PS10/24, implementing reforms to the UK’s Solvency II regime for matching adjustment portfolios, came into force on June 30, 2024. The reforms aim to increase investment flexibility and provide a wider range of options for insurers to deploy capital, including by broadening the matching adjustment asset eligibility criteria to allow assets with highly predictable cash flows.

On 6 June 2024, the UK’s Prudential Regulation Authority (PRA) published its long-awaited policy statement PS10/24, following CP19/23, on reforms to the Solvency II regime for matching adjustment (MA) portfolios. The MA is effectively an adjustment to the discount rate used to value certain insurance liabilities that represents a proportion of the spread (above the relevant risk-free rate) that an insurer projects to earn over the lifetime of the assets matching its MA liabilities. It effectively increases the capital resources of the insurer through the associated reduction in the valuation of the MA liabilities.

PS10/24 implements and works alongside the Insurance and Reinsurance Undertakings (Prudential Requirements) Regulations 2023 (IPRRR). Among other things, the IPRRR expand the MA eligibility criteria to allow assets with highly predictable (HP) cash flows, thereby broadening the range of permissible investments that can be included in UK Solvency II insurance firms’ (collectively, insurers’ or firms’) MA portfolios. PS10/24 came into force on 30 June 2024.

This LawFlash considers some of the changes introduced by PS10/24 and what they mean for insurers in terms of investment flexibility, particularly in the context of investment by insurers in structured and alternative investment products.

SUMMARY OF CERTAIN CHANGES TO THE MA REGIME

Prior to 30 June, cash flows of MA asset portfolios were required to be fixed and were not capable of being changed by the issuers of the assets or any third parties. Examples of assets that would not meet the criteria for fixity would be assets with “rights of redemption or termination that are entirely at the discretion of the issuer or third party.” [1]

This would not, however, include assets where the right of redemption is triggered by events that are not reasonably foreseeable; are outside the issuer’s or third party’s control; cannot be avoided by the issuer or a third party; and would otherwise materially change the nature or substance of the obligations of the issuer or counterparty under or as a result of the contract. [2]

These carveouts would therefore include mandatory prepayment events where, e.g., a tax event has occurred that results in a gross-up obligation for the issuer of the obligation or a mandatory prepayment event for the issuer following an illegality, whereas voluntary prepayment rights of an issuer or third party would mean an asset fails to meet the fixity requirements under the rules and would not be eligible for inclusion in an insurer’s MA portfolio.

PS10/24 has expanded this to include assets with HP cash flows, subject to various safeguards including a 10% cap of total MA benefit. The PRA has clarified that the 10% limit applies to the amount of MA benefit for which credit is taken, rather than placing an absolute limit on the permitted holdings of HP assets.

To be eligible, assets with HP cashflows would need to be

• contractually bound in timing and amount, and failure to meet such contractual terms is a default;
• bonds or have bond-like cash flow characteristics; and
• capable of receiving either an external or internal credit rating.

Insurers should also consider whether they would be suitable for matching liability cash flows, and they must be able to demonstrate that all assets can be managed in line with the Prudent Person Principle by, amongst other things, determining internal quantitative investment limits for the assets they are proposing to invest in, reflecting the firm’s investment expertise.

IMPLICATIONS FOR INSURERS FOLLOWING REFORMS

Broadening the MA asset eligibility criteria to allow assets with HP cash flows will be welcomed by insurers and the wider investment community. The previous fixity requirement for asset cash flows meant that assets with HP cash flows had to be restructured, repackaged, and/or have their cash flows hedged in some way in order to be MA eligible. Some of these structures may no longer be required for eligible assets with HP cash flows.

Amongst assets that may become MA eligible under the reforms are those with prepayment risk or construction phases (as discussed further below). The reforms also mean that where firms have structures in place for assets with HP cash flows, they may include these in unrestructured, unrepackaged, unsecuritised, or unhedged form going forward (although this would require a new MA application) subject to the restrictions on investments in HP assets described in CP19/23.

The reforms also remove the limit on the amount of MA that may be claimed from sub-investment grade assets. The PRA expects firms to only invest in sub-investment grade assets where they have an effective risk management system in place to enable them to identify, measure, monitor, manage, and report on the additional risks associated with these assets compared to those for investment grade exposures.

In addition, the types of firms have been expanded to enable firms with other types of insurance business to benefit from the MA. The permissible underwriting risks in MA portfolios are expanded to include recovery time risk, i.e., the recovery period on income protection claims in payment. This will be in addition to longevity, expense, revision, and (limited) mortality risks, which are allowed under the previous MA portfolio rules.

WHAT DOES THIS MEAN FOR INVESTMENT BY INSURERS IN STRUCTURED AND ALTERNATIVE INVESTMENT PRODUCTS?

Asset eligibility in the context of a firm’s MA portfolio must be demonstrated to the PRA by the relevant firm in its MA applications. For the purposes of demonstrating satisfaction of the MA asset eligibility conditions, the PRA expects a firm to consider all of the features of the assets against all of the relevant MA asset eligibility conditions, and not just the conditions that the firm considers to be most material.

On that basis, it is very much a matter for the insurer and the PRA to determine MA asset eligibility. However, on the face of it, the reforms might mean that the following products, for instance, may now be considered for inclusion within an insurer’s 10% MA eligibility bucket, noting that each transaction would have to be assessed according to its own particular features:

• Mezzanine and/or subordinated notes issued as part of a securitisation transaction;
• Back leverage financings and ABL facilities advanced to private credit funds and CRE debt platforms;
• More generally, fund finance products and assets backed by fund finance products (this seems especially relevant given the shift towards non-bank fund finance lending since the dislocation in the market following the US bank failures of 2023), e.g., net asset value (NAV) facilities, and products where insurers seek exposure to private credit funds (or infrastructure funds) via rated debt instruments such as rated note feeder funds and collateralised fund obligations;
• As banks increasingly focus on managing their capacity and continue to pay close attention to their balance sheets, significant risk transfer transactions backed by portfolios of fund finance products such as subscription lines and, potentially, NAVs; and
• Assets with prepayment risk (e.g., callable bonds) or construction phases with a lower credit rating due to lack of historical data (e.g., assets relating to infrastructure or commercial real estate development projects).

Generally, whether a firm can include assets within its MA portfolio (on the basis that the cash flows are HP) will come down to, among other things, a risk identification exercise by the firm to consider the impact of the protections provided by the relevant financing agreement(s) in terms of covenants and structural protections as well as any security package.

In the context of income-producing real estate assets (or assets backed indirectly by income-producing real estate assets such as loan-on-loan/note-on-note, single-asset securitisation, or repo financings), this will include a risk identification exercise considering at least the following areas:

• Cash flow predictability (taking into account, e.g., tenants, lease terms, voids, re-lettings);
• Collateral (taking into account the characteristics of the asset, e.g., location, design and condition, valuation risks, and the ability to realise the collateral in a downside scenario);
• Loan characteristics (e.g., any margining/mark-to-market protections in favor of the lender; the amount of leverage, serviceability, prepayment risk, and refinancing risk);
• Risks arising from third parties (e.g., strength of sponsor/any recourse to sponsor (e.g., a limited guarantee), and the parties involved in servicing the loan and when they can be replaced, e.g., on a downgrade);
• Concentration risk within certain asset classes (which in the commercial real estate context is more material than, e.g., corporate bonds due to macro-economic factors pertaining to subclasses of real estate assets such as office assets);
• Basis risk; and
• Liquidity risk and other idiosyncratic risks.

CONCLUSION

The changes to the MA regime have introduced increased flexibility and should provide a wider range of options for insurers to deploy capital. This addresses concerns from the PRA about insurers crowding into particular asset classes just because they are MA eligible and creating too much concentration and systemic risk as a result. The aim of the changes is to allow a broader range of investable assets. That said, in the short term we understand that it will take some time for insurers to reorganise their internal models and MA approvals before we see anything too exotic in terms of new asset classes.

It is also worth noting that there is not a huge incentive for large approval processes given insurers are limited to 10% of their MA benefit (as opposed to assets in MA funds). From what we understand, some insurers are now considering including fund finance products and some ABS/MBS and callable bonds under the HP sleeve, but it seems likely that insurers will start slowly and diversify into more exotic assets with HP cash flows in time.

Morgan Lewis lawyers are monitoring the impacts of changes to the MA regime and stand ready to help companies navigating the new regime.

[1] Bank of England, PRA, Supervisory Statement | SS7/18 Solvency II: Matching adjustment (July 2018).

[2] Bank of England, PRA, Appendix 3a: Proposed update to SS7/18 – Solvency II: Matching Adjustment (Sept. 2023).

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