UK regulator the Prudential Regulation Authority (PRA), part of the Bank of England, wrote to life insurers to highlight the key risks about the use of funded reinsurance (FundedRe).
FundedRe involves transferring the significant risks of both asset/investment and longevity to a reinsurer, effectively transferring all the substantial risks associated with a Business Portfolio Administration (BPA) transaction.
In an increasingly competitive market for BPA in the global life insurance industry, market participants are turning to innovative arrangements to address key challenges.
Recent conversations with industry experts indicate that these arrangements are primarily driven by capital deployment restrictions, limits on asset origination capabilities, and the pursuit of market presence growth, the regulator noted.
The demand for BPA is expected to witness a significant upswing following recent improvements in funding ratios. However, it is essential to consider the associated risks in light of the rapid structural shifts occurring within the global life insurance market.
The International Association of Insurance Supervisors (IAIS) has highlighted increased uncertainty stemming from evolving business models and the emergence of new market entrants.
Recognising the potential risks posed by counterparties in this evolving landscape, the Prudential Regulation Authority (PRA) is actively mindful of the likelihood of underestimating counterparty risks faced by UK life insurers.
The PRA is closely monitoring the risk of UK life insurers underestimating counterparty risks in response to evolving market dynamics. The PRA has identified four key areas of concern.
Firstly, the probability of recapture (PR) is high due to the presence of new reinsurers with rapidly growing business models and existing reinsurers whose operations are increasingly concentrated. Historical default risk data may not adequately capture the complexities of recapture risk.
Secondly, the shift towards credit-focused business models increases the likelihood of credit cycle shocks impacting multiple reinsurers simultaneously, leading to correlated PR.
Thirdly, loss given recapture (LGR) poses a significant risk as credit cycle shocks could result in the simultaneous deterioration of both the reinsurer and the collateral portfolio.
Lastly, management actions during recapture, such as hedging or rebalancing, may prove ineffective, particularly in the midst of a credit cycle stress when replacement contracts may not be readily available. These risks necessitate careful risk management and monitoring by UK life insurers to mitigate potential vulnerabilities.
The review conducted by the PRA has identified significant shortcomings in several areas related to recapture risks in FundedRe transactions during times of market stress.
Firms exhibited deficiencies in their practices concerning structuring, risk management, and capital requirements, which were found to be below the PRA’s current policies and expectations. Two key sources of risk were identified.
Firstly, the potential for sub-optimal collateral portfolios, where firms recapture portfolios with depressed values and inadequate assets that cannot be effectively transformed into their preferred portfolio. Structural features of contracts were identified as contributing to this risk.
Secondly, the sufficiency of firms’ resources, both financial and operational, was found to be at risk during recapture. Although there has been improvement in internal risk frameworks and models, there is a need for closer alignment with contract terms and a reduced reliance on management actions under stress.
Addressing these shortcomings is crucial to ensure the safety and soundness of the PRA and to protect policyholders, and firms are urged to take appropriate actions to enhance risk management in these transactions if they wish to participate in this market, the regulator noted.
