In its November Financial Stability Report , the Financial Policy Committee concluded that the Matching Adjustment reduces potential instability across the financial system. Another effect is to bring forward part of the future yield on an insurer’s assets into current capital. A bigger Matching Adjustment therefore improves an insurer’s return on Solvency II capital. 4  http://www.bankofengland.co.uk/publications/Pages/fsr/2016/nov.aspx  5  All speeches are available online at www.bankofengland.co.uk/speeches  5  Under Solvency II, Matching Adjustment assets need to be “bonds or other assets with similar cash flow 5  characteristics” . They also need to have cash flows that are “fixed and cannot be changed by the issuers of the assets or any third party”. UK insurers can restructure assets through internal securitisations in order to produce senior tranches that meet the Solvency II tests for the Matching Adjustment. A material amount of illiquid direct investments by annuity writers have been transformed in this way. The Matching Adjustment benefit is capped at the level of BBB-rated assets. Insurers are therefore targeting a Matching Adjustment ‘sweet-spot’ in order to maximise the return on Solvency II capital. Market contacts have described to us an excess of funding for infrastructure projects near that sweet spot. Given the potential impact on an insurer’s capital position, we are taking a close supervisory interest in this area. First, we will consider whether insurers are taking an appropriate Matching Adjustment in calculating their base balance sheets. Put another way, the Fundamental Spread must fully reflect the risks the insurer has retained.

Equity release mortgages can be a valuable product for borrowers, allowing them to unlock the equity in their homes. They can also be an appropriate asset to back annuities as part of a diversified portfolio. But they are a more direct exposure to house prices than conventional mortgages for which the lender’s primary source of repayment is the borrower’s income. Insurers are protected by low loan-to-value ratios. However these will tend to increase over time as interest is rolled up, particularly if the interest rates exceed house price appreciation. And the Solvency II Matching Adjustment increases the effective loan-to-value ratio by allowing insurers to bring forward a portion of the expected income on the loan into current capital. The Matching Adjustment allows an insurer to reduce the value of long-term liabilities, such as annuities, by discounting them using a spread in excess of risk-free rates. The idea is that if long-term liabilities are fully matched by long-term assets, the Matching Adjustment captures the excess market returns in relation to risks to which such a buy-and-hold investor is not exposed. It is calculated as the remainder after subtracting two components of the market yield on an asset: first, the equivalent risk-free rate; and second, the so-called Fundamental Spread, which is mapped from the credit rating of the borrower and used as a proxy for risk. One desirable effect of the Matching Adjustment is to insulate an insurer’s capital position from volatility in 4  market prices.