On November 16, 2023, the Prudential Regulation Authority (PRA) published consultation paper CP24/23: Funded reinsurance, setting out its proposed expectations in respect of life firms entering into or holding funded reinsurance arrangements as cedants.

The PRA recognises that such reinsurance arrangements are an important part of risk management. However, the PRA sets out its concerns in respect of counterparty risks which may be underestimated, as a result of the counterparty concentration risk; the risk profile of the counterparties (who may be exposed to illiquid investments); the uncertainty around the effectiveness of management actions in stress, and in particular, the fact that the potential for the recapture of such arrangements is assumed to be remote such that this risk is not fully priced into the transaction.

Background

Funded reinsurance is a form of collateralised quota share reinsurance which transfers part or all of the asset and liability risks associated with a portfolio of annuities to a third party.

The PRA notes that in recent years there has been an increase in the use of funded reinsurance arrangements in the UK life insurance market to support bulk purchase annuity (BPA) business.

The PRA has identified a structural shift in the global life insurance sector, with the emergence of cross-border funded reinsurance arrangements and newer counterparties which are potentially less diversified and have a similar credit focused business model. The PRA fears that such trends could lead to a concentration of exposure in a small number of funded reinsurance counterparties with a highly correlated risk of default. This trend, combined with the competitive nature of the BPA market, which means that the desire to achieve the best pricing could lead to dilution of risk management standards, may lead to a deterioration in the quality and nature of the collateral agreed with a counterparty.

CP24/23 sets out in Appendix 1 a new draft supervisory statement (SS) – Funded reinsurance (Appendix 1), outlining regulatory expectations on:

1. Management: ongoing risk management of funded reinsurance arrangements;
2. SCR: modelling of the solvency capital requirement associated with funded reinsurance arrangements, including recapture of matching adjustment (MA) portfolios; and
3. Structuring: how firms should consider the entering into and structuring of funded reinsurance arrangements.

Proposals

The PRA proposes to establish further expectations on funded reinsurance transactions, in addition to those requirements provided for in Solvency II (including SS1/20: Solvency II: Prudent Person Principle (PPP)). The further expectations will seek to ensure both: (i) the efficient risk management of counterparty exposures (including internal counterparty limits and collateral policies); and (ii) that firms have the financial resources to withstand any single funded reinsurance arrangement recapture or multiple recaptures from correlated counterparties under stressed conditions.

Counterparty internal investment limits

The PRA proposes that firms should set additional limits on their exposures to funded reinsurance counterparties, over and above those expectations on risk tolerance limits set out in SS1/20.

The PRA suggests the ‘normal’ approach to asset concentration limitations (i.e. by measuring the market value of particular assets relative to the rest of the assets held to support policyholder liabilities) is “less appropriate” for funded reinsurance since on recapture, UK cedants would see an increase in capital requirements associated with the recaptured business. Accordingly, the PRA suggests that firms adopt an ‘immediate recapture’ metric which would measure the impact on a firm’s SCR ratio where all ceded business with a counterparty is immediately recaptured, ignoring both the likelihood of such an event and any mitigating management actions. The “immediate recapture” metric applies only for the purpose of setting internal investment limits. Firms will be expected to consider a number of factors, including the nature of the collateral they may inherit; “broader factors” than just credit ratings as regards counterparty risk; operational capabilities on recapture; and a limit based on simultaneous recapture from multiple highly correlated counterparties.

Collateral policy

The PRA proposes that firms have in place clear collateral policies to enable the firms to formulate an “execute-able” recapture plan under stressed conditions. Noting that firms are increasingly accepting illiquid assets to back collateral for funded reinsurance policies, and that such assets can be difficult both to value and sell, the PRA proposes new expectations on firms in relation to their collateral policy for illiquid assets in collateral pools. As regards illiquid assets, the collateral policy must include, as a minimum, approaches to credit assessments, valuation methodologies, MA eligibility conditions monitoring, SCR modelling of such assets and investment management approaches on recapture.

Recapture plans

The PRA will require firms holding or entering into funded reinsurance arrangements to document a Board-approved recapture plan for funded reinsurance arrangements, enabling firms to make robust forecasts of the costs of such recapture under stressed conditions. The recapture plan should form an integral part of a firm’s funded reinsurance risk appetite, both in terms of volume and nature of the arrangements.

The recapture plan should cover as a minimum:

• approaches to monitoring the financial condition of the counterparty to the funded reinsurance arrangement, and activities carried out if a deterioration is identified;
• a step-by-step process for achieving the recapture of all the assets and liabilities from relevant counterparties, taking into account all applicable laws;
• a step-by-step process for asset transfers by asset class, including contract novation (e.g. derivatives);
• actions to achieve/ensure MA compliance where recapture into the MA portfolio is assumed; and
• areas of uncertainty in the recapture process.

The PRA also expects firms’ recapture plans to articulate a clear and structured decision-making process for assessing whether ceded business should be recaptured when optional contractual termination event clauses are triggered.

Solvency capital requirement

The PRA’s main concern in this area relates to firms using internal models to calculate their counterparty risk SCR, especially where the internal model may have been approved before funded reinsurers became material counterparties for those firms.

The PRA highlights that such internal models should be continually reviewed to ensure they remain appropriate to accurately calculate a counterparty SCR for funded reinsurance. Such reviews should include looking at (i) the probability of default assumptions, (ii) loss given default assumptions, (iii) the effect of a downgrade of the counterparty, (iv) justification of the inclusion of any management actions, (v) the loss-mitigating effect of collateral (including any mis-match risk) and (vi) recapture within MA portfolios.

On point (vi), the PRA proposes to set an expectation that firms assume that assets and liabilities associated with funded reinsurance be recaptured outside of an MA portfolio, unless the firm is able to clearly demonstrate that such an inclusion would not result in MA non-compliance in base conditions and stressed conditions. Where this can be demonstrated, the PRA will additionally expect that calculations take into account the rebalancing and trading activities necessary to comply with the MA conditions.

Risk assessment

The PRA identifies as unsatisfactory the approach of certain firms which assess reinsurance structuring on a ‘pass-fail’ basis, under internally-approved minimum guidelines on each specific area of the reinsurance contract. The PRA believes such an approach might not allow for aggregate measurement of risks generated by the funded reinsurance contract as a whole. Accordingly, the PRA expects firms to have a quantitative risk assessment process to identify and measure the specific risks it might incur when negotiating the funded reinsurance, for the purposes of internal limits and risk management. This assessment is expected to include an approved internal contractual risk appetite statement setting out the maximum acceptable loss at the individual funded reinsurance contract level; and is expected to reflect all forms of basis and collateral mismatch risk, including stressing risk factors that would lead to significant basis and collateral mismatch risk over an appropriate time horizon.

The PRA also expects firms to have internally approved minimum guidelines on contractual features for funded reinsurance transactions which they would apply when deciding whether to enter into a funded reinsurance arrangement. This would include, but is not limited to, the approaches to termination clauses, substitution rights for collateral assets, valuation approaches, concentration limits, and choice of applicable law. The guidelines should also cover investment guidelines taking into consideration the PPP and the firm’s internal investment strategy. The PRA expects firms to document the rationale for the choice of the minimum guidelines adopted in their policies.  The PRA also expects firms to use clear risk-based collateral haircuts linked to the risk being addressed.

Next Steps

The PRA invites feedback on the proposals set out in the consultation paper, which closes on February 16, 2024.