Given that the livelihoods of millions of pensioners depend on getting this right, we think we need to recognise this uncertainty – by deducting a bit more from what can be counted as capital up-front to allow for it. I should be clear that this isn’t just the view of a prudential regulator – any sensible financial market participant will demand some buffer of safety (or ‘credit risk premium’) when potential losses are uncertain, and it is odd that the EU’s MA construct does not explicitly address this. [5] Second: wrong asset, wrong risk. Under the rules we have inherited from the EU, the amount of future losses firms are required to expect on their assets is based on the historical performance of corporate and government bonds. At the time the rules were negotiated these assets accounted  Page 6  for the very large bulk of insurers’ investments, so this made sense – but as insurers invest more in other sorts of assets, there is an obvious risk that those assets’ future performance will diverge from the benchmarks used in the rules. For example, it is reasonable to question whether the losses which might arise from investments in a commercial real estate loan today will be the same as those experienced on corporate bonds in the past – even if they have the same credit rating.
It allows insurance companies to recognise as capital  Page 4  up-front a part of the income they expect to earn on their assets in the future, but only as long as they can show that the cashflows they expect to receive from those assets closely match the payments they have undertaken to make to their insurance policyholders (hence “matching” adjustment). This is therefore most relevant for the annuity business, where insurance companies promise to pay individuals’ pensions far into the future. You might ask why the regulator favours such an arrangement, which is not common in other bits of regulation, when perhaps it would be more prudent to make insurance companies wait until those returns (for instance, interest payments on corporate bonds) are actually paid to them before recognising them as capital which could be paid out to shareholders. The reason is that we think it protects policyholders if insurance companies are incentivised to invest in assets which will produce cash at the right time, so that insurance companies are not scrabbling around for the right assets when they have to make payments to pensioners in the future. [2] However, you would be right to think that if we allow such an arrangement we must operate it with a very high degree of confidence that those future returns will in fact materialise – in other words that insurance companies do not recognise up-front returns which then later don’t show up. Second, why does the MA matter? For me there are two reasons.