Prudential Regulation Authority Rulebook

1.1

This supervisory statement (SS) sets out the PRA’s expectations in respect of firms investing in illiquid, unrated assets within their matching adjustment (MA) portfolios. It is relevant to life insurance and reinsurance companies holding, or intending to hold, unrated assets (including restructured equity release mortgages (ERMs)) in an MA portfolio.

1.2

This statement should be read in conjunction with regulations 4, 5, 6 and 7 of The Insurance and Reinsurance Undertakings (Prudential Requirements) Regulations 2023 (referred to here as the ‘IRPR regulations’), the Matching Adjustment Part of the PRA Rulebook and the Matching Adjustment Permissions statement of policy.^[1] In this statement, any reference to any provision of direct EU legislation is a reference to it as it forms part of assimilated law.

1.3

To determine the basic fundamental spread (basic FS),^[2] the PRA expects that a firm will need to group the assets in an MA portfolio by credit quality step (CQS), asset class and duration. For assets with credit ratings provided by credit rating agencies^[3] (CRAs) and referred to in the Annex to Commission Implementing Regulation 2016/1800, the CQS and hence the assignation process for determining the basic FS, including any adjustments to reflect differences in credit quality by rating notch, is relatively prescriptive, with the only judgement being over the categorisation by asset class. In contrast, for internally-rated assets^[4], there is more judgement involved in determining the internal credit assessment and the CQS that should apply.

1.3A

Firms will also need to apply judgement in determining what fundamental spread (FS) additions^[5] (if any) should be made to the basic FS. Pursuant to Matching Adjustment 4.16 and 8.2, firms must apply FS additions for assets with highly predictable cash flows. Firms may also apply FS additions to any assets, not just assets with highly predictable cash flows, for example as part of the attestation process.^[6] The PRA expects a firm to pay particular regard to internally-rated assets when comparing its risk profile to the assumptions underlying the MA^[7] and considering whether FS additions may be needed.

1.4

Firms need to have confidence that the risk management of these more complex credit exposures, in particular the internal credit assessment, CQS mapping and determination of the overall FS, is appropriate and in accordance with the assumptions underlying the MA. Firms also need to be satisfied that the size of the MA benefit claimed on them is fit for purpose, taking into account that MA contributes to firms’ capital resources. It is therefore expected that firms will be able to provide strong evidence to support the appropriateness of the steps taken to determine the MA, particularly for those internally-rated assets that present the greatest complexity and/or risk exposure.

1.5

The PRA reminds firms of the responsibilities resting with Senior Management Functions in this context under the Senior Managers Regime (SMR). Specifically the:

• Chief Actuary is responsible for advising the board about the reliability and adequacy of the calculation of the technical provisions (TPs);^[8]
• Chief Risk Officer is responsible for reporting to the board on the risk management strategies and processes in relation to credit assessments;^[9]
• Head of Internal Audit is responsible for independent assurance on the adequacy and effectiveness of these processes and the firm’s accounting and reporting procedures;^[10] and
• Chief Financial Officer is responsible for the management of the financial resources of a firm and typically has the prescribed responsibility of the production and integrity of the firm’s financial information and its regulatory reporting (PR Q) and hence attestation of the FS and the MA.^[11]

1.6

Where material reliance is being placed on internal credit assessments and the CQS mapping for internally-rated assets, the Chief Actuary, Chief Risk Officer and, for the purpose of paragraph 1.5 above, the Chief Financial Officer will need to be satisfied that an appropriate FS is being applied, whilst the Internal Audit function will need to be satisfied that appropriate processes and procedures have been followed.

1.7

Chapter 2 of this SS clarifies the PRA’s expectations where internal credit assessments are used as part of determining the basic FS, including some expectations that are specific to restructured assets (including ERMs). Chapter 3 then sets out some principles to be applied when assessing the risks from guarantees embedded within ERMs, for the purposes of verifying the appropriateness of the FS (including any FS additions); these apply to both restructured ERM notes and un-restructured ERMs that may be included in the MA portfolio under the limited proportion of assets with highly predictable cash flows. Chapter 4 sets out the PRA’s expectations regarding the risk identification exercise and the risk calibration and validation of internal models for illiquid assets.