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.
In particular, to quote Solvency II directly, “the Matching Adjustment must not include the Fundamental 9  Spread, reflecting the risk retained by the insurance or reinsurance undertaking” . Since the credit rating is the main driver of the Fundamental Spread, this means the credit rating must reflect the risk retained by the insurer. One key characteristic of illiquid assets is that they are not usually externally rated. Instead, Solvency II permits insurers to use internal ratings to determine the Fundamental Spread. Since illiquid assets will often not have market valuations, insurers will often also base the asset valuation on the internal rating by mapping to equivalent traded assets of the same rating. The internal rating may therefore drive both determinants of the Matching Adjustment: the spread over risk-free rates and the Fundamental Spread. Getting it right is important! The PRA set out its views on this subject in a supervisory statement (SS 3/17) last year. 10  We said that  internal ratings must lie within a plausible range of the ratings that would be given by external rating agencies. Individual ratings may vary, depending on credit judgements, but there should be no overall upward bias in internal compared to external ratings. Supervisors are reviewing insurers’ internal ratings and may seek greater assurance where assets have spreads that look large for the rating, leading to a large matching adjustment in absolute or relative terms. We will also consider the complexity of the assets and their materiality to the overall solvency position of the insurer.