General Insurance Article - PRA increases insurer supervision on Funded Reinsurance

 The Prudential Regulation Authority (PRA) implemented a new Supervisory Statement on 26 July 2024. It was issued with a ‘Dear CEO’ letter to UK life insurers and focussed on the use of FundedRe across the industry.

 The new guidance is effective immediately and insurers are required to provide various reporting to the PRA by 31 October 2024, including a summary of any areas of existing non-compliance.

 Under the new requirements, insurers are required to adopt prudent risk management frameworks in relation to FundedRe transactions, along with greater ongoing disclosure to the PRA. At this stage however, the PRA has not gone as far as setting explicit limits on the use of FundedRe and instead will rely on the principles of prudent risk management.

 With appropriate risk controls in place, FundedRe transactions can support greater new business volumes in the bulk annuity market over time.

 Early indications from insurers are that this latest guidance is unlikely to have a material impact on pricing. However, we expect that trustees and sponsors will want to carefully consider insurer due diligence before and following their transaction.

 In Aon’s view, the use of FundedRe can be a useful tool for insurers to enable competitive pricing and capital efficiency, particularly for larger transactions, as well as manage risks across their portfolio. However, we do welcome the focus from the PRA to ensure appropriate controls are in place to maintain policyholder protection and we hope that the lack of public disclosure will improve in future.

 What is Funded Reinsurance?
 Reinsurance is a method of risk transfer, frequently used by life insurers. Traditionally, this was primarily used to transfer longevity risk to the global reinsurance market but is also now increasingly being used to transfer some asset risk. The reinsurance of asset risk (or both asset and longevity risk on a combined basis) is known as ‘FundedRe.’

 FundedRe is normally arranged by the payment of an upfront premium to the reinsurer in respect of part of the liabilities under a bulk annuity. The reinsurer then pays income back to the annuity provider over time in respect of the pension benefits due. Without further action to protect the annuity provider, this could involve a substantial counterparty risk exposure to the reinsurer, which is typically based in another regulated insurance market outside the UK (e.g. Bermuda). As we describe below, in practice there are risk mitigations in place for this.

 We often see FundedRe used by an insurer as part of a large transaction where they are reinsuring the asset and longevity risk for a subset of the deal. This can allow the insurer to write a larger transaction at a lower capital strain.

 Why is it becoming more popular?
 We are aware of five bulk annuity providers that have recently used funded reinsurance, to varying degrees, although public disclosure in this area is particularly limited.

 There are a number of factors that can make FundedRe attractive:
 • Price optimisation – most reinsurers operate in territories with different regulatory regimes to the UK. This can mean that the reserving cost is lower for some tranches of business (e.g. longer-dated liabilities). Accessing this through FundedRe can allow the UK insurer to optimise the overall bulk annuity price.
 • Increased capital capacity – with rising demand for bulk annuities, UK insurers are looking for ways to increase their capacity for writing transactions, particularly the largest transactions. Through FundedRe, the insurer can reduce the amount of its own capital that is required to back a new transaction.
 • Support for asset sourcing – FundedRe allows insurers to access a greater pool of investment opportunities via the reinsurer, giving faster overall asset sourcing and potentially a better overall yield. When writing a bulk annuity transaction, the insurer needs to find appropriate assets to back the new liabilities they have taken on. The assets need to match the liabilities being taken on, but also to deliver a yield that supports a competitive annuity price. With greater demand for bulk annuities, asset sourcing has become a key challenge.

 Risk mitigations

 International solvency regimes
 A key aspect is ensuring the continued creditworthiness of a reinsurance partner which is based outside the UK and is therefore subject to different reserving requirements. If the reinsurer were to fail, the liabilities would fall back to the UK insurer to meet. However, there are several safeguards here.

 The reinsurers involved in FundedRe transactions are typically large multinational insurance groups, with the reinsurance placed in a group’s Bermuda insurance company.

 Bermuda has a well-established insurance solvency regime, which requires reserves against known liabilities and contingencies. The regime has been granted equivalent status to Solvency II by the European Insurance and Occupational Pensions Authority (EIOPA). The regime has recently been strengthened, including more prescription over the rate of return assumed for determining reserves, which brings it closer to the UK and EU regimes.

 Collateral
 The reinsurer counterparty risk will be mitigated via collateral pools backing the funded reinsurance deal. The reinsurer will hold ring-fenced collateral which would be passed to the annuity provider in the event of reinsurer failure. The reinsurance treaty will include detailed requirements for the quality and magnitude of asset holdings within the collateral pool.

 Insurers pay particular attention to:
 • The amount of total collateral posted (in some cases ‘over-collateralisation’ can be used to provide additional security);
 • The ability of the insurer to enforce the collateral (including the triggers that qualify as reinsurer failure events); and
 • The nature of the assets posted as collateral (including credit quality and whether the assets could be used in the annuity fund if recaptured by the insurer upon a reinsurer failure event – this will depend partly on the scope of the insurer’s internal model approved with the PRA).

 In addition, UK insurers are required to make explicit allowance for counterparty risk in their reserves.
  
 Why is the PRA concerned?

 The PRA has been flagging potential risks with FundedRe for some time, in particular:
 • Collateral portfolios – the PRA had concerns over the quality of some collateral pools and the risks associated on recapture.
 • Resource availability on recapture – the PRA identified a risk that some insurers lacked the financial and operation resources to deal effectively with a recapture event following a reinsurer default.
 • Assessment of risk – the PRA has flagged that adverse events could impact the assets of the insurer and their reinsurers at the same time (i.e. risks are highly correlated), and set requirements for the measurement of risk and the reserving for the impact of a recapture or failure of reinsurance.

 While the PRA do report it has seen some improvement over 2024 in relation to risk management, it remained concerned that the rapid growth of the bulk annuity market, and with it increased use of FundedRe, could lead to a build-up of risks in the industry.

 Actions for insurers

 The PRA has requested that insurers provide to them the following information by 31 October 2024:
 • Self-assessment analysis: an overview of the insurer’s current practices against the new requirements and any areas of current non-compliance.
 • Limits: summary of the counterparty limits for individual reinsurers, correlated reinsurers and an overall limit on FundedRe.
 • Remediation activities: a timeline of the activities expected to fully comply with the new requirements.
 • Level of confidence in modelling: an overview of the perceived confidence of the insurers’ internal modelling for FundedRe.
 • Risk appetite: summary of the steps the insurer’s Board has taken to limit its risk appetite for FundedRe.

 In addition to the above, the PRA has confirmed that their 2025 stress testing exercise of the UK insurance market will include a specific scenario covering a recapture event of FundedRe arrangements. It is expected that summary results of the exercise will be published in Q4 2025.
  
 Additional insurer reporting and governance
 The new requirements place a number of additional requirements on insurers in relation to modelling FundedRe, calculating the risks involved, ensuring appropriate risk frameworks are agreed at Board level and reporting to the PRA.

 Additional costs for insurers
 The PRA did acknowledge that for some insurers, the additional requirements would increase the costs of compliance. However the PRA consider this as proportionate given the benefits of greater risk controls.

 Throughout the consultation responses, it is clear that a number of respondents were seeking to reduce the additional modelling and governance requirements.

 The PRA dismissed most of the feedback on the grounds that the additional requirements were necessary to provide them with confidence in the risk management of FundedRe transactions.

 Limits on counterparty exposure
 Insurers are now required to set internal limits on single counterparties and on the use of FundedRe at an aggregate level. These limits should be set with reference to any concentration risks, the likelihood of recapture and the quality of the collateral pool available on recapture. The intention is to avoid insurers being exposed to a small number of correlated reinsurers which would intensify the negative impact of any adverse shock events.

 Whilst the PRA has not set any explicit limits, it does refer to the Prudent Person Principle that underpins the risk control framework within an insurer. The PRA very clearly refers to its statutory powers to take further action if it does not believe an insurer is meeting its expectations on risk management procedures.

 Collateral policy expectations
 Insurers are also now required to set clear collateral policies for funded reinsurance transactions, including developing a recapture plan for each individual deal and ensuring the risks associated with the recapture of assets are appropriately assessed.

 Where assets are expected to be eligible for the insurer’s Matching Adjustment portfolio on recapture, insurers should ensure this is monitored regularly and that the haircuts applicable to any illiquid assets are understood.

 Following the consultation period, the PRA was keen to stress that the new proposals intentionally do not distinguish between differing financial strengths of potential reinsurer entities. The PRA consider that the risks, such as the risks associated with collateral pools, could arise irrespective of the strength of the counterparty.
  
 Impact on the UK bulk annuity market
 The concept of FundedRe is not new to the industry. It has however been used more widely by several insurers to support UK bulk annuity pricing in recent years.

 A number of larger UK bulk annuity providers have also been using FundedRe internally for some time – reinsuring risks to subsidiaries in other territories within their own group, partly to manage risk diversification across the group.

 Used in moderation with appropriate risk mitigations in place, we believe FundedRe can help support bulk annuity capacity in the UK during a period of significant demand from defined benefit pension schemes.

 We welcome the Supervisory Statement from the PRA to formalise the risk management framework for FundedRe transactions. The new requirements do not go as far as setting explicit limits on the use of FundedRe, but instead rely on the framework of strong and prudent risk management and on PRA oversight. The PRA has clearly set expectations that it will seek greater risk management controls if it is not sufficiently reassured by insurer behaviour.

 Whilst the new requirements are a positive step, we continue to be concerned about the lack of public disclosure from insurers regarding FundedRe. We hope the continued attention to this area leads to more public disclosure to provide greater reassurance to customers. Despite the lack of disclosure, it is clear that insurers already do spend considerable time on risk controls in this area, and the PRA requirements should drive more consistency in their stringency.

 Finally, we expect that this is an area that will continue to evolve, as the PRA continue to keep a close eye on developments and as the market continues to innovate to support the strong demand for bulk annuities. Early indications from insurers are that this latest set of developments is unlikely to have a material impact on pricing. However, we do expect that trustees and sponsors will want to carefully consider appropriate insurer due diligence before and following their transaction – including the role of FundedRe as a component of overall risk exposure.