Why is the Prudential Regulation Authority revisiting the Solvency II matching adjustment?

The purpose of Bank Overground is to share our internal analysis. Each bite-sized post summarises a piece of analysis that supported a policy or operational decision.
Published on 18 October 2021
Solvency II rules for insurers are under review, with changes to the matching adjustment (MA) being considered. MA gives high balance sheet stability but low risk sensitivity. We are exploring new options to achieve a better balance.

Solvency II has set the regulatory requirements for insurers since 2016. A Government review of the package is currently under way, including the matching adjustment (MA). The MA recognises that insurance firms that meet certain conditions – including close ‘matching’ of long-term assets and liabilities – are less exposed to price movements related to liquidity and allows them to value their liabilities at a higher than risk-free rate.

In an April 2021 speech, Charlotte Gerken, the Bank of England’s executive director for insurance, highlighted a potential problem with the MA. The current design is insensitive to market signals from changes in credit spreads, and might miss some of the risks that insurers face, which in turn could lead to lower policyholder protection.

Solvency II rules split the spread of an MA-eligible asset into two components: the fundamental spread (FS) represents compensation for retained risks around credit losses, and the MA represents a liquidity premium. Setting aside the case where the asset rating changes, almost any change in spread is treated as a change in liquidity. This means that insurers may not recognise a change in credit risk contained in the credit spreads, because the FS for any given rating is based on 30-year long-term averages, and therefore is extremely slow to change.

The dependence on credit ratings and insensitivity to the signals contained in spreads is an issue for two reasons. First, credit rating changes are a lagging indicator of risk. Second, many MA-eligible assets are assigned ratings by insurers themselves and are therefore subject to less external scrutiny than external ratings.

Solvency II aimed to improve signals to risk management. The Prudential Regulation Authority (PRA) supports the MA but is concerned that some of the returns treated as a liquidity premium by the MA might instead be compensation for uncertainty around future credit losses and that this component should have greater sensitivity to market signals.

The Solvency II review offers an opportunity to consider the balance between a low and risk-insensitive calibration for retained risks, which provides perceived balance sheet strength and stability for insurers, and a calibration that provides better signals for effective risk management.

A Quantitative Impact Study (QIS) tested two exploratory scenarios that explicitly recognise compensation for variability around future credit losses and are more responsive to signals about credit risk (Chart A).

The QIS data will help us develop future policy options. Any changes in this area will be subject to consultation.

Chart A: QIS scenarios more responsive to credit spreads than current FS calibration

Illustrative A-rated 10-year financial bond spread, the component allocated to retained risk by Solvency II FS and QIS Scenarios A and B


  • Sources: Data from Refinitiv Eikon from LSEG and PRA analysis.

This post was prepared with the help of Jemima Ayton, Wendy Fu, Dan Georgescu and Shamir Patel.

Part of this analysis was presented in Charlotte Gerken’s speech at the 18th Conference on Bulk Annuities in April 2021. It has been supplemented with the QIS Scenarios A and B.

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