One suggested solution to address the Prudential Regulation Authority’s concerns on the current design and calibration of the fundamental spread – a key aspect of the Solvency II matching adjustment – was to increase the graduations in ratings (notching) as well as to recognise the positive and negative ratings outlooks by ratings agencies when setting the fundamental spread.

The Prudential Regulation Authority said this was the “most frequently suggested” solution after receiving 22 responses to its discussion paper about potential reforms to the Solvency II risk margin and matching adjustment, which ran in tandem with the Treasury’s own consultation on Solvency II earlier this year. 

The government said yesterday it would not change the fundamental spread – a decision welcomed by many UK insurers. 

According to the PRA’s feedback statement, published yesterday right after the Treasury released its own consultation feedback, the regulator cited respondents’ views by saying the recommendation would increase the granularity of the fundamental spread design beyond the current differentiation by credit quality step, and would also improve its risk sensitivity and responsiveness to changes in credit risk conditions.

Another frequent suggestion was to recalibrate the existing fundamental spread framework, increasing the fundamental spread somewhat so it reflects a more appropriate allowance for long-term credit risk.

The increased use of risk management tools was also recommended to the PRA.

According to a report published in July by the Institute and Faculty of Actuaries’ Matching Adjustment Working Party, the fundamental spread is an allowance for the credit risk of an asset, in other words the probability that the income expected to be received from an asset is not realised. 

It is used in the calculation of the discount rate for certain types of insurance liabilities (primarily annuities) where a firm has approval to apply it. 

Actuaries at the working party said its formulation has a “profound effect on not just the size of the MA (and hence the size of the insurance liabilities), but also the sensitivity of insurers’ balance sheets to credit spreads”.

The PRA raised three concerns in its discussion paper. It said:

·        The fundamental spread does not capture all retained risks which insurers face and as such its level (in basis points) is generally too low as it “does not fully and explicitly allow for uncertainty around credit risk”;

·        It is not sensitive to differences in risks across asset classes for a given currency, sector, and Credit Quality Step (CQS); and

·        It does not adjust to reflect structural shifts in the credit environment over time, unless there are actual defaults or downgrades.

According to the regulator, the majority of respondents – particularly those from life insurers – did not agree with the PRA’s case for reform, with at least one considering the concerns set out to be “more theoretical in nature rather than practical issues”.

Some respondents supported the PRA’s assessment that the fundamental spread should be made more risk-sensitive, the regulator noted, and agreed with the suggestion to introduce a specific allowance for credit risk uncertainty. 

Of these, the authority said some went further to argue that the PRA’s suggested method to address the concerns it had set out “did not go far enough”, or that the MA should be removed entirely given the risks associated with recognising unearned profits upfront.

Other responses, particularly those from UK life insurance firms, were generally opposed to reform of the fundamental spread and argued the PRA had not provided sufficient evidence to support its concerns. 

Others acknowledged the case for some reform and recognised there were limitations in the current approach but considered any weaknesses in the current design and calibration “to be less material than the PRA had set out” in the discussion paper.