UK regulator continues to raise concerns that current market practices could lead to systemic risk.

The Prudential Regulation Authority (PRA) has issued another communication, the latest of a series related to reinsurance arrangements for the UK life insurance sector. Charlotte Gerken, Bank of England Executive Director, Insurance Supervision and chair of the PRA’s main executive committee, issued a letter on 15 June to Chief Risk Officers (CROs) communicating the PRA’s insights from its recent schematic review of funded reinsurance. The PRA has identified reinsurance arrangements, which UK annuity providers use extensively, as an area of potential risk, including potential systemic risk due to increasing exposures to a limited number of longevity reinsurance providers to the sector. The latest missive focuses specifically on reinsurance under which the insurer transfers both asset and investment risk as well as the longevity risk to a particular reinsurer — a form of reinsurance increasingly popular for annuity providers writing large amounts of bulk pension annuity business.

The PRA engaged in a schematic review with participants in the market looking at drivers of funded reinsurance structures, typical structures, and the associated risk framework and capital requirements. The PRA noted that many transactions resulted in an upfront positive economic capital benefit for the insurer due to premium differentials between the bulk purchase annuity contract and the funded reinsurance arrangement and the way in which the counterparty risk exposure is reflected in the solvency capital requirement of the cedant.

In a speech at the end of April 2023, Gerken acknowledged the potential benefit of funded reinsurance given the demands of the growing pension risk transfer market in the UK, constraints on the sourcing of suitable assets to back these liabilities, and the capital requirements needed to support the increasing demand. However, she also outlined to the industry that the PRA would be highly focused on the risks it perceives in this increasingly large UK insurance market. In the latest letter, the PRA has identified the following four key areas of risk:

• Increased risk of counterparty default
• Reinsurer business models focusing on credit (i.e., gearing business models at earning investment spreads)
• “Wrong way” risk due to credit cycle shocks impacting reinsurers at the same time as collateral portfolios
• Potential lack of availability of replacement contracts or other management actions at the time of a reinsurance failure

The PRA has indicated that it requires firms to take action to improve the management of these risks. CROs are expected to carefully consider the findings of the letter and take appropriate remedial action under threat of continued challenge if the PRA observes weaknesses.

The scrutiny will not end there. The PRA continues to plan further supervisory work around the use of funded reinsurance, which will include targeted work relating to collateral risk management and internal model approaches.

The PRA has requested an immediate change to its notification requirements so that all insurers would now need to notify their PRA supervisors promptly of new individual material funded reinsurance transactions, with an indication that arrangements with a gross premium in excess of £200 million would be considered material.

Increased counterparty default risk

The PRA comments on the recent development of the funded reinsurance market, referring to new entrants and greater concentration to this class of risk for existing reinsurers. In particular, PRA does not believe that historical data regarding default risk will capture all elements of recapture risk. The PRA considers that the collateralisation levels it has observed in arrangements could result in an under collateralisation risk due to market conditions at recapture, which relevant firms need to carefully understand.

Linked to counterparty default risk, we have observed significant negotiation between cedents and reinsurers with respect to termination triggers based on the reinsurer’s solvency ratio. The PRA has identified the benefit of cedents having early termination triggers that apply ahead of the regulatory intervention level and ideally on an automatic basis. Consequently, we anticipate that these termination triggers, which do often fit within these parameters, will be increasingly the focus of regulatory scrutiny.

Another recent market trend has been for cedants to request change of control termination rights on the basis that their counterparty risk limits may be adversely affected by a change of ownership of the relevant reinsurer. Such clauses may be sought with greater frequency in light of PRA’s focus on counterparty exposure.

Reinsurer business models focusing on credit

Given the increased focus on credit within reinsurers’ business models, PRA has expressed concerns that shocks in credit markets would affect multiple reinsurers at the same time. Concerns about systemic risk in reinsurance of UK annuity business has been a running PRA theme.

Counterparty risk limits also merit a PRA mention. Firms usually set these at a level such that recapture would not cause a firm’s solvency ratio to drop below its risk appetite. In the PRA’s view, limit setting should be informed by the credit rating and solvency coverage of the reinsurer, as well as its business model.

Wrong way risk

We have observed an increased trend in the use of illiquid and private assets as part of the collateral pool and note that this is an area increasingly negotiated by cedents and reinsurers when agreeing the eligibility criteria for their arrangements. Similarly heavily negotiated is the level of collateralisation provided by the reinsurer and whether this is set at less than 100% of initial premium or not.

The PRA has identified that collateral requirements can be affected by market spreads of the collateral portfolio. In such cases, the PRA expects firms to have appropriate safeguards to avoid the reinsurer changing the portfolio to higher spread assets.

Clearly the PRA also expects collateral valuation haircuts to be incorporated into firms’ transactions, noting that haircuts can help to mitigate wrong way risk.

Another area of potential risk identified is the use of collateral triggers that increase collateralisation upon a credit rating downgrade for the reinsurer. The PRA notes that the operation of these triggers, depending on levels set, could increase liquidity stress for the reinsurer and then lead to a deterioration in the security package. Market terms we have seen indicate that some reinsurers avoid credit rating downgrade triggers as a matter of policy, but we do observe these in some arrangements.

Management actions

Typically reinsurance arrangements provide for termination amounts to be calculated using a close-out calculation based upon the present value of the future cashflows. PRA has signalled its concern that cedants may not be able to enter into replacement reinsurance arrangements or other hedging or rebalancing actions due to the position of credit markets at the time of recapture. Consequently, we expect even greater focus on collateral eligibility and collateral levels given PRA’s concerns that recapture portfolios may be unmatched or otherwise inadequate, so as to create a value gap when redeployed to a firm’s preferred portfolio upon recapture. Accordingly, when considering the counterparty exposure measurement that a cedent applies upon recapture, the PRA regards a method which assesses the risk immediately following recapture as more reliable than one which takes account of management actions.

Historically we have seen some arrangements that include additional termination payments based upon the prevailing cost of securing replacement reinsurance, if available, although these are by no means market standard. They may become a more popular request by cedants in light of PRA’s concerns.

We will continue to carefully monitor developments in this area.