Published with kind permission of www.insuranceerm.com. Original article December 2025:
https://www.insuranceerm.com/analysis/assessing-risk-in-highly-predictable-cashflows.html
The PRA’s highly anticipated Solvency UK reforms (SS7/18,PS10/24, following CP19/23) expanded Matching Adjustment (MA) eligibility to include assets where the cashflows are not completely fixed, but are “Highly Predictable”(HP).
In principle this helps UK insurers who seek assets which provide an attractive yield under the Solvency UK regime. The PRA has defined HP to mean the cashflows which are contractually bounded to a finite range by timing and amount with issuers retaining the right to change the cashflows within this range. The PRA expects firms using these assets to demonstrate the risks to the quality of matching are not material.
There are several asset types with HP cashflows, some of which are shown below:
· Callable bonds – the issuer has the right to change the timing of the asset redemption payment in accordance with a set of specified timings
· Leases – with contractual rent reviews with upwards adjustments being subject to contractual limits
· Construction phase debt or leases – where there payment schedule is contractual and bounded
The main reason to invest in these assets is the higher yields. For example, “callable bonds have both higher yields and lower market prices than matched non-callable bonds of the same issuer-time.” [1]
Issuers of HP assets can adjust the cashflows in accordance with the terms of the asset contract. Firms are expected to use historical data (where available) and apply economic reasoning to define how issuers would be expected to adjust their cashflows.
Using callable bonds as an example of the process required; historical evidence suggests that, prior to the 2008–2009 financial crisis, issuers - primarily financial institutions - typically redeemed these bonds at the first call date when interest rates had fallen and refinancing was financially expedient. However, during the financial crisis, despite lower rates, some issuers postponed redemption at the first call date. This reflected market dislocation, capital constraints, and regulatory requirements. Such delays were consistent with the contractual terms of callable bonds and allowed issuers to defer redemption payments during a period of extreme market stress.
Since the2008-2009 financial crisis it has become a bit more common for issuers to exercise the option to delay redemption payments, aligning first call date decisions with their best economic interests. These call decisions tend to correlate strongly with the issuer’s credit strength and interest rate movements. Deferring redemption beyond the first call date could carry some reputational risk for the issuer. For example, for weaker issuers failure to redeem at the first opportunity may signal limited financial flexibility - such as liquidity stress or an inability to refinance due to elevated debt costs- which may adversely impact the issuer’s rating outlook and/or credit rating. Conversely, for issuers with strong financial flexibility, delaying a call can be a strategic measure to preserve liquidity and mitigate refinancing risk. In volatile markets, such prudence may be viewed positively from a credit rating perspective if it reflects disciplined balance sheet and liquidity management rather than financial distress.
If interest rates rise or credit spreads increase, the yield on a newly issued asset may be higher than if the firm delays redemption of principal beyond the first call date. This gives a clear economic incentive for the firm to delay principal repayment beyond the first call date.
During periods of market volatility or capital constraints, issuers may prefer to conserve liquidity rather than redeem at the first call date and hence preserve financial flexibility. For example, in stressed markets even accompanied with a relatively low-interest rate environment (e.g. 2008 -2009 crisis), access to refinancing can be limited or prohibitively expensive incentivizing issuers to delay the redemption payment until market conditions normalize. In addition, for banks and insurers, callable instruments often qualify as regulatory capital so delaying redemption can help maintain capital ratios if replacement funding is uncertain or costly.
In a declining interest rate environment, issuers may strategically defer redemption beyond the first call date when further rate reductions are anticipated. By postponing redemption, issuers preserve the option to refinance at lower future costs, thereby optimizing debt management and minimizing long‑term funding expenses.
It is possible to construct a set of defined rules based on the market conditions and issuer credit rating at which it would be in the best economic interests of the issuer to change the timing of redemption payment. These rules should be based both on the economic interest of the issuer as well as historical data showing that they have been applied historically.
If a firm has an insignificant holding of HP assets it would reasonable to model them assuming “yield to worst” where the redemption date is assumed to be the most economically favourable for the issuer.
For more material holdings (still within the 10% threshold for HP assets) the PRA expects firms to use a probability weighted methodology. In practice, a similar methodology used for the liability cashflow calculation would be used for HP assets. Considering the callable bond example again, this would effectively mean applying the rules defined in Section 3 (above) within a stochastic economic scenario model. For example, if the call date as above depends on interest rates, credit spreads and credit ratings, these factors would be stochastically modelled to capture the resulting callable bond cashflows.
Across say 100,000 scenarios there would be 100,000 modelled sets of cashflows for each callable bond. These can then be probability weighted to produce cashflows for the callable bond for the purpose of the MA calculation. The probability weighting would be carried out in a very similar way to what is carried out for liability cashflows, with a 1/100,000 weighting allocated to each set of cashflows and the probability weighted version being used.
There are a number of limits on the use of HP assets in the MA portfolio:
1. New MA matching tests specific to portfolios with HP assets
2. Fundamental Spread (FS) add on requirements for HP assets
3. The 10% limit of MA value restriction to MA assets
To test the matching of the HP assets the PRA has introduced two new MA matching tests specifically applied to MA portfolios with HP assets.
Test 4 –MA loss test for assets with HP cashflows
· For each asset, determine the cashflow profile that results in the lowest possible MA
· Work out the loss in MA for each HP asset and sum across the MA portfolio
· The loss in MA from these HP assets should not be bigger than 5% of the total MA benefit across the entire MA portfolio
Test 5 –Modified Accumulated Cash Flow Shortfall test
· Test 1, the accumulated shortfall test is repeated with the HP assets having their cashflows extended to the longest possible term under the contract
· The value of accumulated shortfalls should not exceed 5% of the discounted liability cashflows (at risk free rate)
These tests are to be carried out monthly.
Firms who optimize the hypothecation step of the MA calculation will need to include these new tests into their MA calculations.
The issuer optionality around HP assets would be expected to be part of any additional spread such assets earn over and above fixed cashflows assets. This additional spread should not be passed through entirely to MA and some increase to the fundamental spread (FS) is expected. The PRA outlined a minimum increase of 10bps for the FS on any HP asset.
HP assets also introduce some new risks around matching, such as reinvestment risk and additional rebalancing costs. The firm should ensure these risks and costs are covered in the FS add-on for HP assets.
The amount of MA benefit that can be achieved from HP assets is limited to 10% of the total MA benefit across the whole MA portfolio.
HP assets provide access to a small range of new assets that have hitherto been excluded from insurance company investments. The spreads on these assets will be expected to be higher than the similar fixed cashflows assets, due to the additional risks.
There is a material amount of additional regulatory work required for the initial investment and ongoing management of these HP assets. But in a very competitive life insurance market, in the hunt for yield, this provides another avenue for opportunities. Every basis point counts!
[1] BoBecker, Murillo Campello, Viktor Thell, Dong Yan, Credit risk, debt overhang, and the life cycle of callable bonds, Review of Finance, Volume 28,Issue 3, May 2024, Pages 945–985, https://doi.org/10.1093/rof/rfae001
