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Matching Adjustment: a review of the methodological approach

The current context of prolonged interest rate falls is having a significant impact on the technical provisions of insurance companies, especially for long-term life products. For years, insurance companies in Spain have, by Ministerial Decree, applied to matched portfolios a credit-risk-adjusted interest rate similar to that used for discounting technical provisions in the asset portfolio, thus offsetting the impact of lower interest rates on the  financial statements.

In the light of the above, with the advent of Solvency II and the requirement to assess technical provisions at market value using the risk-free interest rate curve, this problem has taken on special relevance for some European institutions. For this reason the Supervisor, after performing a series of quantitative exercises with the  industry, established mechanisms such as Matching Adjustment in order to  mitigate such impact.

Matching Adjustment concept and regulatory implications

Historical information from debt markets on the price of bonds shows that bond valuation is significantly volatile if a short time window is used. Such frequent changes mean the speculative or illiquidity components are the major cause of price variations. Other causes, however, such as the probability of loss due to default, are smaller and less volatile in comparison, having a smaller impact on the price of instruments.

Insurers providing long-term life products have on their balance sheets assets associated with those products - usually bonds -  that will  be held to maturity, so short-term changes in the price of the assets in question should not affect their value, and should consequently not affect the Solvency Capital requirement for insurers. For this reason the Omnibus II Directive, which entered into force on 1 January 2016, included the Matching Adjustment mechanism, which allows the  impact of short-term volatility on long-term assets to be cancelled.

Matching Adjustment is an adjustment to the discount curve used to calculate Best Estimate technical provisions, through which the  portion of the spread not related to the default risk on assets or the probability of loss in the  credit quality of assets is accounted for.

Also to be taken into account when considering implementation is the fact that, in addition to the Matching Adjustment, the Omnibus II Directive introduces other regulatory methodologies to address issues related to the treatment of long-term insurance products, such as the transitional measure on technical provisions, the transitional measure on the risk-free  interest rates and Volatility Adjustment. As a result of this,  the use of Matching Adjustment is incompatible with the joint use of Volatility Adjustment and the transitional measure on the risk-free interest rates.

Furthermore, it should be remembered that organizations will not be able  to use Matching Adjustment without approval from the national regulator - the DGSFP in the case of Spain. As part of this  request-for-approval process, sufficient information must be provided showing that all requirements are met, all internal procedures and policies are in place and the impact of using Matching Adjustment is disclosed.

It should be kept in mind that this process is not immediate, since the DGSFP has 6 months from receipt of the full application to decide whether or not to approve the use of Matching Adjustment.

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© GMS Management Solutions, S.L., 2017. All rights reserved. The information contained on this publication is of a general nature and does not constitute a professional opinion or an advisory service. The data used in this publication come from public sources. GMS Management Solutions, SL assumes no liability for the veracity or accuracy of such data.