Insurance podcast series – Episode 2: Matching Adjustment Attestation

In our latest podcast, insurance partner Kate McInerney discusses the matching adjustment attestation regime with our global co-head of insurance Philip Jarvis and Claire Haydon, executive director of A&O Shearman’s consulting business. Together they look at the implications of the new matching adjustment attestation regime, and discuss learnings from other attestation regimes.

Listen to the conversation about the matching adjustment attestation here, and read the transcript below.

• Kate: Hello and welcome again to A&O Shearman's insurance-focused podcast. In our last podcast, we spoke about the matching adjustment reforms, but we promised to come back to the attestation regime and the governance requirements. So here we are again, discussing matching adjustment reform from a slightly different angle, and this time we're joined by Philip Jarvis, who leads our global insurance practice, and Claire Haydon, who is an executive director of our consulting business, Consulting by A&O Shearman.
• Philip: And Claire brings an interesting perspective because this isn't the PRA's first time at the attestation rodeo. Attestation is something that has been part of their regulatory toolkit for a few years now. So Claire is going to talk about some of the lessons for firms that can be taken from how attestation regimes have worked in the past, and relating those lessons to what is happening for insurers in the context of the matching adjustment reforms right now. 
• Kate: But before we get to that interesting stuff, a quick recap. On the 6th of June, the PRA (Prudential Regulation Authority) released its final policy statement on the matching adjustment, which liberalises the matching adjustment rules in a couple of key areas. We covered those liberalisations in our last podcast, which you can find on aoshearman.com. But we also noted that the PRA had tightened the rules in a few key areas, for example, including compliance with the Prudent Person Principle within the matching adjustment requirements, introducing more risk sensitivity around the fundamental spread in the form of so-called notching, but also in introducing enhanced governance requirements around the matching adjustment. These governance requirements include, as their centrepiece, attestation requirements. So Philip, what exactly is being attested to here? 
• Philip: So matching adjustment attestation will require insurers to get a senior management function holder, usually the CFO, to confirm two things at least annually, at the same time as they do their SFCR (Solvency and Financial Condition Report), and potentially more frequently, for example, where there is a large transaction which relates to the matching adjustment fund. And these two things are, firstly, that the fundamental spread reflects compensation for all retained risks. Now the premise here is that insurers who are entitled to use the matching adjustment aren't exposed to liquidity and reinvestment risk on the assets which match their matching adjustment liabilities because the insurers should never have to sell their matching adjustment assets, so the part of the yield which relates to those risks, the so-called non retained risk, can be used to increase the discount rate by way of the matching adjustment. Everything else, which increases yields, for example credit risk, is a retained risk and has to be stripped out by being reflected in the fundamental spread. The higher the fundamental spread, the smaller the matching adjustment, reducing the discount rate and increasing the present value of the insurer's liabilities.
  The second is that the matching adjustment can be earned with a high degree of confidence from the relevant assets. In essence, once you've stripped out the fundamental spread, are you highly confident that the amount of excess spread will actually be realisable? In thinking about this, the PRA has devised a basic fundamental spread that is prima facie applicable to standard corporate bonds and to the extent an asset is set to generate a matching adjustment above that which will be generated by the equivalent standard bond, then firms will need to be able to justify that access. The onus is on the insurer to go through a process to show how that increased yield is justified. And it's worth making a couple of observations at this point. Clearly, there's a high degree of subjectivity and judgment in all of this, and that is something which has been acknowledged by the PRA. And while the right answer is no doubt important, what's really critical here is demonstrating that rigour and care has been taken in the approach taken to reaching these judgments. Put simply, the PRA wants insurers to show their workings.
• Kate: Claire, what can you tell us about this? What should firms be doing? And is this like other attestation regimes that people might be familiar with?
• Claire: So I think the phrase "show your workings" is absolutely spot on. We know that whenever firms are taking decisions that involve a high degree of judgment, and particularly where those decisions have capital benefits, then the regulator will really want to understand all of the factors that have been considered in coming to a determination. So this will include things like detailing the assumptions made and setting out why these were considered appropriate, explaining the methodology that's been used, and justifying choices in the approach taken, and detailing models used and explaining why they are appropriate and effective.
  The PRA will also want to understand the governance process by which a firm has come to a determination on the fundamental spreads and matching adjustment. They'll be looking for evidence that there's been rigorous governance applied to all aspects of the process with strong internal debate and challenge on all of these matters at an appropriately senior level with the right levels of expertise around the table. The attestation policy that firms are required to put in place and have signed off by the board is therefore going to be a really critical document because it will need to set out an appropriate framework for review, including details of the process by which the attestor should review the fundamental spread of matching adjustment and an approach for determining the amount of any addition to the fundamental spread.
  Now, the PRA has set out an example of the process that firms might go through in making the attestation, which provides a really useful insight into the level of regulatory expectation here, including the types of risks that should be considered and areas where the firms will be expected to document their rationale for certain actions. There are a number of places within the supervisory statement where the PRA has indicated that it will expect the attestation to include explanation or justification, but these should not be viewed as the only items that should be covered.
  Finally, the PRA is requiring firms to list all of the evidence relied upon in making the attestation and the supervisory statement sets out a number of items that are expected to be on that list. Now, regulators do tend to take the view that if something isn't written down then it didn't happen and firms should absolutely be expecting requests from the regulator to provide items from that evidence list to them following submission of their attestation.
  So, Kate, you asked if this attestation process is like others we've seen before. I'd say it actually looks a little bit different, including things like the requirement to have an attestation policy in place, and I think that difference is really down to the importance of this process given it's creating Tier 1 capital, it's going to be done at least once a year and it's highly judgment based. So firms really need to be thoughtful about designing an attestation policy that's going to ensure a robust and comprehensive framework for determining the fundamental spread and assessing that the matching adjustment can be earned with a high degree of confidence. The CFO is going to be reliant on this as the one signing the attestation.
• Philip: So that issue of CFO reliance is a really interesting one. By directing the attestation requirement to the top of the house, to the CFO, the PRA is signalling a couple of things. Firstly, this is serious and important. The PRA has made the point throughout its various publications on this subject that the matching adjustment creates Tier 1 capital and so it has to be looked at in the same light. There needs to be a commensurate degree of rigour as you might find with a Tier 1 issuance, even if there is no asset by asset approval requirement.
  Secondly, personal responsibility is at the core of this approach. The PRA is placing this requirement on CFOs where the power to influence behaviour and systems is typically greatest, but is also expecting senior management to self-police, knowing that the SMF conduct rules and the PRA's related powers will focus minds. Probably, for a simply invested matching adjustment portfolio where everything is in corporate bonds and the insurer can look at the PRA's basic fundamental spread, this attestation may not be very onerous or difficult, but it's very easy to see how things could get significantly more tricky for a CFO, for example, where an off-cycle attestation is required as a result of a big transaction, perhaps in circumstances where a large portfolio of new assets are coming onto the insurance balance sheet and there is no established benchmarking, or in relation to investments in more structured assets. In these cases, we can see how the attestation regime may actually influence deal behaviours, for example potentially reducing the attestation burden by staggering asset transition.
• Kate: Yes and I can see that there will be a lot to dig into around some of those more complex scenarios. And if personal accountability is at the heart of all of this, Claire, what can CFOs do to stay safe when they're giving attestations?
• Claire: So, attestations are a popular tool for regulators because they really drive individual accountability for key issues. Given the formal status that attestations have, there are high stakes for the individual senior managers giving them, so it's essential that they have a strong basis for the commitment being given. And by high stakes obviously what we're talking about is the potential for sanction for the attesting individual under the SMCR (Senior Managers and Certification Regime), or perhaps for the firm if there's an incomplete or false attestation given.
  Now both the PRA and the FCA (Financial Conduct Authority) have already said a fair amount on what they expect on attestations, either through final notices or through thematic work that they've done looking at how firms and individuals have made attestations in the past. So, a few things to think about. Firstly, you'll want to ensure that there is a well-designed programme of work to support the attestation with clearly defined governance, accountabilities and roles and responsibilities, so everyone in the firm is clear how the attestation and the work to support it will be delivered and what reliance is being placed on other individuals within the firm. While it is the CFO who's going to be giving the attestation to the regulator, they're likely to be relying on input from a number of different functions and senior individuals when doing so, such as the Chief Actuary or the Chief Risk Officer. So one thing to consider is whether sub-attestations may be required. It's quite common to see firms putting in place an accountability matrix, setting out how the attestor has relied on others within the business to provide assurance. And of course, there may also be a need to rely on external sources of information, so again, there will need to be rigour around internal validation of that externally sourced information.
  Now, given the importance of the matching adjustment to the firm, thought should also be given to the appropriate governance for decision making. While it is one person who's being asked to give the attestation that doesn't mean the decision making authority should sit with them. Firms will need to think about the role of the board and the executive team and decide what is the most appropriate level at which to review and sign off the fundamental spread and matching adjustment within the firm.
  Now, one thing we also suggest that firms think about is what specific assurance activity might be required ahead of the attestation to give the CFO comfort when signing on the dotted line. This might include risk or internal audit reviews of particular aspects of the process. Materials that are generated by routine internal audit work or compliance monitoring can be used as part of the process as well, but really shouldn't be seen as a substitute for bespoke assurance work where that's useful. Now, given the breadth and depth of activity that may be required for the CFO to gain the necessary comfort ahead of signing the attestation, this whole programme of work should be well planned to ensure that there is sufficient time for it to be completed and tested and for the attestor to review it and raise any questions or concerns ahead of the deadline for submission of the attestation.
  And finally, of course, it is essential that robust records are kept to show the basis upon which the attestation has been given. Attestors should always assume that the PRA may request sight of all of the underlying records at some point in the future.
• Kate: Thank you. Yes, and as you said, if it isn't written down, it didn't happen. Which calls to mind that old philosophical thought experiment: if a tree falls in a forest and no one is around to hear it, does it make a sound? On that note, we're going to leave you all in peace. We'll be back soon with more from the A&O Shearman insurance-focused podcast and we'll be covering topics such as AI and insurance and enforcement themes. Look out for all of that. Thank you for listening and goodbye.