Prudential Regulation Authority Rulebook

4.1

This Chapter applies to a firm that has been granted a matching adjustment permission.

4.2

A firm with a matching adjustment permission must calculate the matching adjustment in accordance with 4.3 to 4.8.

4.3

For each currency the matching adjustment must be equal to the difference of:

1. (1) the annual effective rate, calculated as the single discount rate that, where applied to the cash-flows of the relevant portfolio of insurance or reinsurance obligations, results in a value that is equal to the value of the portfolio of assigned assets; and
2. (2) the annual effective rate, calculated as the single discount rate that, where applied to the cash-flows of the relevant portfolio of insurance or reinsurance obligations, results in a value that is equal to the value of the best estimate of the relevant portfolio of insurance or reinsurance obligations where the time value of money is taken into account using the basic relevant risk-free interest rate term structure.

4.4

For the purpose of the calculation referred to in 4.3:

1. (1) assigned assets only includes assets whose expected cash-flows are required to replicate the cash-flows of the relevant portfolio of insurance or reinsurance obligations, excluding any assets in excess of that;
2. (2) valuations must be calculated in accordance with the Valuation Part.

4.5

In 4.4(1), the ‘expected cash-flow’ of an asset means the cash-flow of the asset adjusted to allow for the probability of default of the asset that corresponds to the element of the fundamental spread set out in 4.10(1) or, where no reliable credit spread can be derived from the default statistics, the portion of the long term average of the spread over the basic relevant risk-free interest rate term structure (as provided in 4.11 and 4.12).

4.6

The matching adjustment must not include the fundamental spread (as calculated in accordance with 4.10 to 4.17) reflecting the risks retained by the firm.

4.7

The deduction of the fundamental spread under 4.6 from the result of the calculation set out in 4.3 must include only the portion of the fundamental spread that has not already been reflected in the adjustment to the cash-flows of the assigned portfolio of assets in accordance with 4.3 to 4.5.

4.8

The fundamental spread referred to in 4.6 and 4.7 must be calculated in a transparent, prudent, reliable and objective manner that is consistent over time and based on relevant indices where available.

4.9

The fundamental spread must be calculated in accordance with 4.10 to 4.17.

4.10

The fundamental spread must be equal to the sum of the following:

1. (1) the credit spread corresponding to the probability of default of the assets; and
2. (2) the credit spread corresponding to the expected loss resulting from downgrading of the assets.

4.11

For exposures to the central government of the United Kingdom and the Bank of England, where the fundamental spread would otherwise be lower than 30% of the long-term average of the spread over the risk-free interest rate of assets of the same duration, credit quality and asset class, as observed in financial markets (the ‘average spread’), the fundamental spread must be 30% of the average spread.

4.12

For assets other than exposures to the central government of the United Kingdom and the Bank of England, where the fundamental spread would otherwise be lower than 35% of the long-term average of the spread over the risk-free interest rate of assets of the same duration, credit quality and asset class, as observed in financial markets (the ‘average spread’), the fundamental spread must be 35% of the average spread.

4.13

For the purposes of 4.10 to 4.12:

1. (1) the calculation of the ‘credit spread’ must be based on the assumption that in case of default 30% of the market value of the assets can be recovered;
2. (2) the ‘probability of default’ must be based on long-term default statistics that are relevant for the asset in relation to its duration, credit quality and asset class;
3. (3) the ‘expected loss’ must be based on long-term statistics that are relevant to changes in the credit quality of the asset and correspond to the probability-weighted loss the firm incurs where the asset is downgraded to a lower credit quality and is replaced immediately afterwards, and the calculation of the expected loss must be based on the assumption that the replacing asset meets all of the following criteria:
   1. (a) the replacing asset has the same cash-flow pattern as the replaced asset before downgrade;
   2. (b) the replacing asset belongs to the same asset class as the replaced asset; and
   3. (c) the replacing asset has the same credit quality as the replaced asset before downgrade or a higher one;
4. (4) the ‘long-term average of the spread over the risk-free interest rate’ must be based on data relating to the previous 30 years;
5. (5) the methods to derive the fundamental spread of a bond must be the same for each currency and each country and may be different for government bonds and for other bonds.

4.14

For the purposes of 4.13(2) and (3), where no reliable credit spread can be derived from the default statistics, the fundamental spread must be equal to the portion of the long-term average of the spread over the risk-free interest rate set out in 4.11 or 4.12.

4.15

Where part of the data referred to in 4.13(4) is not available or where the available data is not reliable, constructed data based on prudent assumptions may be used; and the constructed data must be based on available and reliable data relating to the previous 30 years.

4.16

A firm must increase the fundamental spread calculated under 4.10 to 4.15 in accordance with 8.2.

4.17

A firm may increase the fundamental spread calculated under 4.10 to 4.16 where necessary to ensure it covers all risks retained by the firm.

[Note: This Chapter replicates the provisions for the calculation of the matching adjustment and fundamental spread contained in regulations 5 and 6 of the IRPR regulations]

[Note: The IRPR regulations refer to the ‘assigned portfolio of assets’. This has the same meaning as the relevant portfolio of assets, except for regulation 5(5) which is replicated in 4.7 where the ‘assigned portfolio of assets’ is referring to assigned assets as set out at 4.3 and 4.4]