In the past 12 months or so, the Prudential Regulation Authority (PRA), the UK insurance regulator, has increased its scrutiny over the use of funded reinsurance, a type of reinsurance many life insurers use to offset some of the longevity and investment risk they acquire when entering into bulk purchase annuity (BPA) transactions.
By taking both assets and liabilities off of life insurers’ books, funded reinsurance increases life insurers’ solvency ratios and enables them to bid for larger deals, more deals, or both. It also helps remove volatility from balance sheets, enables better asset-liability matching and removes the burden of administering pension scheme risks.
But funded re plays a small role in insurers’ PRT risk offset strategies. Fitch Ratings forecasts from 2024 suggested that funded reinsurance will have supported less than 30% of insurers’ bulk annuity premiums by 2026.
The PRA is concerned, however, that such strategies place additional potential risks on the insurers in the event of a recapture scenario.
Regardless, the PRA has issued a series of cautionary statements on the practice, including a “Dear CEO” letter last year that set out the regulator’s expectations for bulk annuity providers to limit their exposure to the strategy.
The most recent utterance came in a speech by Gareth Truran, Executive Director for Insurance Supervision, who explained that the PRA had been gathering intelligence about how insurers and reinsurers conduct such transactions and how the risks are being managed.
In his speech, he articulated the PRA’s concern about the suitability of some non-traditional reinsurance counterparties, some of them having connections to alternative asset managers, that are offering to take on those risks.
“These transactions often involve counterparties with business models more heavily focused on private asset origination rather than traditional reinsurance, with higher concentrations to illiquid investments which may have more correlated risk of default,” he said at the Westminster and City Annual Bulk Annuities Conference at the end of April.
Truran said the PRA is also concerned that some insurers who migrate their pension assets and risks to reinsurers don’t have the buffers in place to recapture those liabilities again should the counterparty default.
He noted in his speech that previous warnings had made little apparent difference in improving the quality of insurers’ activities in this area.
“While our expectations were designed to set important baselines for prudent risk management practices, they have not so far appeared to materially alter the outlook for funded reinsurance volumes, nor do they appear to have prevented a trend towards weaker collateral standards.”
The PRA’s concern has been triggered in part by the record-breaking growth of BPA transactions in the UK over the past few years. Truran said the market is likely to see more than 300 contracts signed this year and cited LCP data that estimates the combined value of buy-ins and buy-outs will exceed £60bn by 2027.
With increasing interest in PRT, it’s likely that funded reinsurance will be used more “without adequately recognising the inherent uncertainties and risks involved”, Truran said.
Those fears may be exaggerated. Rishikesh Sivakumar, Director at Fitch Ratings, pointed out that funded reinsurance is used as a way of enabling an insurer to bolster its capital capacity when putting together large deals.
Only a portion of the assets and liabilities of a scheme tend to be covered by funded reinsurance, if the insurer can get a price good enough to balance the risks of doing so and only if that frees up enough capital to enable it to write other business or meet regulatory solvency rules.
In the past couple of years, however, new PRT business has been biased towards smaller schemes, in which insurers have the capital to cover all the liabilities.
“The small scheme transactions have been very prominent… which means for these transactions, funded re is definitely not used because the insurers don’t need much capital to write these,” Sivakumar said.
Neither does he expect funded reinsurance to make up a larger part of the PRT market in the future, even as it is projected to grow. He believes it will simply remain an “optionality” for larger deals and that, consequently, Fitch is not “concerned” about the potential for additional risks to accumulate in the space.
The factor that is more likely to influence the role played by funded reinsurance in the PRT space in the next six months, he said, will be an on-going PRA stress test of life insurers.
The Life Insurance Stress Test (LIST), announced in 2023, is designed to assess the industry’s solvency, liquidity and resilience to adverse scenarios, and then to subsequently study the efficacy of their risk management provisions.
One of the three scenarios tested will be insurers’ resilience to recapturing collateral of their “most material funder reinsurance arrangement”.
The results of LIST will be published in the fourth quarter of this year and the market is watching.
“That could sort of inform the future policy direction of the PRA, so we are quite interested to see what happens,” said Sivakumar.
Despite the PRA’s interest and concern about funded reinsurance, Sivakumar doesn’t expect the strategy to be dropped from trustees’ shopping list of options. Such structures can, after all, benefit scheme administrators if they are struck at a lower price than using longevity swaps, reinsurance or other offset structures, for example.
“We don’t think trustees would not deal with companies who do funded reinsurance, but they would want to make sure that those companies have sufficient protection and safeguards in place before they feel comfortable in dealing with them.”
