Funded reinsurance - The PRA's final policy

[co-author: Marcus Gwyer]

The PRA published Policy Statement 13/24 (PS13/24) on 26 July 2024 providing feedback on the PRA’s Consultation Paper 24/23 (CP24/23) on Funded Reinsurance (FundedRe). PS13/24 is published alongside the PRA’s final policy in the form of a supervisory statement 5/24 (SS5/24) and a Dear CEO letter on 26 July 2024.

SS5/24 came into effect immediately and the letter to CEOs requires firms that have entered or are considering entering into FundedRe to provide the PRA with certain information by 31 October 2024 including a summary of the remediation activities they intend to carry out to meet the expectations the PRA sets out in SS5/24.

PS13/24 is relevant to UK Solvency II firms, and insurance and reinsurance undertakings that have a UK branch, where they hold, or are intending to enter, FundedRe arrangements.

The PRA found that respondents generally welcomed the PRA’s proposals to clarify expectations in relation to FundedRe and as a corollary, the proposals from CP24/23 remain substantially intact. We expect that finalisation of the policy statement should remove some uncertainty that has caused some firms to be tentative in their use of FundedRe.

The PRA’s proposals should also provide comfort to those who deal with UK insurers about the PRA’s vigilance on this issue, answering concerns that FundedRe is proliferating unchecked. Meanwhile, we expect UK insurers who use or intend to use FundedRe to be busy preparing their boards for the governance requirements that PS13/24 introduces.

Background

FundedRe has gained traction in the UK to support the expansion of the growing bulk purchase annuity market. Deals have been done, but, largely due to their unique collateral features, remain highly bespoke and carry a degree of complexity which separates them from standard longevity reinsurance.

The PRA’s continued focus on FundedRe demonstrates its concern with the current growth of FundedRe transactions, and the potential build-up of risks in the sector relating to underestimation of counterparty risks on UK insurers’ balance sheets, the capital requirements associated with these risks and the risks of recapture of the assets onto cedants’ balance sheets if a FundedRe counterparty were to default. The PRA appears to be particularly concerned about the decreasing quality of collateral offered by reinsurers and the nature of the counterparties active in the market.

The PRA’s 2023 draft supervisory statement on FundedRe provided helpful guidance on how regulatory concerns can be addressed. Here we have drawn together some of the key takeaways from the publishing of PS13/24, SS5/24 and the letter to CEOs and outline how these impact CP24/23.

By and large, the PRA’s policy on FundedRe remains intact. The most significant changes that come from PS13/24 include:

1. The addition of an overall clarifying statement confirming that firms may consider diversification between FundedRe counterparties and associated risks;
2. Clarifications on how firms will be expected to set internal investment limits;
3. Adjustments to the expectations around collateral policies to clarify how the underlying nature of collateral assets should be considered and how these policies should be documented;
4. Adjustments to the expectations around board involvement with recapture plans; and
5. Amendments to how the PRA will expect firms to use collateral haircuts and overcollateralisation.

Risk management of FundedRe agreements

The key feedback to, and changes made, by the PRA in PS13/24 with respect to expectations around risk management is set out below.

Single recapture limit threshold

CP 24/23 set an expectation that firms should have internal investment limits such that a single recapture event from one counterparty does not threaten the firm’s business model. The PRA has clarified in PS13/24 that it is for firms to determine the scale of loss that would pose a risk to their business model, based on their risk appetite, risk management policies, risk tolerance limits and investment strategy alongside their overall business strategy.

That being said, the PRA emphasised it expects firms to avoid taking on single counterparty exposures which would result in them not meeting their solvency risk appetite or require “significant value destroying management actions” (such as entering run off) in the event of recapture. The PRA indicated that over-reliance on FundedRe having regard to this test could itself constitute a breach of the Prudent Person Principle, a matter which could lead to enforcement action and/or a capital add-on. This statement on single counterparty investment limits sits alongside the requirement spelled out in CP 24/23 for firms to set limits based on recapture from highly correlated counterparties.

Other elements of SS 5/24 relevant to counterparty internal investment limits include:

1. Management Actions in investment limits - responding to arguments that, in setting investment limits, firms should take into account management actions, the PRA determined management should set investment limits to reflect the maximum possible loss in a stressed situation. The PRA rejected responses which suggested the limits should be considered in tandem with management actions to reduce losses.
2. Solvency Capital Requirement (SCR)-based investment limits - the PRA clarified that a firm’s immediate recapture metric should be based on long term target SCR coverage ratios, reflecting a concern that if limits are set by reference to higher (but potentially less persistent) SCR coverage ratios, this could lead to firms being over exposed.
3. Diversification allowances - several responses to CP24/23 commented that firms should be more explicitly encouraged to diversify their FundedRe counterparties and FundedRe arrangements. Whilst the PRA clarified that there may exist diversification benefits in FundedRe contracts, it said that firms should be particularly careful in recognising these benefits in their risk management arrangements.
4. Treatment of collateral - the PRA has maintained certain expectations that firms consider the ‘worst case’ collateral recapture, but has clarified that, where a firm assumes recapture into the matching adjustment portfolio, that rebalancing and trading costs associated with this worst case assumption could be reflected other than through an adjustment to matching adjustment spread, providing additional flexibility in terms of how the “worst case” is reflected.
5. Reliance on ratings - the PRA has clarified that firms should not rely solely on external ratings when setting investment limits. Instead, firms should form a view based on established internal monitoring processes, and this monitoring, while not needing to be “continuous” (per the PRA’s 2023 draft supervisory statement) should be “ongoing”.
6. Board involvement in recapture plans - the PRA has clarified that board involvement is expected in setting the high-level principles underlying recapture plans and assessing uncertainties, and it does not expect explicit board approval of every element of each individual recapture plan. It said it would expect the level of board involvement in reviewing and approving the recapture plans to be proportionate to the level of risk being taken.
7. Collateral policy expectations - the PRA has clarified that the level of detail in the collateral policy should reflect the materiality of exposures, and ongoing monitoring should reflect the characteristics and materiality of the collateral assets and outline some of the factors that could lead to an asset being considered illiquid. The PRA has further clarified that the collateral policy should consider investment management approaches under different circumstances and that it would expect firms to consider the nature of the collateral, their ability to manage the collateral long term if not easily saleable, and factor this into their limit setting processes.
8. Own Risk and Solvency Assessment (ORSA) stress testing - the PRA has adjusted the ORSA expectation so that firms are only expected to analyse their FundeRe exposure annually and only include specific stress testing in respect of FundedRe where exposures are material.

Solvency capital requirement

As stated above, the PRA is concerned that the risks that FundedRe may pose are not adequately catered for by firms when calculating their SCR. Some of the main changes PS13/24 makes in this regard are set out below.

Proportionality and materiality - the PRA proposed to adjust how firms can meet the standards for the counterparty risk module of their SCR. If firms identify areas of uncertainty in their internal modelling, they would be expected to consider this in their risk management system. The PRA suggests firms do this by, for example, limiting their exposure to factors which increase the level of uncertainty by either setting tighter FundedRe investment limits or reducing risk-taking in contractual structures or collateral portfolios.

Probability of recapture, linked to dispute and termination clauses - the PRA proposed that firms take into account transaction document credit events when calibrating their probability of default and has clarified its expectation that firms do not need to calibrate their internal model explicitly to cater for the interaction between a counterparty’s solvency ratio and termination triggers. Instead, the PRA expects that firms should consider how those two interact when calibrating their probability of default, consistent with the approach set out in the recapture plan.

Day one gains validation cannot be adequately modelled - there are clarifications as to how the validation exercise (which requires firms to explain the sources of any day one new business gain generated by entering a FundedRe arrangement) could be carried out. The PRA suggests a way to do this could be by comparing the premium charged by a reinsurer with the premium that would have been charged by the insurer and reconciling the difference. The difference may be down to differences in gross investment spread given different investment and hedging strategies, differences in expenses, and differences in the cost of capital. Note this is not intended to be exhaustive.

Entering into and structuring of FundedRe agreements

The PRA sets out various proposals with respect to firms entering into and the structuring of FundedRe arrangements. These included setting out expectations that cedants have a quantitative risk assessment process for FundedRe arrangements, allow for basis risk and collateral risk mismatches, have an internally approved set of minimum guidelines on contractual features of FundedRe transactions and have clear risk-based collateral haircuts (amongst others). Key changes made to these proposals are set out below.

Haircut policy - the PRA has revised wording which states that the PRA expects firms to use clear risk based collateral haircuts or, alternatively, overcollateralisation linked to the risk being addressed. It lists the examples of appropriate situations for both of these. Where risks relate to a specific collateral asset, the PRA suggests a haircut may be most appropriate, and where the risks are general overcollateralisation may be more appropriate.

Frequency of collateral rebalancing - the PRA removed specific wording related to the frequency of collateral rebalancing but expects firms to justify the frequency of rebalancing when considering whether there is a risk that large shortfalls emerge at recapture and to take account of the potential size of those shortfalls in capital and limits.

Other feedback

SS5/24 clarifies that firms may consider benefits resulting from well diversified FundedRe portfolios or diversification between the cedant and the counterparty’s risk profile or asset holdings into their risk management and modelling. The PRA further clarifies that it does not expect firms to renegotiate the terms of contracts they have already entered into, but firms should consider their position. Finally, the PRA has made a number of changes to proposals to highlight that proportionality and materiality are relevant considerations throughout the proposals.

Dear CEO letter

The Dear CEO letter makes clear that further work is required by firms to meet the policies and expectations of the PRA including those set out in SS5/24. In order for the PRA to assess firms’ current position against the PRA’s expectations, firms that have entered or are considering entering into FundedRe must provide the PRA with the following information by 31 October 2024:

1. A self-assessment of the firm’s current risk management practices against all expectations set out in SS5/24;
2. A summary of the firm’s board approved FundedRe limits for individual counterparties, correlated counterparties and the firm’s aggregate limit;
3. A summary of the remediation activities the firm intends to carry out to meet the expectations set out in SS5/24;
4. An overview of the firm’s level of confidence achieved on the internal model output and its impact on the firm’s FundedRe limits; and
5. An overview of the firm’s steps to limit its risk appetite for future FundedRe transactions and any gaps against SS5/24.

Next steps

The PRA is continuing to monitor FundedRe market practices and is alive to any risks from its growth. It is keeping under review whether any further intervention or further policy measures are required. While the proposals are mostly high level, immediate next steps include the board reporting on the items set out in the Dear CEO letter (set out above) and carrying out remediation activities with respect to SS5/24.

[View source.]