In response to the rapid growth in the UK Bulk Purchase Annuity (BPA) market, the Prudential Regulation Authority (PRA) has put forth proposals aimed at enhancing the risk management and structuring of funded reinsurance arrangements.
The PRA’s concerns center around the specific risks associated with these arrangements, particularly the challenges in calculating the Solvency Capital Requirement (SCR) due to the perceived low probability of liabilities needing to be recaptured.
“The PRA proposes that firms should set limits to their exposures to funded reinsurance counterparties.”
The proposed guidelines emphasise the need for firms to focus on the tail risks associated with funded reinsurance contracts, highlighting the unusual ‘fat-tailed’ loss distribution characterised by infrequent but significant losses.
The PRA is seeking to clarify expectations for risk management frameworks and modeling of funded reinsurance arrangements, especially for firms using internal models to calculate their SCR.
Key among the consequential risks identified by the PRA is the counterparty credit risk. Firms engaging in funded reinsurance expose themselves to the possibility of counterparty defaults, necessitating the recapture of liabilities and the need for financial and non-financial resources to manage the recaptured risks.
The proposed collateral arrangements between firms and reinsurance counterparties are acknowledged as potential mitigators of counterparty risk, though the adequacy of collateral for liability cashflow remains crucial.
The PRA emphasises the importance of information provided during the structuring process, urging transparency that reflects the risks and uncertainties associated with funded reinsurance arrangements.
The aim is to encourage prudent behaviours and create a risk-return trade-off that supports the stability of the financial system.
The proposed supervisory standards are part of the PRA’s broader strategy to address the risks arising from the use of funded reinsurance.
With the UK BPA market predicted to witness a substantial increase, potentially reaching £90 billion, the PRA anticipates a greater reliance on funded reinsurance arrangements by insurers to meet internal targets.
The regulatory proposals are designed to provide clarity and set expectations for firms entering into such arrangements.
Pending consultation feedback, the PRA intends to assess the practical implementation of these expectations, focusing on exposures deemed to present the greatest risk.
The regulatory body will continue monitoring market practices and may consider additional measures, including tools to address sector-wide vulnerabilities, if necessary for maintaining UK financial stability.
In June, PRA wrote to life insurers to highlight the key risks about the use of funded reinsurance (FundedRe).
