The Matching Adjustment and Volatility Adjustment
Two Solvency II tools let insurers discount long-term liabilities at a higher rate than the risk-free curve, recognizing that if assets and liabilities are held to maturity, short-term market swings in bond value do not have to be booked.
Prerequisites: Solvency II and the Standard Formula
Under Solvency II, insurers discount their future liability payments back to a present value using a risk-free yield curve, and a lower discount rate makes liabilities look larger. But an insurer holding long-duration bonds to fund long-duration annuity payments does not actually care about day-to-day swings in those bonds' market price, because it plans to hold them to maturity and collect the coupons and principal exactly when the annuity payments are due. The matching adjustment lets an insurer add an extra spread on top of the risk-free rate when discounting liabilities, provided its asset and liability cash flows are closely matched in timing and the assets are held to maturity — this avoids booking artificial volatility in liabilities that would never actually be paid at today's market price anyway.
The volatility adjustment is a milder, blunter version aimed at insurers whose asset-liability matching is not tight enough to qualify for the matching adjustment: it adds a smaller, regulator-published spread to the discount curve for all eligible insurers in a market, intended to offset temporary bond-spread widening during market stress rather than a structural, permanent mismatch.
Both adjustments raise the discount rate applied to insurance liabilities above the pure risk-free rate, on the reasoning that insurers who hold matching assets to maturity should not have to book paper losses from short-term market volatility they will never realize.
Further reading
- EIOPA, Guidelines on the Matching Adjustment and Volatility Adjustment