Regulatory Review of Funded Reinsurance Arrangements

On 15th June 2023, the PRA published a letter addressed to the Chief Risk Officers of life insurers to provide feedback from their thematic review of funded reinsurance (FundedRe1) arrangements in the UK Life insurance market. FundedRe are common in bulk purchase annuity (BPA) transactions, where the market has grown significantly due to recent improvements in funding ratios of pension schemes. The PRA is concerned that the continued use of funded reinsurance would render the payment of a significant value of UK pensions dependent upon the strength of a concentrated and correlated group of reinsurers. The PRA has identified weaknesses in several areas of the FundedRe transactions including counterparty risk, inadequate collateral arrangements, and risk management. We outline key findings from the review and provide an insight into addressing the inadequacies identified.

Counterparty risks

The PRA has identified the following four components of counterparty default risk that it considered are modelled inadequately by life UK life insurers:

1. Probability of recapture (PR) – historical probability of default may not truly reflect the underlying risks as the market is made up of new reinsurers or existing reinsurers with heavily concentrated exposures.

2. Correlated PR – This is the risk that the credit cycle shocks affect multiple reinsurers at the same time as the business models of the reinsurers are increasingly credit focused.

3. Loss given recapture (LGR) – FundedRe arrangements tend to give rise to ‘wrong way’ risk, i.e. a credit cycle shock causing the deterioration of both the reinsurer and collateral portfolio at the same time.

4. Management actions – Certain management actions might not be effective on recapture, e.g. replacement contracts may not be available.

Main Thematic Findings

The PRA is concerned that the firms’ practices showed some material shortcomings in several areas including structuring, risk management, capital requirements when assessed against the PRA’s current policies and expectations. Two key sources of risk identified were:

a) Sub-optimal collateral portfolios – the PRA identifies the below structural features of the funded Re transactions that may leave the firms with sub-optimal portfolios (unmatched or with inadequate assets) on recapture:

• Under-collateralisation – contracts collateralised at less than 100% of the premium.

• Asset-liability mismatch – duration mismatches between the assets in the collateral pool and the liabilities ceded, and absence of matching key rate durations or cashflow matching.

• Absence of adequate valuation haircuts to the assets posted as collateral.

• Termination triggers based on solvency ratios of reinsurers were set at levels that were not sufficiently prudent.

• Infrequent collateral balancing requirements and the absence of ad-hoc options for rebalancing.

• Contractual triggers for strengthening of the collateral package at certain events not set at appropriate levels.

b) Resource Sufficiency – The second source of risk arises from the firm’s insufficiency (financial and operational) on recapture. While firms have shown improvement in their internal risk frameworks and internal models, the PRA has identified the below shortcomings:

• Counterparty risk limits were set at a level to prevent solvency ratio to drop below the internal solvency coverage ratio appetite.

• Reliance on management actions that may not be viable in all market conditions.

• Also, firms need to fully understand the scope of potential actions and the estimated cost of such actions under stress.

• Inadequate scenario and stress testing in counterparty risk to understand the level of rebalancing and trading required under stress.

• Not considering the reasons that could lead to recapture other than the default of the reinsurer.

Next Steps

FundedRe transactions are likely to be subject to increased scrutiny from the PRA and it has asked all firms to notify them of any material (gross premium in excess of £200mn) transactions entered from the date of issuance of the letter. To address the regulatory concerns, firms should conduct a thorough risk assessments of their FundedRe arrangements and ensure adequate collateralisation, and management of counterparty risk. The specific remedial actions identified by the PRA includes:

• Setting dynamic counterparty risk limits considering the credit rating, solvency coverage and business model of the reinsurer.

• Devising a clear framework for setting valuation haircuts to reflect underlying risks in the collateral portfolio. This can be beneficial in addressing wrong way risk and wider ALM considerations, such as unhedged currency mismatches or rebalancing needs..

• Consider embedding stricter ALM principles (key rate duration or cashflow matching) to avoid large rebalancing actions in stress.

• Performing adequate scenario and stress testing to understand the scale of the rebalancing and trading required in the event of stress.

• Consider ‘immediate recapture’ (no management actions) to understand the impact on firm’s solvency coverage ratio in the event of recapture.

Overall, the PRA expects firms to have appropriate procedures and processes in place to ensure that the risks in the FundedRe transactions are within their internal risk appetite and can be monitored effectively going forward.