Matching adjustment eligibility after a downgrade
A life insurer has £5.0bn of immediate annuity liabilities backed by a ring-fenced matching adjustment portfolio. The portfolio is £2.9bn A-rated corporate bonds, £1.2bn gilts, £0.6bn BBB infrastructure debt and £0.3bn equity release mortgages. The approved MA is 95bp. A rating agency downgrades £300m of the corporate bonds from BBB to BB; those bonds now fail the MA eligibility rules. The firm's SCR coverage is 138%, just above its 135% board risk appetite. Selling the bonds today would crystallise a £28m loss and cost 35bp in transaction costs; holding them would require a capital charge and may reduce the MA. Gilt yields have risen 40bp in the past month. The investment committee wants to know whether to sell, hold or restructure the portfolio, and how to report the impact.
1. Quantify the likely impact of the downgrade on technical provisions and SCR, and recommend whether to sell or retain the bonds. State any assumptions.
Read the worked answer
Assume the £300m is 6% of the £5.0bn liability and that the BB bonds carry a spread of about 200bp versus 20bp on gilts. If the bonds are excluded and replaced by gilts, the MA falls by roughly 6% x (200bp - 20bp) = 10.8bp. The technical provision increase is about £5.0bn x 10.8bp = £5.4m. Holding the BB bonds gives a similar MA effect plus a BB credit risk charge, so SCR also rises.
Selling crystallises £28m plus 35bp x £300m = £1.05m, total £29.05m. If the proceeds are reinvested in eligible A-rated corporate bonds with a similar spread, the MA is largely preserved and the BB capital charge is removed. If reinvested in gilts, the MA falls and the £5.4m technical provision increase remains. Given SCR coverage of 138% against a 135% appetite, a £5m-plus technical provision increase plus a higher SCR charge could breach appetite.
Recommendation: sell the BB bonds and reinvest in eligible A-rated corporate bonds of similar duration, not gilts. The £29m loss is a capital management cost, but it removes downgrade risk and protects the MA. If liquidity is poor, hold only under a board-approved exception with a clear plan to restore coverage.
2. Explain how the firm should treat the downgrade in its ORSA and what management actions could restore SCR coverage.
Read the worked answer
The ORSA should record the downgrade as a risk event and show sensitivities of technical provisions and SCR to MA eligibility, credit spread, default and further downgrades. A reverse stress test could assume a further £500m of bonds fall out of the MA portfolio and spreads widen by 50bp.
Management actions include selling the ineligible bonds and reinvesting in eligible assets, injecting capital, reducing new annuity sales, purchasing reinsurance or using a volatility adjustment where eligible. Each action should be assessed for cost, liquidity and execution risk. The board should also confirm that the MA portfolio remains ring-fenced and that the matching test still holds after the gilt yield rise. Reporting should distinguish the accounting loss from the economic and capital effects.