Matching adjustment ring-fencing provisions ‘a threat’ to mutual insurers

Provisions would prevent common funds structures and reduce diversification benefits, say insurers

Mutual insurers have slammed the ring-fencing requirements of the matching adjustment, saying the versions of the measure being tested in the long-term guarantees impact assessment (LTGA) would damage their business model.

Many mutual companies combine their with-profits business with other business lines, typically annuities, in a common fund in order to reduce their capital requirements through risk diversification. Under the LTGA's technical specifications, insurers would need to place a ring-fence around the assets backing the non-with-profit policies in order to utilise Solvency II's matching adjustment.

This, mutual insurers argue, would cancel out the diversification benefit and undermine the usefulness of a common fund structure to mutuals.

Martin Shaw, Lincolnshire-based chief executive of the Association of Financial Mutuals (AFM), says: "Our initial view is that putting an additional 'ring-fence' around matching adjustment contracts is unjustified and likely to undermine the benefit a matching premium is intended to provide [by eliminating diversification benefit]."

Conditions on the application of all five versions of the matching adjustment contained in the LTGA technical specifications require ring-fenced funds to be managed separately from the rest of the business of an undertaking "without any possibility of transfer".

While the European Insurance and Occupational Pensions Authority (Eiopa) which is running the LTGA, claims that the ring fencing provisions are preliminary and apply for LTGA purposes only, mutuals remain unhappy.

David Gulland, chief risk officer at mutual insurer MGM Advantage, based in Worthing, says this rigid approach does not take into account how mutual insurers undertake risk management. By pooling the diverse risks attached to both non-with-profit and with-profit business in one fund, mutuals can afford to hold less reserve capital to protect their policyholders, he says.

"If you've got longevity risk, equity risk, credit risk and lapse risk all in the same fund then you have diversification benefit. If you separate it out then you don't get that diversification," says Gulland. "Surely there are benefits in having more risks in one fund than having separate funds, with the risks ring-fenced, and having to have the capital to support all those risks individually?"

If the ring-fencing provisions are maintained companies will have to make a judgement on whether the matching adjustment – aimed at reducing the balance sheet volatility arising from spread movements on assets held to maturity to back certain long-term products – or diversification benefit is of greater value to them.

Theresa Chew, senior consultant at Towers Watson, the consultancy firm, in London, says: "For business that doesn't get so much benefit [from the matching adjustment] anyway, which is anything but annuity business, then they really want to think whether they want to apply the matching adjustment at all. You can choose to apply a matching adjustment or not, but once you've chosen to apply you can't move [ring-fenced assets] in or out."

The threat of Solvency II to mutual insurers' business models is already driving some firms to restructure. Last week, MGM Advantage agreed to sell to private equity firm TDR Capital, which would take over its front-end annuity business.

"One of the drivers [of the proposed deal] was where Solvency II would end up, how the matching adjustment would work and, in particular, how ring-fenced funds would work in that arrangement," comments Gulland.

The mutual sector, Gulland urges, should continue to make its case to the Financial Services Authority (FSA) and Eiopa following the completion of the LTGA. "Everyone needs to give feedback either in taking part in the impact assessment formally or informally to feed back the implications [of the current rules]," he adds.

Years of negotiations between mutual companies and the FSA bore fruit earlier this year with the regulator's recognition that providers had a right to deploy the inherited estates bound up in their common fund to service non-with-profit business.