Developments in the PRA's
supervision of annuity providers
Speech given by
Charlotte Gerken, Executive Director Insurance Supervision
The 18th Conference on Bulk Annuities
29 April 2021
I would like to thank Anu Ralhan and Rob West for their help in preparing these remarks.
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Thank you to Westminster and City for inviting me to speak at your bulk purchase annuities conference.
At the time the 2020 conference was scheduled to take place, we were all grappling with the early impacts of
the COVID 19 pandemic on our work, our lives and loved ones. In the months since, life insurers' staff have
worked hard and in challenging circumstances to serve their customers in very difficult times.
As companies, life insurers have so far come through the pandemic well. That is not to say things have been
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perfect, but we recognise the commitment of firms and their staff to ensuring business continuity
particularly important when considering in the case of annuity providers that an annuity may be a substantial
portion of the retirement income of the recipient.
In previous conferences (2018 and 2019), the former Executive Director for Insurance Supervision,
David Rule, talked to you in his speeches 'An Annuity is a very serious business' Parts 1 and 21
about:

The key risks facing annuity writers and the treatment of unrated, direct investments under the
Matching Adjustment in 2018, with a focus on equity release mortgages; and
 How Solvency II works to address risks to annuity providers, serves protection of policyholders and
allows insurers to invest for the long term in ways that support the UK economy in 2019
There is continuity in that I will be looking at aspects of the Matching Adjustment (MA), but today I will be
focussing on three areas of our supervisory risk analysis.
1. I will take stock of market developments since 2019.
2. I will talk about the implications of those developments for our supervision, in particular the Matching
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Adjustment putting it in context, setting out the rationale behind it, and discussing asset eligibility
matters; and
3. Finally, I will share some thoughts from our supervisory analysis on the size of the MA, how the
current fundamental spread (FS) approach has been implemented, and looking at the risk sensitivity
of the FS.
You will hear more on developments in regulation following HM Treasury's Call for Evidence2
in due course;
but today I would like to explore what we have learnt through our supervision of annuity writers since the
inception of Solvency II. What we have learned will, as you would expect, inform our considerations of
potential Solvency II reform.
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https://www.bankofengland.co.uk/speech/2018/david-rule-2018-conference-on-bulk-annuities-and-longevity-risk-transfer and
https://www.bankofengland.co.uk/speech/2019/david-rule-westminster-and-city-programmes-2019-bulk-annuities-conference
2
https://www.gov.uk/government/publications/solvency-ii-review-call-for-evidence
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1. Market developments since 2019
The annuity market largely bifurcates into bulk purchase annuities and the purchase of annuities from
personal and occupational pensions. Since David spoke to you in 2019 the growth in the bulk annuity
market has continued, and is expected to continue [Chart 1 in the Appendix].
From our perspective, the additional capital that annuity firms bring to back these pension obligations
provides increased security for scheme members, and gives pension scheme sponsors the opportunity to
benefit from de-risking.
For some insurers, annuities are part of a wider product set, diversifying with for example term assurance or
general insurance products. But for specialist annuity firms the increase in annuity sales leads to
concentration in both longevity and credit risk. Chart 2 shows the composition of the solvency capital
requirement (SCR) across a range of specialist and mixed-line annuity firms:
What this chart does not convey is that the longevity component would be notably larger were annuity writers
retaining all of this risk. We are aware that the design of the risk margin has had a number of unwelcome
effects such as adding excessive balance sheet volatility which has contributed to longevity risk being
something many annuity writers continue to look to cede. Our views on the risk margin have been set out
previously, and we welcome its inclusion in HMT's Call for Evidence on Solvency II reform.
2. Implications for supervision
Context
The growth of annuity lines through bulk purchase transfers from defined benefit pension schemes, and the
specialisation in annuity lines, attracts significant supervisory focus. With much longevity risk currently being
reinsured, firms will not have failed to notice that our engagement on asset risk has increased markedly as
investment returns on assets backing the annuities are the key driver of pricing in the bulk annuity market.
MA portfolios have increased since the start of 2018 by 30%, to around £335bn3 [Chart 3]. The range of
assets that firms hold in their MA portfolios suggests to us that Solvency II is not of itself a barrier to firms
investing in a wide range of asset classes. We see everything from covered bonds to infrastructure; and
social housing to restructured Equity Release Mortgages (ERMs) backing annuity liabilities. And whilst the
majority of exposures are what might be deemed traditional annuity assets, such as gilts and corporate
bonds, less liquid exposures as a proportion of the MA portfolios are large and increasing [Chart 4].
3
QRT data at YE20, PRA Analysis
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The risk management of less liquid assets is of particular concern to us. Insurers may be sole or significant
investors in specialised lending and will require a commensurate level of expertise to assess, maintain and
potentially work-out such assets.
Rationale for the MA
Before discussing our supervisory analysis on MA portfolios, I will recap on the rationale for the MA.
There are several schools of thought on whether illiquid liabilities should be discounted at a rate,
"risk-free"
or if it is appropriate in some cases to allow for some addition to the risk-free rate. The PRA accepts that a
component of the credit spread represents an illiquidity premium, and that an allowance may be made for
this where firms: hold debt-like instruments to back annuities; are able to hold those assets to maturity; and
they closely match asset and liability cashflows. Solvency II has formalised the conditions for when that
illiquidity premium can be recognised, often referred to as "eligibility".
Under Solvency II this increase to the discount rate is called the MA. The MA reduces the value of liabilities
in the base balance sheet, and hence increases own funds [Chart 5].
The MA performed its expected function in 2020, allowing insurers to look through the sharp spike in credit
spreads. And the MA also served broader financial stability as insurers did not behave in a procyclical way,
as they did not need to sell assets as market prices fell [Chart 6].
Asset eligibility
assets backing MA eligible liabilities should be 'fixed'.
On the eligibility side, Solvency II requires that the
This fixity in the assets results in a higher level of confidence that asset cash-flows will be available as the
liabilities fall due; and hence that firms have largely mitigated credit spread exposures arising from being
either forced sellers of assets or reinvestors of cash. It is for this reason that assets with prepayment risk are
typically not suitable for inclusion in matching portfolios, unless they include suitable protection from the
financial consequences of prepayment.
We are mindful that being closely matched today does not mean that all is well for the run off of the liabilities.
Even for a fixed book of business, changes in demographic experience may result in divergence from initial
expectations. Therefore, it is important to us that firms regularly revisit their matching profile; indeed that is
"Solvency II: Matching adjustment"4
why we have set out tests in Supervisory Statement 7/18 to assist with
assessing ongoing matching. This is another reason why even a well matched firm may need to turn over
part of its portfolio over time, suggesting prudence is necessary when deciding how much MA benefit to
claim based on its current matching position.
4
https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/supervisory-statement/2018/ss718.pdf
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In our view the MA does not stop firms investing in assets such as construction phase assets structured as
debt, or in pools of assets that might not be MA eligible themselves. As I said earlier, MA portfolios already
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include many types of debt instrument, and where assets are not MA eligible firms may consider if
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appropriate holding them outside the MA portfolio to back other liabilities. And the PRA has taken, as far
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as possible, a pragmatic approach to fixity for example for floating rate bonds and for assets with
inadequate modified Spens clauses.
Over 2020, we saw very few applications for asset classes not already held in peer MA portfolios, instead
seeing firms applying to invest in less liquid asset classes such as ground rents and ERMs. While the asset
classes may not be new to us, firms can expect to be challenged when investing in asset classes that are
in Supervisory Statement 1/20 "Solvency II:
new to them. We have published supervisory expectations
Prudent Person Principle"5 and Supervisory Statement 8/18: "Solvency II: -
Internal models modelling of the
matching
adjustment"6. These cover risk management aspects including the consistency of investments with
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the prudent person principle, the ability to manage the assets including in stress or in default and the
ability to model the solvency capital requirement appropriately.
Next I would like to touch on the future direction for new asset classes in MA portfolios. As Sam Woods, the
PRA's Chief Executive
Deputy Governor for Prudential Regulation, and said in his March speech7 at the ABI,
we are wary of calls to encourage specific forms of investment with prudential regulatory incentives. We do
want to see firms invest in ways that support the wider economy, including to manage the risks arising from
However when assessing capital requirements, and here I am thinking of 'green' assets and
climate change.
'productive finance', we must as a prudential regulator consider the risks in individual assets. A departure
from such an approach reduces the resilience of firms and potentially the wider financial system.
However, as Sam also said we are open to removing unnecessary barriers. A significant constraint currently
is the binary nature of MA approvals, and in the course of supervisory engagement firms have raised the risk
of the loss of the MA where breaches have not been rectified within two months. As part of considering the
responses to HMTs Call for Evidence on Solvency II reform, we will review the MA approvals process. And,
whether changes there need to be balanced by stronger post-approval supervision to ensure the MA
framework continues to work as intended.
3. Supervisory analysis on sizing the MA
Once assets are in the MA portfolio, Solvency II sets out the mechanism for deriving the fundamental spread
(FS), which reflects an allowance for risks retained by insurers. Deducting the fundamental spread from the
credit spread, gives the quantum of the MA [Chart 7].
5
https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/supervisory-statement/2020/ss120.pdf
6
https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/supervisory-statement/2018/ss818.pdf
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https://www.bankofengland.co.uk/speech/2021/march/sam-woods-association-of-british-insurers-executives-neds-and-chairs-networkwebinar
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The current calibration of the FS has three components for investment grade assets: the probability of
default, the cost of downgrades, and a floor based on long term average spreads (the LTAS floor). For
sub-investment grade assets a fourth component limits the MA on such assets to that of an investment grade
corporate bond.
The components of the FS are based on historic averages to varying degrees, notably the LTAS floor which
is 35% of the average spread over the previous 30 years. What often surprises is the extent to which the
LTAS floor actually bites, for example in Chart 8 we show the components of the FS for non-financial BBB
corporate bonds, which highlights that the LTAS floor is often biting.
The LTAS floor is, as the name says, a long term average. Accordingly it is relatively unresponsive to
changes in market spreads, and this is a key reason for the FS being slow to respond to market signals.
Implementation issues
Moving from FS components to firms' implementation: to know what FS to apply, firms are required to
determine two parameters; the credit quality step (CQS) and the fundamental spread sector.
Firstly, the CQS.
For many assets in MA Portfolios the CQS can be mapped by looking at the rating assigned by an External
Credit Assessment Institution (ECAI). However, as I mentioned earlier, we see increasing volumes of less
liquid and more complex assets for which firms have themselves to assign a CQS.
Given firms' judgements play an important role in determining the CQS we need to be confident that their
internal rating processes are robust. We have set expectations for firms in Supervisory Statement 3/17:
"Solvency II: Illiquid assets"8, that where ratings are a significant driver of technical provisions and capital
requirements, we expect those ratings assigned by firms to be broadly consistent with public ratings that
could be obtained from ECAIs. Consistency with ECAI public rating methodologies, including any allowance
for rating caps, are key points to distinguish from opinions ECAI only provide privately, based on other
assumptions.
Rating consistency remains a key area of PRA engagement with firms, and to demonstrate consistency firms
need to show that they understand what ECAIs do, and then to internalise this in their own processes.
Secondly, the fundamental spread sector.
As well as credit rating, the sector that an asset comes from is a key driver of the FS. Chart 9 compares at
year-end 2020 the FS for A-rated assets depending on whether the financial or non-financial FS is used.
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https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/supervisory-statement/2020/ss317-update-april-2020.pdf
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A key challenge in Solvency II is that the FS has been calibrated for corporate bonds, but firms now hold
ever increasing exposures to less liquid asset classes, with significant basis risks between asset exposures
and the FS calibration data. We consider that there is potential merit in differentiating the FS by asset class,
however, this needs to be balanced against the extent to which different asset classes are sufficiently
homogenous, as well as the availability and credibility of data available to derive such calibrations.
A more granular FS could therefore give rise to additional risks. Related to this, firms make their own
delineation between financial and non-financial assets, and it is important that their assumptions are prudent.
Risk Sensitivity of the FS
The current construct of the fundamental spread has some advantages: it has been largely predictable under
stress, and it promotes counter-cyclicality. However, it is reasonable to ask whether the FS has gone too far
in this direction. The impact of the long-term average spread floor makes the FS a predominantly backwards
looking measure, insensitive to current market signals.
For example, in Chart 10 are the credit spreads for A-rated financial corporate bonds, set against the
year- end 2020 FS9.
Under stress, firms will only see the FS increase under a ratings downgrade, thus completely setting aside
any information contained in market spreads. Such ratings downgrades may not occur immediately, leaving
a window where policyholders may be less well protected. Further, where ratings downgrade by a notch but
remain within the same CQS, again the FS is unchanged.
Another way of looking at the question is to consider how much of the credit spread the FS strips out in
percentage terms [Chart 11].
So, at year-end 2020 perhaps 70% of the credit spread on such assets is removed for retained risks, with a
much lower figure if spreads reached the levels seen in the Global Financial Crisis. The insensitivity to
market signals is a feature of the current FS construct, and is why for internal model firms we set an
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expectation in Supervisory Statement 8/18: "Solvency II: Internal models modelling of the matching
adjustment"10, that when determining the FS in stress firms should not simply mechanistically recalculate the
FS, but should determine a stressed FS that better reflects the risks retained.
To be more forward looking, one alternative could be for an approach where the risk allowance reflects
compensation for: expected losses; uncertainty around expected losses; and any further risks retained by
investors. Such an approach might place less weight on credit ratings, which particularly in the case of
internal ratings present challenges around availability of data, and expertise in the business and risk
9
Illustrative bonds of 10-15 year term, duration c. 10 year at YE20
10
https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/supervisory-statement/2018/ss818.pdf
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teams. A framework that takes some signals from market prices could be more forward looking, for
example, recognising the market pricing of climate risks, rather than a backwards view of the risks of failure.
However, any alternative framework may bring in new risks, potentially in being over risk-sensitive; or for
example if provisions are linked to credit spreads, there may be incentives to value assets nearer the top end
of the plausible range, understating the credit spread. While this is likely a smaller risk for traded corporate
bonds, the shift to less liquid assets brings in greater scope for valuation uncertainty, which may also need to
be factored into the FS.
Conclusion
I have focussed today on risks inherent in the MA, in particular on risks from less liquid assets stemming
from uncertainty about the credit rating, uncertainty around valuations, and uncertainty about the amount of
benefit that should be taken as a credit to insurers' balance sheets. These are all risks that insurers'
MA
Boards and senior management need to be across and to understand the vulnerabilities in assumptions that
have to be made.
The MA is a significant benefit for firms, in bringing forward unrealised profits that are then available to be
deployed to grow businesses, or to reward shareholders. However, an addition to the risk-free rate is
appropriate for annuities where they are well matched, and the MA is a valuable source of resilience for
annuity writers. We will want to continue to have a very high level of confidence that there are no material
risks to those returns being earned.
Close supervision of the MA contributes to securing an adequate degree of protection for policyholders and
we will continue to develop our analysis both to improve our supervision and to inform policy development.
The Call for Evidence has drawn a wide range of views on the nature of the MA and we are committed to
working with industry and HMT to deliver meaningful and progressive reform to Solvency II, in line with
HMT's objectives for the
review.
Annuity writers may rightly feel that they receive significant supervisory challenge from the PRA. This will not
change, given the nature and importance of the annuity product, the significant judgements and assumptions
that underpin the MA benefit available to firms, and the impact of annuity providers on our policyholder
protection objective.
As you have heard before, from Jane Austen and David Rule, annuities are a very serious business.
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Appendix
Chart 1: Buy-in, buy-out and longevity swap volumes. Source: LCP
Chart 2: Breakdown of the major UK annuity writers' SCR (YE19). Source: QRTs, PRA analysis, YE19
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Chart 3: MA Portfolios. Source: QRTs, PRA analysis
Chart 4: Illiquid proportion of MA portfolio assets. Source: QRTs, PRA analysis
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Chart 5: The impact of MA on the base balance sheet. Source: PRA analysis, Solvency II Regulations
Chart 6: Credit Spread on Investment Grade Corporate Bonds. Source: Bloomberg data, PRA
analysis
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Chart 7: Decomposition of Bond Spread. Source: PRA analysis, Solvency II Regulations
Chart 8: FS Components: Non-Financial CQS 3 (BBB-rated). Source: PRA analysis, YE20
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Chart 9: FS Credit Quality Step 2 (A-rated). Source: PRA analysis, YE20
Chart 10: Illustrative A-rated 10 year financial bond. Source: Bloomberg data, PRA analysis
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Chart 11: 2020YE FS as % spread - Illustrative A-rated 10 year financial bond. Source: Bloomberg
data, PRA analysis using YE20 FS
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