Funded Reinsurance (funded re) is not a new concept for life insurers but the upswing in pension risk transfer (PRT) activity in the UK in recent years has prompted an increase in its use.
Insurers are favouring funded re as it helps firms manage the market and longevity risks associated with writing bulk purchase annuity (BPA) business by reducing capital charges and therefore making PRT deals more competitive.
According to WTW, striking a funded re transaction can, in certain cases, even result in negative capital charges on new deals.
Unsurprisingly, given its growth and potential for capital optimisation, UK regulators have been carefully watching the increased use of funded re. In June 2023, the Prudential Regulatory Authority (PRA) sent a “Dear CRO’ letter to heads of risk at UK life insurers.
The letter outlined the regulator’s two main concerns from a sectoral review which it had carried out.
“One of the key risks arising in funded re is that firms recapture sub-optimal portfolios with depressed values and with limited ability to be transformed effectively to the firms’ preferred portfolio,” the PRA letter said.
The UK regulator said that the second source of risk within funded re comes from ‘recapture’ risk – that is when the ceding insurer’s assets and liabilities are returned in the event a counterparty is unable to fulfil its contract.
The PRA letter said it had observed an improvement in firms’ internal frameworks for dealing with the two risks, but these practices needed to be more closely aligned to the terms of funded re contracts.
Exact figures of the amount of funded re being written in the UK pension risk transfer and life back book markets is unclear. But Craig Turnbull, Partner at actuarial consultants Barnett Waddingham, says that activity levels have been above market norms in recent years.
“Given that there has been an unexpectedly high volume of funded re activity the PRA is concerned that it might be driven by some kind of capital arbitrage between the UK and offshore markets, though other factors such as the differential tax treatments in the UK and offshore markets could also be important drivers,” Turnbull said.
“There’s also been the widening of the asset universe in recent years and that broader investment approach is a supervisory topic that the regulators have been looking at closely,” he added.
The PRA followed up its June letter with a November consultation which closed on 16th February but Turnbull says that the regulator is unlikely to make dramatic changes to the prudential framework.
“The PRA consultation essentially proposes changes to its supervisory expectation which suggest there won’t be formal changes in the PRA rulebook but rather guidance on what is expected in terms of risk management.
“But if regulators find these changes don’t give them the comfort, they are seeking around how funded reinsurance is used then more action may follow,” Turnbull says.
Michael Abramson, Partner at Hymans Robertson, says the funded re consultation has been prompted by similar previous concerns by the UK regulators over longevity de-risking.
In 2020 the PRA ordered a reappraisal of longevity risk transfers following an upswing in transactions in the wake of Solvency II.
“The regulator was worried that some of these longevity contracts were being put with carriers outside the UK. Once they had reviewed the risk controls insurers had put in place they became more comfortable with this exposure,” says Abramson.
Funded re, however, poses a bigger challenge than longevity risk transfers. These are typically structured to pay out on the difference between the predicted and the realised life expectancy. With funded re, the whole of the liability is dependent on a third party and is typically much larger than a pure longevity deal.
According to Abramson, if a number of firms are exposed to the same reinsurer, it could pose an industry wide risk in a default scenario.
“The exposure of an individual insurer to a single funded reinsurer might be limited. But if every carrier in the UK is a counterparty of the same firm then that introduces some kind of systemic risk,” says Abramson.
Abramson says the PRA was concerned about recapture risk because of the trend for funded reinsurance deals to be backed with more illiquid types of asset than has previously been standard in the sector.
“The regulator has a number of questions about these assets, the primary one is, ‘are they matching adjustment eligible?’” he says.
The matching adjustment is a list of high quality predictable assets which can be used to ‘match’ insurers long term liabilities. It’s a category of the EU’s Solvency II regulation and a part of the impending Solvency UK regime which is expected to come into force later in 2024.
The Bermuda Monetary Authority is also consulting over its solvency capital regulation which will include a version of a matching adjustment, a move which Turnbull says is also potentially significant for the UK market.
“The Bermuda Monetary Authority is changing its rules on capital requirements for this type of business and this could have as much of an impact on the funded re market as any initiatives from the PRA,” says Turnbull.
Abramson says the BMA’s move is important because a lot of funded re trades are with counterparties based outside the UK, in non-Solvency II jurisdictions such as Bermuda.
The PRAs focus on funded re over the last 12 months has had the knock on effect of raising awareness of the practice among UK pension fund trustees says Turnbull.
He says the trustees are now paying closer attention to the reinsurance arrangements of BPA deals.
“Pension fund trustees take a lot of comfort from the fact that UK insurance firms are effectively regulated by the PRA. These trustees are now starting to take an interest in the use of funded re by buyout firms,” he says.
Abramson echoes Turnbull’s points around increased trustee awareness of funded re and he says it is important that the sector’s risks are fully understood by its potential clients.
“Funded re is an area of risk that pension fund trustees are trying to understand better. It is really important to understand that there is no direct link between a reinsurance treater and one particular policy.
It’s more important to understand the risk exposure of the insurer in aggregate to reinsurance and funded reinsurance,” he says.
