The PRA Tightens Expectations for Funded Reinsurance for the UK Bulk Buy Annuity Market | Skadden, Arps, Slate, Meagher & Flom LLP
On 16 November 2023, the UK Prudential Regulatory Authority (PRA) launched draft measures to handle perceived dangers out there for funded reinsurance, which is extensively used as a part of transactions that shift pension scheme liabilities to insurers.
The majority buy annuity (BPA) market, by which UK defined-benefit pension schemes offload liabilities and property to specialised life insurance coverage carriers, continues to increase. Business estimates predict that the UK life insurance coverage trade may tackle greater than £600 billion of pension liabilities and related property over the approaching decade.
To assist this enlargement, life insurers are making elevated use of funded reinsurance, which reduces the capital pressure on insurers in comparison with a conventional reinsurance technique of reinsuring longevity threat and retaining asset threat. Insurers are additionally constrained by asset origination capabilities and the extent of value competitors out there.
In funded reinsurance (typically known as asset-intensive or asset-backed reinsurance), related pension scheme property journey as much as the reinsurer as premium, and the reinsurance constitutes the only recourse of the cedant with respect of the liabilities reinsured. In lots of circumstances, the reinsurance association is important to the flexibility of the cedant provider to enter into the BPA transaction within the first place. Funded reinsurance is akin to a quota share reinsurance treaty in a property and casualty context, whereby the reinsurer takes on threat holistically.
Importantly for the reinsurer, funded reinsurance entails a a lot bigger premium than a traditional longevity reinsurance, giving the reinsurer a big pool of property to take a position. That’s notably enticing for reinsurers related to massive different asset managers. Reinsurers lively on this market are sometimes primarily based offshore in Bermuda, though a big quantity are within the US.
The PRA has noticed that insurers are making elevated use of cross-border funded reinsurance preparations. They’ve notably famous the emergence of latest reinsurers:
- related to different asset managers, whose enterprise fashions are extra closely pushed by funding in non-public credit score property (and actual property/infrastructure) and who’ve a decrease urge for food for insurance coverage dangers, or
- current reinsurers whose enterprise fashions could go away them more and more uncovered to a small variety of reinsurance counterparties (or associated collateral pots).
These traits have additionally been famous by worldwide establishments such because the Worldwide Affiliation of Insurance coverage Supervisors (IAIS) and Worldwide Financial Fund (the IMF).
Earlier this 12 months, the PRA concluded a thematic overview of the usage of funded reinsurance that’s driving this BPA exercise. See our 9 Could 2023 alert “The UK PRA Warns the Bulk Buy Annuity Market” and our 30 January 2023 alert “The UK PRA’s Priorities for Insurance coverage Supervision in 2023”.
The 16 November 2023 proposals observe on the thematic overview. They are often seen as a “turning of the screw” on these transactions, requiring companies to self-assess completely whether or not every reinsurance association is prone to meet the PRA’s issues, particularly round counterparty and focus dangers.
We summarise these as follows.
1. Counterparty inside funding limits
The PRA proposes that insurers set limits on their publicity to funded reinsurance counterparties. These ought to apply not simply to a person counterparty (independently of different counterparties out there), but additionally to a number of extremely correlated counterparties, along with an combination restrict centered on the insurer’s personal want for a diversified asset technique.
These limits are designed to make sure that an insurer’s publicity to funded reinsurance counterparties is restricted to a degree that doesn’t threaten the insurer’s ongoing enterprise mannequin viability within the occasion the reinsurance is terminated (in any other case known as recapture), each on a person idiosyncratic foundation and throughout a number of extremely correlated counterparties (in a a number of reinsurer failure situation).
The priority round focus pertains to reinsurers whose enterprise fashions could also be correlated to one another and to broader credit score circumstances, particularly in instances of stress (e.gthey’re investing closely in non-public credit score or different different property and have an possession whose fortunes are linked to the non-public credit score or different different markets).
2. Collateral coverage
In a funded reinsurance transaction, the collateral ought to signify the discounted worth of the legal responsibility money flows payable to the insurer. The dimensions of this collateral in a funded reinsurance transaction is massive. It’s current from inception and can be posted to the cedant insurer.
The PRA proposes that insurers ought to have clear collateral insurance policies in place as a part of their threat administration insurance policies intently linked to their threat urge for food. These would, at a minimal, element approaches to credit score assessments, valuation methodologies, matching adjustment (MA) eligibility monitoring, solvency capital requirement (SCR) modelling, and funding administration approaches on recapture.
Explicit issues are expressed in regards to the growing use of illiquid property as collateral, particularly the place insurers are assuming that illiquid collateral property could be recaptured into MA portfolios. The PRA says there’s elevated uncertainty in regards to the valuation of privately sourced illiquid property and their related credit score threat, notably in a stress situation. There can be extra expectations for insurers assuming the MA eligibility of recaptured property, to make sure that such a recapture wouldn’t end in a breach of MA circumstances beneath base or confused situations.
The PRA expects that insurers will have in mind any rebalancing and buying and selling actions essential to realize compliance with the MA circumstances on recapture. The place MA eligibility depends on assumed administration actions, the PRA expects insurers to show the market feasibility of those administration actions beneath stress, and that they’ve the operational readiness and capabilities required to carry out the administration actions in stress.
There’s a concern that eager value competitors within the BPA market raises the danger of decreased requirements for funded reinsurance as insurers compete for contracts. This may increasingly encourage a discount within the high quality of the reinsurance collateral agreed with counterparties. The PRA is apprehensive that this aggressive strain leads insurers to enter funded reinsurance offers that expose them to property which are inappropriate to again their liabilities, or the place related dangers usually are not correctly thought-about. As well as, the regulators say these dangers could compound throughout the sector, making a systemic subject.
3. Recapture plans
The PRA is worried that the opportunity of a funded reinsurance association being recaptured is usually assumed by insurers to be distant and/or far sooner or later, and so the dangers related to the recapture will not be totally priced into transactions or appropriately managed.
Consequentially, the PRA proposes that insurers formulate and doc a step-by-step recapture plan for his or her funded reinsurance preparations, clearly defining the collateral to be recaptured, making an allowance for all relevant governing legal guidelines. This would come with an “fast recapture” metric to measure the impression on the agency’s SCR protection ratio in a situation the place all ceded enterprise with a counterparty is recaptured, ignoring the probability of such an occasion. The potential impression of mitigating administration actions ought to be omitted to supply administration the gross view of the dangers they’re going through, and to permit for the time it could take to implement mitigating actions, beneath stress.
The place the MA is used, insurers ought to assume that property and liabilities related to funded reinsurance contracts are recaptured exterior of an MA portfolio, except they’re able to clearly show that such an inclusion wouldn’t end in non-compliance with the MA circumstances beneath each base and confused situations.
4. Inner mannequin/SCR
The PRA proposes that the next elements be mirrored in an insurer’s inside mannequin (the place relevant) to handle the recognized uncertainties inherent to funded reinsurance preparations.
Likelihood of default (PD). Insurers ought to clearly articulate their information selection for setting PD assumptions for funded reinsurance preparations, to incorporate:
- whether or not the information adequately displays the counterparty’s enterprise mannequin;
- contractual occasions of default within the related devices; and
- wider concerns, such because the probability of regulatory intervention, forward of insolvency.
This concern arises partially from the character of reinsurance counterparties with newer enterprise fashions and, in most cases, an absence of immediately related historic information. The usage of proxies from the company bond market or different listed markets could not mirror all of the specificities of funded reinsurance counterparties.
Loss given default (LGD) and downgrade. Insurers ought to stress, when calculating a confused finest estimate legal responsibility (BEL) worth, the underlying legal responsibility cashflows utilizing the identical approaches utilized in the primary modules of the inner mannequin. The PRA additionally expects companies to have the ability to show that their inside fashions or partial inside fashions seize “wrong-way” threat.
Collateral. Insurers ought to:
- stress their underlying collateral portfolios on a look-through foundation, making an allowance for key market dangers;
- contemplate the place mismatches between collateral and underlying liabilities could come up beneath stress; and
- make prudent assumptions across the capability of counterparties to re-collateralise in confused circumstances.
Insurers must also preserve a risk-based collateral haircut coverage offering, at a minimal, that haircuts:
- seize and transfer consistent with key threat drivers which are related within the transactions. This contains value volatility (if property usually are not supposed to be, or can’t be, retained) and foreign money volatility (if the danger shouldn’t be hedged).
- seize different broader threat concerns, the place related. This contains however shouldn’t be restricted to wrong-way dangers and money stream mismatches.
- are primarily based available on the market dangers of the property outlined as eligible beneath the collateral settlement.
- are calibrated at a excessive confidence degree, utilizing a protracted historic time interval that features a minimum of one stress interval.
- are calibrated to incentivise appropriate behaviour on the a part of the counterparty.
The PRA notes that modifications to an insurer’s inside mannequin could should be accepted by the PRA earlier than it enters into a cloth contract with a reinsurer on a funded reinsurance foundation.
5. Entry into and structuring of funded reinsurance preparations
Insurers ought to keep away from a “pass-or-fail” method to their reinsurance structuring as a part of their inside threat urge for food framework. As a substitute, insurers ought to preserve a quantitative threat evaluation for a given commerce:
- setting out the utmost acceptable loss on the particular person funded reinsurance contract degree.
- at the least, reflecting all types of foundation and collateral mismatch threat and embrace stressing threat elements that might result in important foundation and collateral mismatch threat over an applicable time horizon.
Corporations must also preserve internally accepted minimal tips on contractual options for funded reinsurance transactions together with, at the least, approaches to:
- termination clauses.
- substitution rights for collateral property.
- valuation approaches and focus limits.
- selection of relevant legislation.
In abstract, companies can count on a considerably enhanced diploma of regulatory oversight of funded reinsurance preparations. The mixed impact of this plethora of regulatory expectations is that, in observe, a deal is not going to undergo except and till the PRA is glad within the spherical. Thus, regulatory engagement and the opportunity of problem will clearly have to be constructed into the transaction timetable.
Insurers can even have to put money into compliance insurance policies and personnel forward of time. Clearly, it’s going to make sense to develop and agree on these insurance policies with the PRA upfront to be able to pave the best way in the direction of their implementation in an precise deal.