Out-Law / Your Daily Need-To-Know

Large UK insurers should prepare to submit Solvency II matching adjustment applications, expert says

05 Mar 2015, 5:09 pm

Large UK insurers that hope to be subject to less stringent capital requirements which come into force across the EU from the start of next year should be finalising applications now, an expert has said.

Rabbani Choudhury of Pinsent Masons, the law firm behind Out-Law.com, said that the Prudential Regulation Authority (PRA) would be looking for a "high standard" of evidence from firms that they are eligible for a partial exemption from the general solvency requirements because some of their assets were not as sensitive to market fluctuations as other assets.

From 1 April, PRA-regulated insurers will be able to apply to use a 'matching adjustment' (MA) when calculating their capital requirements under the Solvency II regime, removing the requirement for them to compensate for market volatility that they are not exposed to.

"The PRA will review asset portfolios on a case-by-case basis as part of the approval process, and there is no 'closed list' of eligible asset classes," Choudhury said.

"Firms must be able to demonstrate that the overall cash flows from a portfolio are fixed in terms of timing and amount, and cannot be changed by the issuers of the assets or any third parties in order to be eligible to use the MA. They must also be able to demonstrate that they will receive compensation in the event of a change in the cash flows to negate any risk," he said.

The EU's Solvency II Directive comes into force on 1 January 2016. It sets out broader risk management requirements for European insurers and requires firms to be capable of covering all their expected future insurance or reinsurance liabilities. Insurers will be able to apply to national regulators to use an MA to reduce this capital requirement in order to reflect the extent to which they are already protected against market volatility. The PRA will accept applications to use the MA from 1 April 2015.

Eligibility criteria governing the use of the MA are set out in article 77b of the Solvency II Directive. These criteria define specific behavioural features that the asset portfolio, and in some cases the individual assets within it, must have. Assets of any class will be eligible for inclusion in the MA provided that they meet these criteria. The portfolio must have cash flows that are fixed in terms of timing and amount. Cash flows that are simply 'very predictable' will not meet this requirement.

Firms must also ensure that the arrangements set out in their application comply with broader Solvency II risk management and 'prudent person' regulatory requirements, and will be required to submit a liquidity plan. They may enter into securitisation or hedging arrangements specifically to secure compliance with article 77b criteria, provided that these arrangements also meet Solvency II risk management requirements. For example, firms must be able to demonstrate that they have assessed the behaviour of hedging arrangements under stress and mitigated any new risks generated, such as counterparty exposure. Firms will also be able to pair or group certain assets for the purposes of their application, provided that they can demonstrate that cash flow from that pair or grouping is fixed.