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Responses are requested by Friday 16 February 2024.
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Prudential Regulation Authority
1.1 This consultation paper (CP) sets out the Prudential Regulation Authority’s (PRA) proposed expectations in respect of life insurance firms entering into or holding funded reinsurance arrangements as cedants. Funded reinsurance is a form of collateralised quota share reinsurance contract which transfers part or all of the asset and liability risks associated with a portfolio of annuities to a third party. The contracts are typically collateralised with a portfolio of assets which meets the investment guidelines agreed between the cedant and the third party.
1.2 The PRA considers that by setting out its expectations for life insurers’ use of funded reinsurance, the proposals will advance its primary objectives for safety and soundness and policyholder protection while allowing the life insurance sector to continue to play an important role in productive investment in the UK economy. The PRA’s proposals reflect its assessment that there are significant potential risks to the PRA’s primary objectives arising from increased use of funded reinsurance arrangements in the UK insurance industry, including the potential for excessive concentrated exposures to correlated, credit-focused counterparties.
1.3 The proposals in this CP result in a new draft supervisory statement (SS) – Funded reinsurance (Appendix 1). This SS would cover expectations on:
- the ongoing risk management of funded reinsurance arrangements;
- the modelling of the solvency capital requirement associated with funded reinsurance arrangements; and
- how firms should consider the structuring of funded reinsurance arrangements.
1.4 This CP is relevant to UK Solvency II firms and insurance and reinsurance undertakings that have a UK branch (third-country branch undertakings) when they hold, or are intending to enter into, funded reinsurance arrangements.
1.5 The PRA has a statutory duty to consult when introducing new rules (FSMA s138J), or new standards instruments (FSMA s138S). When not making rules, the PRA has a public law duty to consult widely where it would be fair to do so. The PRA has consulted the Insurance practitioner panel in relation to the matters in this SS.
1.6 In carrying out its policymaking functions, the PRA is required to comply with several legal obligations. The analysis in this CP explains how the proposals have had regard to the most significant matters, including an explanation of the ways in which having regard to these matters has affected the proposals.
1.7 The PRA proposes that the implementation date for the changes resulting from this CP would be Q2 2024.
Responses and next steps
1.8 This consultation closes on Friday 16 February 2024. The PRA invites feedback on the proposals set out in this consultation. Please address any comments or enquiries to CP24_23@bankofengland.co.uk. Please indicate in your response if you believe any of the proposals in this consultation paper are likely to impact persons who share protected characteristics under the Equality Act 2010, and if so, please explain which groups and what the impact on such groups might be.
Funded reinsurance in the bulk purchase annuity market
2.1 In recent years the PRA has seen a growing appetite for the use of funded reinsurance arrangements in the UK life insurance market to support the writing of bulk purchase annuity (BPA) business.
2.2 The PRA performed a thematic review of the use of funded reinsurance arrangements by UK insurers in 2022-23 and shared its findings in a letter to CROs published on Thursday 15 June 2023. The PRA notes that funded reinsurance is currently being used in large volumes in the BPA market which is itself seeing a large increase in demand, resulting from improved funding ratios of pension schemes over the last few years. BPA volumes are predicted to be circa £600 billion over the next decade according to some market observers,footnote  with a number of large, lumpy transactions, often referred to by market observers, as ‘jumbo’ deals.footnote 
2.3 The PRA understands that the main drivers for the growth in funded reinsurance include the large increase in demand for BPAs described above and an appetite from pension scheme trustees to transact so-called ‘jumbo’ deals in one go. In the short run, UK firms are also constrained by asset origination capabilities to back new business, capital deployment restrictions and high level of price competition in the market.footnote  However, the PRA notes that UK insurers use funded reinsurance to support an acceleration of the existing demand for BPA, without materially changing the overall volume of possible BPA in a large but finite market largely in run-off.
Funded reinsurance in the UK prudential regime
2.4 The PRA recognises that reinsurance is an important component of well-functioning insurance markets, if counterparties themselves have the financial strength to absorb the risks they are taking on. From a risk management perspective, it allows insurers to achieve the balance of underwriting and credit risk management in line with their risk appetite while continuing to deliver for their clients. It allows counterparties to gain indirect access to diversification or natural hedges that might not arise on their own balance sheet.
2.5 The recognition of reinsurance qualifying as risk mitigating technique under the current regulatory regime can lead to a significant reduction in the cedant’s balance sheet and in the amount of capital required to support long term policyholder liabilities. In the case of assets and FSCS-protected liabilities ceded as part of a funded reinsurance arrangement, this reduction can represent a large proportion of the capital required, replaced by a contingent claim on a counterparty.
Risks from the use of funded reinsurance
2.6 The PRA and international institutions such as the International Association of Insurance Supervisorsfootnote  and International Monetary Fundfootnote  have identified a structural shift in the global life insurance sector, with insurers increasingly making use of cross-border funded reinsurance arrangements. This includes the emergence of newer counterparties, with business models more heavily focused on credit returns and with more limited appetite for insurance risks, or existing reinsurers whose business models are increasingly concentrated. Moreover, these counterparties may be more exposed to a range of illiquid investments including through private asset origination capabilities of affiliated alternative asset managers. This is evidenced by a growth in the alternative asset allocation by these counterparties, which is used to support pricing of some funded reinsurance transactions. As a result, some potential funded reinsurance counterparties may be less diversified and have similar credit focused business models which might be correlated to each other and to broader credit conditions especially in times of stress. Given these risks and potential future growth in BPA business, there is a risk that UK cedants rapidly increase their exposure to such counterparties, without adequately recognising the inherent uncertainties and risks involved in funded reinsurance transactions.
2.7 At an aggregate industry level, these trends could also lead to a build-up of risks across the sector if the exposures are concentrated to a small number of funded reinsurance counterparties with highly correlated risk of default.
2.8 In addition, the PRA notes that the competitive nature of the BPA market raises the risk of management standards around funded reinsurance being diluted as firms compete for contracts. Commercial incentives may encourage deterioration in the quality and nature of the collateral agreed with the counterparty as this can have a material impact on the day one ‘new business gain’.footnote  There is a potential risk that this competitive pressure leads firms to enter funded reinsurance transactions which expose them to assets which are inappropriate to back their liabilities, or where associated risks are not properly considered.
2.9 The PRA is concerned that these market dynamics and backdrop, if not properly controlled, might lead to a rapid build-up of risks in the UK life insurance market, for example through an underestimation of the counterparty risks on UK cedants’ balance sheets and in the calculation of the SCR. The potential for a funded reinsurance arrangement to be recaptured is often assumed by firms to be remote and/or far in the future, and so the risks associated with the recapture may not be fully priced into transactions.
3.1 The PRA considers that funded reinsurance arrangements create specific risks that require careful consideration by firms when meeting the PRA’s requirements, including but not limited to the calculation of the Solvency Capital Requirement (SCR). The perceived low probability of the liabilities ceded via a funded reinsurance arrangement needing to be recaptured, combined with the uncertainty associated with estimating this probability and the correlation of similar counterparties under stress, make it difficult for firms to manage the risks associated with funded reinsurance arrangements solely via capital requirements. The PRA considers that the risk management framework of any firms using funded reinsurance should include a focus on the tail risks associated with the contracts. Indeed, the loss distribution for funded reinsurance is unusually ‘fat-tailed’, characterised by infrequent but very large losses. Therefore, the PRA is proposing to clarify expectations for firms’ risk management and structuring of funded reinsurance arrangements alongside expectations on how these arrangements are modelled by firms with an approval to use an internal model or a partial internal model to calculate their SCR.
3.2 When entering into funded reinsurance arrangements, firms expose themselves to a number of consequential risks. Of key importance is the counterparty credit risk, ie the risk that the counterparty defaults and the cedant has to recapture the liabilities and find appropriate financial and non-financial resources to manage the recaptured risks. Defaults in this context can include insolvency, dispute, or other credit event set out in the transaction documentation. There may also be circumstances other than a default which could trigger a prudent recapture of the liabilities.
3.3 Collateral arrangements agreed between the firm and the reinsurance counterparty can partly mitigate this counterparty risk, by ring-fencing a portfolio of assets that could be used on recapture to meet the liability cashflow. However, the collateral needs to be sufficient and appropriate for the liability cashflow. Importantly, the collateral arrangement provides only limited protection to the cedant and does not usually cover the other financial and non-financial resources required by the cedant to manage the recaptured risks.
3.4 The PRA considers that the information provided to a firm in the structuring process for new funded reinsurance arrangements should adequately reflect the risks and uncertainties associated with the arrangement. This information should be sufficiently sensitive to reflect the risk-return trade-off for the firm of the structuring process and support and incentivise prudent behaviours.
3.5 The proposals in this CP form part of the PRA’s broader strategy to address the risks arising from firms’ use of funded reinsurance. This strategy has to date included public feedback on what the PRA has seen in industry’s use of such arrangements,footnote  footnote  and targeted supervisory workfootnote . The PRA also notes that other regulators internationally have been increasingly looking at the funded reinsurance market.footnote  The PRA has seen continued rapid growth in the UK BPA market over 2023, and as noted in paragraph 2.2, the predicted large increase in demand in the BPA market, projected by some to be up to circa £90 billion,footnote  is likely to incentivise UK insurers to make material use of funded reinsurance arrangements to meet internal stretched targets. The PRA considers that setting out its proposed expectations for firms clearly will benefit all firms considering entering into funded reinsurance arrangements. The proposed SS will help firms to understand the standards the PRA expects them and other firms using funded reinsurance to meet in order to comply with existing requirements. The PRA considers that the proposals should not have any impact on the ability of firms to invest in UK productive assets directly.footnote 
3.6 Subject to consultation feedback on the proposals, to determine whether these expectations are being met in practice, the PRA would expect to seek assurance on firms’ practice in a proportionate way, focusing on the exposures which in its view present the greatest risk. The PRA may consider this as a topic in a firm’s Periodic Summary Meeting, or where appropriate look to commission a Skilled Persons review. In addition to the proposals in this CP, the PRA will continue to monitor how market practice evolves and will keep under review whether there is a need for further specific policy measures. This could include tools to address a potential build-up of sector-wide vulnerability, where this might pose a risk to UK financial stability.
Risk management of funded reinsurance arrangements
3.7 Solvency II requires firms to have in place an effective risk management system covering the use of reinsurance and other risk mitigation techniques, how suitable reinsurance is selected, how the insurer will assess types of reinsurance that are appropriate to their business, and an assessment of the associated credit risk. The Prudent Person Principle (PPP) set out in the PRA Rulebook also sets standards for prudent investment, and the PRA's expectations around this are laid out in SS1/20 – Solvency II: Prudent Person Principle, including the consideration of risks associated with reinsurance arrangements.
3.8 In this CP, the PRA proposes setting out further expectations in these areas as they relate to funded reinsurance transactions. These include proposed standards to ensure that efficient risk management of counterparty exposures (and in particular a combination of internal counterparty limits and collateral policies), and financial resources allow a firm to withstand any single funded reinsurance arrangement recapture, as well as multiple recaptures from correlated counterparties under stressed conditions.
Counterparty internal investment limits
3.9 The PRA proposes that firms should set limits to their exposures to funded reinsurance counterparties. These will supplement the expectations on risk tolerance limits set out in SS1/20 on compliance with the PPP and are designed to ensure a firm’s exposure to funded reinsurance counterparties are limited to a level which does not threaten its ongoing business model viability in the event of recapture.
3.10 When setting limits for investment assets, firms can usually reliably measure exposures by the market value of the asset and set a limit framework based on the proportion of said asset class to the rest of the asset portfolio held to back policyholder liabilities. The PRA considers that such an approach is less appropriate for funded reinsurance since on recapture of the ceded assets and liabilities, the UK cedants would see an increase in capital requirements associated with the recaptured business. The PRA has observed that firms tend to focus on the losses on recapture taking into consideration the collateral assets backing the arrangements. While the PRA sees the value in this approach (by focusing on the impact rather than the probability of recapture), past reviews by the PRA have identified a wide range of approaches in how firms have implemented such a framework in practice, including significant variation in whether firms have considered scenarios where an arrangement may be recaptured before the full default of a counterparty where this is contractually permitted. In some cases, these variations in approaches lead to ineffective investment limit frameworks that would not result in adequate measurement of the risk or in limits which would not effectively constrain the potential increase in exposure.
3.11. To measure exposures against this limit and demonstrate the effectiveness of their risk-management systems as regards funded reinsurance transactions, the PRA proposes that firms have an ‘immediate recapture’ metric. This metric would measure the impact on the firm’s solvency capital requirement (SCR) ratio of a scenario where all ceded business with a counterparty is recaptured, ignoring the likelihood of such an event. The potential impact of mitigating management actions would also be omitted to provide management the gross view of the risks they are facing given the uncertainty around the effectiveness of such actions, and the time it may take to implement them, under stress.
3.12 Against such an exposure measurement framework, the PRA is proposing that firms set internal investment limits focused on the idiosyncratic risk of a counterparty, which may lead to its default independently of other counterparties in the market. This limit would aim to ensure firms are not exposed to a single counterparty to the extent that the failure of that counterparty would threaten their business model. Where a firm's business model is reliant to a material extent on funded reinsurance with one counterparty, the PRA considers that this could present particular challenges with regards to compliance with the PPP. The PRA is also proposing that firms be expected to have additional limits which consider concentration risks. This should include a limit based on simultaneous recapture from multiple highly correlated counterparties and an aggregate limit focused on the firm’s own need for a diversified asset strategy as well as operational capabilities on recapture.
The use of these limits aims to ensure that firms are considering this potential multiple failure risk during their assessment of new funded reinsurance arrangements.
3.13 The collateral in a funded reinsurance transaction represents the discounted value of the liability cash flows payable to the policyholder. Unlike other reinsurance arrangements, the size of this collateral in funded reinsurance transactions can be very large, is present on day one and will always be posted to the cedantsfootnote . Given the materiality of the collateral in the context of funded reinsurance arrangements, the PRA proposes that firms should have clear collateral policies in place as part of their risk management policies closely linked to their risk appetite. The collateral policy would be essential to enable the firm to adequately formulate an executable recapture plan under stressed conditions. This collateral policy would also allow firms to have a reliable estimate of the impact of recapture, given the value of and quality of liability matching of, recaptured, stressed collateral, to ensure that the firm’s business model can survive the recapture event.
3.14 The PRA has observed that firms are increasingly accepting illiquid assets to back collateral for funded reinsurance policies, and in some cases are assuming that these illiquid collateral assets would be recaptured into MA portfolios. The contractual terms that allow the use of illiquid assets in the collateral may be important to some counterparties, particularly where they are seeking to leverage their own private asset origination capabilities. These illiquid collateral structures bring a number of additional risks and increased uncertainty as to the effectiveness of the recapture process. There is increased uncertainty around the valuation of privately sourced illiquid assets and their associated credit risk, in particular in a stress scenario. If it becomes necessary to sell such assets, the associated trading costs and the time it would take to find a buyer is also uncertain.
3.15 The PRA therefore proposes new expectations on firms around their collateral policy for illiquid assets in collateral pools. Collateral policies would be expected to include at a minimum, details on approaches to credit assessments, valuation methodologies, MA eligibility monitoring, SCR modelling, and investment management approaches on recapture. Additional expectations for firms assuming the MA eligibility of recaptured assets are also proposed, to ensure that such a recapture would not result in a breach of MA conditions under base or stressed scenarios. The PRA would expect these to help the firm clearly define the parameters of the collateral that they will recapture and therefore to formulate a recapture plan with a high degree of certainty.
3.16 The PRA considers that adequate risk management of funded reinsurance arrangements requires a specific focus on recapture plans to allow the firm to demonstrate that its business model can survive any single recapture event and multiple recaptures from correlated counterparties. The PRA therefore proposes that firms formulate and document a recapture plan for their funded reinsurance arrangements. Firms would be expected to be able to make robust forecasts of the cost of these actions under stressed conditions to be able to assess their ability to execute them using the financial resources that will be available. In particular, the recapture plan must be an integral part of setting the funded reinsurance risk appetite both in terms of volume and nature of the arrangements.
Solvency capital requirement (SCR)
3.17 The impact on the SCR is an important metric that firms use in their decision to enter funded reinsurance transactions. For example, the SCR is an essential component of the new business solvency surplus impact, and therefore influence the perceived day one new business gain calculated by firms when entering these transactions. It is therefore necessary for the SCR to be sufficiently accurate to allow senior management to adequately understand the economics of the transaction and consider the risk-return trade-off.
3.18 For firms using the standard formula (SF) to calculate the SCR, the PRA reminds firms of the requirement to include a clear assessment of the appropriateness of the standard formula within the own risk and solvency assessment (ORSA), and that this should include an assessment of the risks retained, and the risks to which they are exposed in respect of funded reinsurance arrangements.
3.19 To date, many firms engaged in funded reinsurance transactions use internal models to calculate their counterparty risk SCR. However, these models may have been approved before funded reinsurers became material counterparties for those firms. This presents a risk that models designed for different types of counterparties may inadequately reflect the risk in the funded reinsurance transactions. The PRA Rulebook requires that firms ensure the ongoing appropriateness of their internal models, and that the internal model continues to appropriately reflect their risk profile on an ongoing basis (Internal Models 10.3). To be able to demonstrate that internal models continue to capture all material and quantifiable risks, the PRA proposes to set expectations on certain elements that should be reflected in internal models to accurately calculate a counterparty SCR for funded reinsurance.
3.20 The proposed expectations summarised below in paragraphs 3.21 to 3.29 are aimed at either addressing the known uncertainties inherent to funded reinsurance arrangements or providing a framework to ensure that the internal model adequately reflects the risks.
Probability of default (PD)
3.21 Generally speaking, counterparty losses can arise from recapture of the business, and there is material uncertainty as to the probability of recapture for firms. This uncertainty arises due to the contractual features, the nature of these newer counterparties with newer business models and in most instances, an absence of directly relevant historical data. As a result, firms often use proxies from the corporate bond market or other listed markets. Such proxies may not recognise all the specificities of funded reinsurance counterparties.
3.22 To demonstrate that assumptions have been set appropriately, the PRA proposes expectations that firms be able to clearly articulate their data choice for setting PD assumptions for funded reinsurance arrangements. This would include a consideration of whether the counterparty operates in a similar market to the one that the PD data is based on, and whether the data adequately reflects the counterparties’ business models. Firms would also be expected to be able to calculate a PD in both base and stressed conditions and set PD assumptions that are informed by contractual terms and wider considerations, such as the likelihood of regulatory intervention, ahead of insolvency.
3.23 Where historical data is used to set PD assumptions, the PRA proposes expectations that firms consider whether this data may fail to capture forward-looking risks to ensure that the resulting assumptions are appropriate. Firms would be expected to consider using private information gathered as part of counterparty due diligence to inform their PD assumptions, and to consider adjusting the PD assumption as a result.
Loss given default (LGD) and downgrade
3.24 The PRA proposes that when setting LGD assumptions, firms would be expected to stress the underlying liability cashflows using the same approaches used in the main modules of the internal model when calculating a stressed Best Estimate Liability (BEL) value. This will ensure consistency within the internal model, and that all material risks are captured. Additionally, firms would be expected to consider in the LGD calculation the impact of a deterioration in the credit quality of the counterparty, the value of the risk margin that may be necessary to set up on recapture of the business, and adequately justify the inclusion of any management actions.
3.25 The PRA notes that the achievable value and availability of collateral to reduce losses under stresses may be particularly difficult to predict. Therefore, additional expectations are proposed around the recognition of the loss-mitigating effect of collateral. In particular, firms would be expected to:
- stress their underlying collateral portfolios on a look-through basis taking into account key market risks;
- consider where mismatches between collateral and underlying liabilities may arise under stress; and
- make prudent assumptions around the ability of counterparties to re-collateralise in stressed conditions.
3.26 To ensure that internal models can properly model stress events impacting funded reinsurance counterparties, the PRA also proposes that firms should clearly articulate how their models reflect scenarios where reinsurance arrangements no longer represent effective risk transfer in their internal models, despite a contract still being in place.footnote 
Recapture within Matching Adjustment portfolios (MAP)
3.27 The PRA notes that the assumption that assets and liabilities associated with funded reinsurance contracts can be recaptured within the MAP has a significant impact on the perceived losses on recapture. There is often; however, material uncertainty as to the ability of firms to recapture assets and liabilities associated with funded reinsurance contracts within their MAP without material and costly management actions in stress. The PRA also notes that privately sourced assets are increasingly being used to back funded reinsurance arrangements, which further increases this uncertainty, particularly where firms’ MA permissions do not include such assets.
3.28 Therefore, the PRA proposes to set an expectation that firms assume that assets and liabilities associated with funded reinsurance contracts be recaptured outside of an MA portfolio, unless they are able to clearly demonstrate that such an inclusion would not result in non-compliance with the MA conditions under both base and stressed scenarios.
3.29 Where this is demonstrated, the PRA proposes to additionally expect that calculations take into account the rebalancing and trading activities necessary to achieve compliance with the MA conditions. Where MA eligibility is dependent on assumed management actions, the PRA also proposes that firms be expected to demonstrate the market feasibility of these management actions under stress, and that they have the operational readiness and capabilities required to perform the management actions in a stress.
Entering into and structuring of funded reinsurance arrangements
3.30 The PRA has observed that several firms currently take a ‘pass-or-fail’ approach to their reinsurance structuring as part of their internal risk appetite framework. The PRA considers that relying solely on a ‘pass-or-fail’ approach, under internally-approved minimum guidelines on each specific area of the funded reinsurance contract, might not be a sufficiently prudent approach. Such an approach might not allow for aggregate measurement of risks generated by the funded reinsurance arrangement as a whole. It might also be insensitive to the risk-reward trade-off made as part of the structuring process.
3.31 Firms may only invest in assets when they are able to identify, measure, monitor, manage, control, and report on the associated risks, which should be taken into account in their assessment of solvency needs in the own risk and solvency assessment (ORSA). The PRA considers that this should include internal quantitative investment limits as set out in paragraph 3.11 of SS1/20. The PRA proposes to set out an expectation to have a quantitative risk assessment process for funded reinsurance arrangements to inform the firm’s internal investment limit framework as part of its investment risk strategy. This assessment is expected to include an approved internal contractual risk appetite statement setting out the maximum acceptable loss at the individual funded reinsurance contract level.
3.32 This risk assessment process is expected to reflect all forms of basis and collateral mismatch risk and include stressing risk factors that would lead to significant basis and collateral mismatch risk over an appropriate time horizon. The PRA proposes elements of basis risks and collateral mismatch risk that should be considered by firms in their framework as a minimum. It also provides expectations on how we expect firms to stress the drivers of such risks and how contractual mitigations can be used to manage the identified risks.
3.33 The PRA considers that this framework provides a simple way of demonstrating that the firm is only investing in assets when it can identify, measure, monitor, manage, control, and report on the associated risks.
3.34 The PRA notes that UK insurers have made increasing use of funded reinsurance arrangements to meet growing demand for BPA business. Given the competitiveness of the BPA market, the PRA considers that without setting the proposed expectations, there is a risk that competitive pressures to achieve the best price may lead to dilution of risk management standards for funded reinsurance. Without firms’ having the appropriate risk management policies and practices in place, this could result in a risk to the PRA’s primary objectives of promoting the safety and soundness of firms and securing an appropriate degree of protection for policyholders.
3.35 The PRA considers that the proposals in this CP would help ensure that firms are properly considering the risks associated with the use of funded reinsurance arrangements, and hence directly advance the PRA’s primary objectives.
3.36 The PRA considers that the proposals would encourage firms to adopt a considered approach to the use of funded reinsurance in a way that is likely to be able to support growth in the UK economy in the medium-to-long term. In the PRA’s view, the proposals would ensure that the UK life insurance sector can continue to provide annuity products to policyholders in a sustainable manner, and that firms can invest in a way which supports long-term economic growth. In particular, the proposals would reduce incentives for firms to take on excessive risk in their funded reinsurance arrangements due to short term competitive pressure in the BPA market. The PRA also considers that the proposals would ensure that funded reinsurance arrangements are managed and modelled to a consistent and appropriate set of standards across the UK insurance industry, helping ensure a level playing field so that some insurers do not use funded reinsurance transactions in an imprudent way to gain a temporary competitive advantage over other insurers that may manage these risks more appropriately. As such, the PRA considers that the proposals would support the PRA’s secondary competition objective and its secondary objective for competitiveness and growth.
3.37 The PRA has considered the costs and benefits associated with these proposals compared to the baseline of its current policies and expectations, taking into account reviews it has conducted into firms’ existing management processes and solvency capital calculations in relation to funded reinsurance. The PRA welcomes feedback on this analysis to inform its final policy decisions.
3.38 The draft SS clarifies and expands upon the PRA’s expectations on compliance with existing rules, regulations, and retained EU law. The SS would set expectations focused on funded reinsurance arrangements which would apply in addition to other relevant requirements and PRA expectations, but it would not impose additional requirements.
3.39 The proposals provide clarity and consistency on the PRA’s expectations and should provide assistance to firms regarding their approach to risk management and solvency capital calculations. Some firms may incur additional costs to bring their current practice in line with PRA expectations. These costs may vary depending on the complexity of a firm’s funded reinsurance arrangements and the firm’s current investment approaches and risk management practices.
3.40 Based on research conducted into firms that use funded reinsurance, the PRA does not expect these costs, when compared with firms’ current practices, to be significant for most firms. An initial analysis suggests that some firms already meet some of these expectations. From the PRA’s own research, the PRA also understands that firms using funded reinsurance arrangements are generally in the process of making enhancements to their risk management and modelling of such arrangements as part of their business-as-usual development of internal processes.
3.41 The PRA does not expect the costs associated with updating processes and modelling to be significant to firms, as they should not represent material deviations from approaches already largely adopted. The PRA also notes that where firms have been considering the use of funded reinsurance with riskier features, the PRA’s proposals may impact their funded reinsurance capacity in the short term. However, the PRA does not expect this to have a significant impact on firms’ business models.
3.42 The proposals in the draft SS are expected to help promote the safety and soundness of firms by ensuring appropriate application of the Solvency II requirements in the context of funded reinsurance transactions. The PRA considers that these risks are becoming more significant, given the increasing use of funded reinsurance in the BPA market. Improved risk management practices and more prudent investment allocation will contribute to improved protection of policyholders and to the safety and soundness of firms.
3.43 Setting out these expectations in a SS will increase transparency and make it easier for firms to incorporate the expectations into their decision-making process, with the aim of ensuring that the risks associated with funded reinsurance arrangements are appropriately managed and modelled. The PRA also considers that this will make its position on appropriate management and modelling of funded reinsurance arrangements clearer to other stakeholders in the BPA market, such as pensions trustees.
3.44 The proposals should also make the PRA’s supervision of firms using funded reinsurance arrangements more efficient, reducing the need for in-depth supervisory activity on an individual firm basis. Such activity can be significantly costly for both firms and the PRA.
‘Have regards’ analysis
3.45 In developing these proposals in this CP, the PRA has had regard to the FSMA regulatory principles, the aspects of the Government’s economic policy set out in the HMT recommendation letter from 2022, and the net zero ‘have regards’. The following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposals:
1. The need to use the resources of each regulator in the most efficient and economic way (FSMA regulatory principles): The PRA considers that the proposals to establish clear expectations on how firms should manage the risks associated with funded reinsurance arrangements and take funded reinsurance into account in their modelling, will assist firms and supervisors determining in a more efficient manner whether a firm is managing these arrangements appropriately or not.
2. The principle that a burden or restriction which is imposed on a person should be proportionate to the benefits which are expected to result from the imposition of that burden (FSMA regulatory principles): The proposals are targeted at a specific business area, the use of funded reinsurance arrangements, where the PRA considers there to be significant potential risks to the PRA’s objectives. The PRA considers that there are benefits to establishing new expectations to mitigate these risks in a consistent way across firms who enter into these transactions. Therefore, the burdens associated with the proposals are considered to be proportionate to the benefits.
3. The desirability, where appropriate, of each regulator exercising its functions in a way that recognises differences in the nature of, and objectives of, businesses carried on by different persons (FSMA regulatory principles): The PRA considers that as the proposals are targeted specifically for firms using funded reinsurance as a risk mitigation technique, they recognise the differences in the nature of firms’ businesses.
4. Growth (HMT recommendation letter), and sustainable growth (FSMA regulatory principles): The PRA considers that making expectations around the use of funded reinsurance more transparent will help firms ensure that they are appropriately managing and modelling the potential risks associated with funded reinsurance arrangements. If these risks were managed ineffectively, it could have a significant negative impact on insurers’ ability to continue to contribute to sustainable economic growth, particularly considering the potential for risks arising from correlated exposures. The PRA therefore considers that the proposals will support long-term economic growth.
5. Competitiveness (HMT recommendation letter): The PRA considers that the proposals in the draft SS will promote the safety and soundness of firms, helping contribute to the strength and stability of UK insurers. This in turn will help support the long-term growth of the UK insurance sector and the competitiveness of the UK. In addition, the PRA considers that the growing use of funded reinsurance might have an opportunity cost in the form of UK productive investment foregone. Indeed, the collateral portfolio of funded reinsurance arrangements rarely include UK productive assets. The alternative to funded reinsurance, where the UK insurers invest directly in a portfolio of assets to back the liabilities, would have generally involved investments in a high proportion of illiquid assets.footnote  A portion of these illiquid assets would have been likely to be UK productive assets.
6. The principle that the regulators should exercise their functions as transparently as possible (FSMA regulatory principles): The PRA considers that the proposals will clarify the PRA’s expectations for firms using funded reinsurance arrangements, and hence make the execution of the PRA’s functions more transparent.
3.46 The PRA has had regard to other factors as required. Where analysis has not been provided against a ‘have regard’, it is because the PRA considers that ‘have regard’ to not be a significant factor for this set of proposals.
Impact on mutuals
3.47 The PRA considers that the impact of the proposed changes to PRA expectations on mutuals is expected to be no different from the impact on other firms.
Equality and diversity
3.48 In making its rules and carrying out its policies, services, and functions, the PRA is required by the Equality Act 2010 to have due regard to the need to eliminate discrimination, to promote equality of opportunity, and to foster good relations between persons who share a protected characteristic and those who do not.
3.49 The PRA has considered the equality and diversity issues that may arise from the proposals in this consultation. The PRA does not consider that the proposals in this CP raise any concerns with regards to equality and diversity.
See the IAIS’s July 2023 Global Insurance Market Report, page 7.
See the IMF’s Global Financial Stability Report, October 2023, Chapter 1, Box 1.3.
A new business gain refers to an increase in regulatory surplus (Own Funds less Solvency Capital Requirement (SCR)), which arises when premium paid to the counterparty is lower than the premium received from the pension scheme, and the counterparty risk exposure does not generate significant SCR. BPA are historically written at new business strain, but funded reinsurance can give rise to new business gain.
See the IAIS’s July 2023 Global Insurance Market Report, page 7.
Annuity firms’ holdings of assets other than corporate or UK government debt has grown from around 15% of assets backing annuities at end-2014 to 45% at end-2020; see Four Rs speech given by Charlotte Gerken in May 2022.
Unlike, for example, longevity reinsurance where the collateral can be posted to the cedant or posted by the cedant depending on the way the experience has deviated from the agreed profile.
In line with the requirement set out in Article 235 (3) of Commission Delegated Regulation (EU) 2015/35.
Annuity firms’ holdings of assets other than corporate or UK government debt has grown from around 15% of assets backing annuities at end-2014 to 45% at end-2020; see Four Rs speech given by Charlotte Gerken in May 2022.