Matching Adjustments (MA) are a significant mechanism within the Solvency II regulatory framework that help insurance companies manage their long-term liability portfolios more efficiently. Designed primarily for life insurers offering long-term guaranteed products like annuities, the MA allows for a more economically realistic valuation of liabilities by recognizing the additional yield insurers can earn from holding certain types of long-dated assets to maturity. This adjustment ultimately reduces the amount of capital insurers are required to hold, while still maintaining prudence and policyholder protection.
At its core, the Matching Adjustment serves to modify the discount rate used to value certain insurance liabilities. Under Solvency II, insurers are generally required to value their liabilities using a risk-free interest rate term structure provided by the European Insurance and Occupational Pensions Authority (EIOPA). However, this standard risk-free rate may not reflect the actual investment returns insurers earn on the backing assets, particularly when those assets are illiquid and held to maturity. The MA is designed to correct for this by allowing insurers to adjust the discount rate upward to reflect the illiquidity premium they earn on such assets.
How do you qualify?
To qualify for a Matching Adjustment, several strict conditions must be met. First and foremost, the insurer must identify a clearly defined portfolio of assets, often referred to as the Matching Adjustment Portfolio or MAP, which backs a specific subset of insurance liabilities. These liabilities typically consist of predictable, long-term cash flows such as those found in annuities or pension obligations. The assets included in the MAP must be fixed in terms of future cash flows and must closely match the expected liability outflows in both timing and amount. Additionally, the insurer must intend to hold these assets until maturity in a buy-and-maintain strategy, as opposed to actively trading them on the market.
The assets eligible for inclusion in the MAP typically consist of high-quality fixed income instruments such as corporate bonds, government bonds, and certain types of private credit and asset-backed securities. Derivatives and equity instruments are generally excluded, unless the derivative is used solely for hedging purposes and does not introduce volatility that would undermine the reliability of the cash flows. The critical requirement is that the cash flows from the assets must be predictable and stable enough to allow for precise matching with liability payments.
The process of calculating the Matching Adjustment involves identifying the yield earned on the eligible assets in the MAP, then subtracting a regulatory deduction known as the fundamental spread. The fundamental spread is determined by EIOPA and represents a conservative allowance for expected credit losses and the risk of downgrades over the life of the asset. The resulting difference—the excess yield after deducting the fundamental spread—is the Matching Adjustment. This figure is then added to the risk-free discount rate curve when valuing the associated insurance liabilities, resulting in a lower present value of liabilities and, consequently, lower capital requirements.
For an insurer to use the Matching Adjustment, supervisory approval is required. This involves submitting a formal application to the national competent authority, such as the Prudential Regulation Authority (PRA) in the United Kingdom. The application must demonstrate that the insurer satisfies all eligibility conditions, including the asset-liability matching requirements, the quality and appropriateness of the selected assets, and the robustness of the insurer’s risk management and governance framework. Furthermore, the insurer must show that it can maintain the matching over time and withstand stress scenarios without breaching regulatory thresholds or exposing policyholders to undue risk.
Once the MA is approved and implemented, it can have a material impact on an insurer’s financial position. By reducing the present value of long-dated liabilities, the MA boosts the insurer’s solvency ratio, which is a key measure of financial strength under Solvency II. This creates capital efficiency and supports the writing of new business by freeing up regulatory capital. Importantly, this benefit is achieved without compromising policyholder security, because the adjustment is based on the actual economic behavior of assets and liabilities held to maturity.
In addition to enhancing capital efficiency, the MA encourages insurers to invest in longer-term, less liquid assets that more closely match the duration and nature of their liabilities. This has a stabilizing effect on investment portfolios and can provide broader economic benefits, such as increased investment in infrastructure, private credit, and other productive long-term assets. It aligns regulatory incentives with prudent asset-liability management practices, fostering a long-term investment horizon.
However, the use of Matching Adjustments is not without challenges. The eligibility criteria are stringent, and maintaining the MA over time requires careful portfolio management, ongoing monitoring, and frequent re-validation of asset and liability cash flows. Any disruption to the matching, such as unexpected policyholder behavior or credit deterioration in the asset portfolio, can force the insurer to revise or revoke the MA. This could result in a sudden increase in reported liabilities and a corresponding hit to the solvency ratio. As such, insurers must put in place strong governance, risk controls, and contingency planning.
In practice, the Matching Adjustment is widely used across the European insurance market, particularly among life insurers that offer bulk annuity and pension risk transfer products. In jurisdictions like the UK, the MA has become a cornerstone of the post-Solvency II regulatory landscape and is central to how insurers structure their balance sheets and manage risk.
Conclusion
In summary, the Matching Adjustment under Solvency II allows insurers to align the valuation of liabilities more closely with the economic reality of their long-term investment strategies. By recognizing the illiquidity premium available on buy-and-hold assets, the MA reduces liabilities, improves capital efficiency, and promotes prudent asset-liability matching. While its application is subject to rigorous requirements and ongoing supervision, it offers substantial benefits to insurers and plays a critical role in supporting the long-term sustainability of guaranteed insurance products.