First, they do not have to hold capital against the full risk that credit spreads will move against them in the market; Second, they are allowed to discount their annuity liabilities at higher than risk-free rates, reducing their liabilities and therefore boosting their current available capital. For UK insurers, the Matching Adjustment currently amounts to a capital benefit of some £ billion, split roughly evenly between lower capital requirements and higher capital resources. The Bank of England supports the Matching Adjustment framework. Properly implemented, it does appropriately reflect the risks to which annuity writers are exposed. As the Financial Policy Committee 7  concluded , it also has important financial stability benefits. It allows insurers to ‘look through’ short-term  volatility in credit spreads, avoiding any undesirable incentives to act procyclically by selling risky assets as market prices fall. Under Solvency II, Matching Adjustment assets have to meet strict criteria. For example, they must match the liabilities and have fixed cashflows. Insurers are seeking illiquid assets that both offer attractive yields and qualify for the Matching Adjustment. The PRA has allowed insurers some scope to restructure assets in order to meet the requirements. For example, equity release mortgage portfolios may be a good maturity match for an annuity book as part of a diversified portfolio. But they do not have fixed cashflows. So  4  Housing Affordability in England and Wales: 2016, Office for National Statistics, 17 March 2017 Miles, D and J Sefton (2017), “Houses Across Time and Space”, CEPR Discussion Paper No.

With most of the longevity risk currently being reinsured, the primary determinant of pricing in the bulk annuity market is the investment return on the assets backing the annuities. The big change here is diversification out of bonds into direct lending (Chart 1). Spreads over risk-free rates on investment grade bonds have been narrow for some time. Insurers have been finding wider spreads in a variety of other long-term financing markets, including social and student housing, financing public infrastructure such as hospitals, commercial real estate lending, wind and solar power financing, rail stock leasing and ground rents (Chart 2). These ‘illiquid assets’ (broadly defined as assets other than traded debt securities) currently make up more than 25% of the assets backing annuities across UK insurers. Insurers’ business plans suggest this proportion might increase to around 40% by 2020. Illiquid assets can be a good match for annuities. Diversification may lower overall portfolio risks. And long-term infrastructure investment has wider economic benefits. But these assets bring a wider range of risks than those familiar to bond investors. Insurers need to ensure they have the skills to understand and manage them. To take some diverse examples, the failure of Carillion left some insurers needing to replace a contractor on construction projects; financing student accommodation exposes insurers to the risk of changing UK student numbers; and financing railway stock creates a risk at the point when a new train operator wins a franchise. These assets also typically lack external ratings and observable market prices.