Partly because the Matching Adjustment benefit to holding sub-investment grade bonds is low, the great majority of these bonds are investment grade. The overall credit quality of the investment-grade bond universe has deteriorated significantly over the past decade. The share of BBB-rated bonds in the sterling market, for example, has increased from under 10% to nearly half since 1998 (Chart 5). Within this BBB-rated segment, analysts have drawn attention to potential ‘fallen angels’ at risk of downgrade to sub-investment grade or even default. These issuers may be at risk because of a combination of excessive debt, structural change in the economy and poor management. Insurers face a risk of reduced Matching Adjustment benefit if issuers are downgraded and financial loss if they default. They should be reviewing the credit quality of their corporate bond investments and focusing in particular on any lumpy exposures. It is reassuring that the proportion of BBB-rated bonds in UK insurers’ aggregate Matching Adjustment portfolios has remained more or less unchanged notwithstanding the increasing share in the wider market. These proportions do vary considerably across individual insurers, however (Chart 6). Firms with higher proportions of BBB assets should be stress testing to make sure that they can comfortably absorb downgrades at a time when markets may be less liquid and they cannot easily rebalance their assets. We will explore this in our upcoming Insurance Stress Test.
These can drive both asset valuations (if insurers use the approach of mapping to valuations of similarly-rated traded assets) and the Matching Adjustment benefit. We said in SS3/17 that: “an internal credit assessment should consider all possible sources of credit risk, both qualitative (eg due to strength of the terms and conditions in the loan agreement or a lack of default data) and quantitative (eg due to economic stresses), and how these may interact. An internal credit assessment will then need to be mapped onto a credit quality step (CQS). The PRA’s view is that the CQS to which an internal credit assessment maps should lie within the plausible range of CQSs that could have resulted from an issue rating given by an External Credit Assessment Institution (ECAI). Broad consistency between the CQSs resulting from firms' internal assessments and ECAI issue ratings will help to mitigate the risk of undue bias in the resulting fundamental spreads.” This does not mean that we want insurers simply to adopt rating agency models across the board. We want firms to develop their own rating models that take into account all possible sources of credit risk.