Illiquidity premium
The extra yield paid by an asset that cannot easily be sold, which an insurer can capture without additional risk when its liabilities are predictable.
Since January 1, 2016, Article 77b of the Solvency II Directive has let an insurer raise its discount rate if it assigns an asset portfolio to liabilities with no surrender option. What it captures that way is the illiquidity premium. An investor who gives up the ability to sell demands extra compensation. That premium is one of the few sources of yield an insurer can capture without increasing its real risk, on one strict condition: its liabilities must be predictable enough in amount and timing that it will never be forced to sell. Annuities in payment meet that condition, a savings contract surrenderable at any time does not, and it is that distinction, not the nature of the asset, that governs prudential treatment. The European regime expresses this through the matching adjustment. It permits a portfolio of liabilities to be discounted at a rate lifted by the premium observed on the assets backing it, subject to strict matching, exclusive assignment and no surrender options. The price of the privilege is permanent discipline: the benefit falls away as soon as the matching conditions are breached. That pairing, a premium granted against a constraint kept, is what makes the mechanism prudentially defensible rather than a favor.
The matching adjustment set out in Article 77b of Directive 2009/138/EC, applicable since January 1, 2016, makes the uplift in the discount rate conditional on the exclusive assignment of an asset portfolio to liabilities with no surrender option. The supervisor verifies that condition continuously.
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