Illiquid unrated assets' (bankofengland.co.uk)

4 - See paragraph 1.13 of Consultation Response-Review of  Solvency II pdf (publishing.service.gov.uk)

5 - See paragraph 4.7 ConsultationResponse-Review of Solvency II.pdf (publishing.service.gov.uk)