The Prudential Regulation Authority (PRA) has published a consultation paper (CP24/23) to seek feedback on a newly proposed supervisory statement titled „Funded reinsurance“ for life insurance firms engaging in funded reinsurance. Funded reinsurance involves arrangements where an insurance company (the cedant) transfers a portion or all of the risks associated with its policies, in this case annuities, to another party, the reinsurer. This transfer of risk is usually backed or supported by a pool of assets that the reinsurer holds as collateral.
The proposed new supervisory statement would thereby address concerns of the PRA about potential risks associated with the increased use of funded reinsurance arrangements in the UK insurance industry. These risks specifically include the possibility of „excessive concentration“ which arises if many insurance companies heavily rely on a few reinsurers for such arrangements. This could create a situation where the financial health of those reinsurers significantly impacts the stability of the insurance industry. Also, the PRA notes that some funded reinsurance arrangements may be highly complex and the consequences of such arrangements may not fully be overseen by insurance (and reinsurance) undertakings. Therefore, the PRA seeks to issue new a supervisory statement that would address the following key issues relating to funded reinsurance arrangements:
(1) Ongoing risk management of funded reinsurance arrangements: The PRA proposes to require firms to set up limits on their exposures to funded reinsurance counterparties to mitigate concentration risk. Also, the PRA proposes to require firms to set up a „recapture plan“ to evaluate the impact on solvency capital requirements if the arrangement was to be terminated and the original risks involving annuities would be transferred back to the insurer (recapture). Furthermore, the PRA seeks to oblige insurance companies to develop policies and procedures relating to the collateral they may post to enter into such arrangements. As the size of collateral can be substantial, it is necessary to include them in the recapture plan as well to assess the impact on these assets once a funded reinsurance arrangement is terminated (particularly if this happens under stressed market conditions). Details on the minimum requirements on a recapture plan are outlined in the supervisory statement. Finally, as increasingly more firms are using illiquid assets as collateral, the PRA proposes to require firms to assess additional risks in this context, e.g. the risk of valuation, liquidity risks, or trading risks, particularly, if such illiquid assets would have to be sold.
(2) Modelling of the solvency capital requirement (SCR) linked to funded reinsurance arrangements: As noted above, insurance firms would be required to include various elements relating to their funded reinsurance arrangements in their recapture plans. Similarly, the PRA would expect insurers to ensure that their solvency capital requirement risk assessments accurately capture material and quantifiable risks associated with funded reinsurance. This includes considerations for Probability of Default (PD), Loss Given Default (LGD), downgrade, collateral, and recapture within Matching Adjustment portfolios (MAP). This requirement particularly holds true for those firms using an internal model to assess SCR.
(3) Considerations of risks relating to funded reinsurance arrangements: The PRA has noticed that some firms use a simplistic „pass-or-fail“ method in their internal risk frameworks for evaluating funded reinsurance arrangements. This approach may not sufficiently assess the aggregate risks of the entire arrangement or may overlook the risk-reward trade-offs that are present in any such arrangement. Therefore, the PRA proposes that firms should adopt a more comprehensive quantitative risk assessment process for funded reinsurance arrangements. This process would inform the firm’s internal investment limit framework and risk strategy. It involves establishing an internal contractual risk appetite statement that outlines the maximum acceptable loss at the individual funded reinsurance contract level. The PRA thereby suggests that this assessment should cover various types of risks, like basis and collateral mismatch risks, and involve stress testing to anticipate potential significant risks over a reasonable timeframe. Additionally, the noted risks should be reflected in the arrangements.