More focus is therefore needed on internal rating and valuation processes. Insurers need to ensure that they are meeting all the elements of the Prudent Person Principle in Solvency II. Finally, when these exposures deteriorate, it is important that insurers have the work-out expertise to mitigate the impact on value, as ultimately disposal is unlikely to be a straightforward option. Equity release mortgages  The illiquid asset category in which exposures have been growing most quickly is equity release mortgage lending. A typical equity release mortgage comprises an advance to a person sixty to eighty years old of 25-50% of the value of their home. Most borrowers do not pay interest which instead accrues over time, increasing the value of the debt. Assuming the borrower does not pre-pay the loan, the insurer is repaid from the proceeds of the house sale when the borrower either dies or moves into long-term care. Insurers guarantee that the amount of the loan cannot exceed the value of the house (the ‘no-negativeequity guarantee’). 3  All speeches are available online at www.bankofengland.co.uk/speeches  3  To be clear, the PRA recognises the value of this product to consumers especially given the aging UK population with high levels of wealth concentrated in housing. £ trillion of £ trillion homeowner equity 3  in England belongs to people aged over 55 . Equity release mortgages give older people the opportunity to unlock this wealth as an alternative to moving into a cheaper house.
Solvency II sets out how to estimate the premium needed to compensate for the risk that the borrower defaults or is downgraded, known as the Fundamental Spread. As an approximation, in equation form:  Matching Adjustment = Yield minus risk-free rate minus Fundamental Spread  The most important determinant of the Fundamental Spread is the credit rating of the asset. Broadly speaking, the higher the yield on an asset for a given credit rating, the bigger the Matching Adjustment. Earlier I showed that insurers were diversifying into illiquid assets because they offered wider spreads than bonds. Chart 7 is the same picture but with the split between the Matching Adjustment and Fundamental Spread added. Not only are the yields on illiquid assets wider but the majority of the additional spread is  being captured in the Matching Adjustment. UK insurers estimate the underlying credit quality of these  assets, reflected in the Fundamental Spread, to be similar or better than their corporate bond portfolios. So the shift into illiquid assets is giving insurers a double benefit: first wider spreads and second a bigger Matching Adjustment. This helps to explain their eagerness to increase their asset allocation towards illiquid assets. But why is the Matching Adjustment on illiquid assets larger than on corporate bonds? One possibility is that that the wider spreads are compensating other investors for the risk that they might need to sell into secondary markets that are less liquid than the corporate bond market.