Prudential Regulation Authority Rulebook

2.1

Chapter 4 of the Matching Adjustment Part of the PRA Rulebook, which restates the relevant provisions of the IRPR regulations, sets out (at rule 4.6) that the matching adjustment must not include the fundamental spread reflecting the risks retained by the firm.

2.2

For the purposes of determining TPs, the FS calibrations used in the MA calculation are, in most cases, provided by the PRA in technical information produced in accordance with Matching Adjustment 4.10 to 4.15. Where a firm has TPs in a particular currency for which the PRA does not publish technical information, it is the firm’s responsibility to propose technical information that complies with Solvency II requirements, and to justify this approach to its supervisor.^[5] Firms are required to adjust this technical information (where possible and appropriate) to allow the FS to capture differences in credit quality by rating notch (Matching Adjustment 6). Firms are required to apply additions to the FS for assets with highly predictable (HP) cash flows (as per Matching Adjustment 4.16) and can apply any further additions to the FS that they consider necessary to ensure it covers all risks retained by the firm (as per Matching Adjustment 4.17). No similar technical information is provided in order to calculate the SCR and the PRA expects firms to consider if and how any adjustments to the technical information, and additions to the FS, used to calculate TPs need to be updated in stress conditions.

2.3

A firm’s SCR should capture all material and quantifiable risks^[6] to which it is exposed. The calculation of the SCR should therefore allow for any changes to the FS and MA following a stress event. In doing this, firms should determine the risks to which the MA portfolio is exposed, how these risks could affect the FS and MA and assess how this impact is captured within the SCR calculation. Changes to the FS in stress conditions should include any changes to additions made to the FS used to calculate the TPs, including those made as part of the attestation process. For assets with HP cash flows, the SCR should specifically allow for changes to the expected cash flow pattern on these assets as well as any changes to any FS additions made in line with Matching Adjustment 8.

2.4

The PRA has identified at least three high-level reasons why the FS could change following a stress:

1. (i) changes in investment portfolio quality due to the occurrence of a stress;
2. (ii) assumption changes to reflect an updated forward-looking view of the FS following the stress, including any changes to additions made to the FS (as per Matching Adjustment 4.16 for assets with HP cash flows, or as per Matching Adjustment 4.17 for other reasons) for the purpose of calculating the TPs; and
3. (iii) assumed management actions, including rebalancing of the MA portfolio, that are required to maintain MA compliance following a stress. The extent of the actions required will be driven by the extent of any mismatch between the asset and liability cash flows following a stress event within the MA portfolio.

2.5

For the purposes of assessing how the assumptions underlying the FS calibration could change post-stress (paragraph 2.4(ii) above), it is important that firms’ internal models are not inappropriately constrained by the assumptions and parameters used to calculate TPs. The PRA would therefore not expect firms to adopt a purely ‘mechanistic approach’ to determine the FS following a stress that directly follows the assumptions and methodology used to determine the FS for the purpose of calculating TPs. The PRA considers that a ‘mechanistic approach’ based on the re-application of the approach used to calculate TPs is unlikely to result in an SCR that takes into account all quantifiable risks to which a firm is exposed, including the risk of losses that are not allowed for within the TP calculation, resulting in an FS that may not capture all retained risks in stressed conditions. This is particularly the case for assets with HP cash flows where firms should consider changes to both the stressed cash flow projection and the level of uncertainty around this projection.

2.6

Firms should ensure that their chosen method to determine the FS under stress takes account of all quantifiable risks to which they are exposed. Firms should particularly consider those risks that have been retained within their MA portfolio(s) and ensure that their modelling approach results in an SCR that covers those risks at the 99.5% confidence level.

2.6A

For some assets, particularly those with HP cash flows, the best estimate cash flows could change under stress for reasons other than default. It may not be possible to derive a full probability distribution. However, firms should consider the consequential impacts on the MA benefit and any rebalancing needed to maintain a matched position.