Letter from Charlotte Gerken ‘Feedback on the PRA’s preliminary thematic review work on funded reinsurance arrangements’

The Prudential Regulation Authority (PRA) has published an open letter that was recently sent to the Chief Risk Officers (CROs) of insurance undertakings concerning funded reinsurance arrangements (FundedRe) in the UK life insurance sector. FundedRe arrangements involve the payment of a single, upfront premium by an insurance company to a reinsurance undertaking which in turn invests the payment to make (future) annuity payments back to the insurer. Hence, the insurer passes on the longevity and investment risks related to its own annuity payments to the reinsurer, thereby, however, taking on additional counterparty risk (if the reinsurer fails to deliver the annuity payments).
Having reviewed the FundedRe arrangements of insurance and reinsurance undertakings, the letter now summarizes the key findings from this thematic review whose objective it was to understand the motivations, nature, and risks associated with these arrangements and their impact on the PRA’s objectives.
#### The key findings and risks identified in the review are as follows:
(1) Key rationale: The use of FundedRe arrangements was found to be driven by capital deployment restrictions, asset origination limitations, and the desire for market presence growth in a competitive bulk purchase annuity (BPA) market.
(2) Potential risks: The review identified four potential risks associated with FundedRe arrangements:
– Probability of recapture (PR): New reinsurers with rapidly growing business models or highly concentrated existing reinsurers may pose counterparty risks to the insurer and which leads to a greater probability to having to recapture the risks from the reinsurance undertaking.
– Correlated PR: Credit-focused business models increase the likelihood of credit cycle shocks affecting multiple reinsurers simultaneously.
– Loss given recapture (LGR): Credit cycle shocks could lead to the deterioration of both the reinsurer and the collateral portfolio.
– Management actions: Recapture during a credit cycle stress may limit the availability of replacement contracts and render market activities ineffective.
(3) Thematic findings: The review found several areas of concern, including the following:
Firms may recapture sub-optimal portfolios with inadequate or unmatched assets, which limits their ability to effectively transform them into their preferred portfolios. In terms of capital requirements, the PRA identified shortcomings as regards the alignment between insurers‘ risk management and capital adequacy frameworks and the terms of the FundedRe contracts. The PRA also found excessive reliance on management actions during times of stress, which may not be feasible in all market conditions.
Another „shortcoming“ identified by the PRA is / was the asset-liability duration mismatch. The analysis revealed significant differences in permissible duration between the assets in the collateral pool and the ceded liabilities. The absence of a more sophisticated matching requirement increases the risk of insufficiently matched portfolios, potentially leading to complex rebalancing actions in stressed markets.
Counterparty risk limits were set in various ways, but most notable, some insurers installed static limits based on their „maximum loss to the solvency coverage ratio“, which can be quite inappropriate in case of market stress.
(4) The PRA’s expectations and its next steps: The PRA expects firms to take appropriate remedial actions based on the review findings. This includes a closer alignment between risk frameworks and contract terms, improved matching requirements, and the adoption of dynamic risk limits. Compliance with existing supervisory statements on prudent principles and reinsurance counterparty credit risk is thereby required. Also, firms are reminded to notify the regulator of any material FundedRe transactions they enter into.
The PRA plans to conduct further supervisory work on collateral risk management and internal model approaches. It is also considering the need for additional policy development and seeking industry input. The potential risks associated with FundedRe in relation to defined benefit pension liabilities will be further examined.