Bank of England has confirmed it will continue to monitor how market practice evolves in relation to funded reinsurance and will keep under review whether further measures are required.

In recent years there has been 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 which has seen some record-breaking transaction levels over the recent years.

It is widely expected that there were circa £50bn in deals in 2023, and 2024 is expected to surpass that with some expecting transactions to reach as high as £80bn.

There is also a growing trend of private equity giants acquiring life insurance and bulk annuity books and establishing themselves on the island of Bermuda, where most of the long-term insurance gets reinsured.

According to a 2023 paper by the  International Monetary Fund (IMF) – Private Equity and Life Insurers – while Bermuda’s solvency regime has been granted equal status to equivalent regulation in the US and UK, “it appears possible to gain recognition for the premium earned on illiquid investments when determining the discount rate for valuing technical provisions more often than in other regimes”.

The paper suggested allocations to illiquids by private equity-influenced reinsurance in Bermuda is a median 20% versus 6% for a sample of 50 major insurers globally.

PRA calls for limited exposure to reinsurance

Regulators are concerned by the trend, with the UK’s Prudential Regulation Authority (PRA) repeatedly encouraging bulk annuity providers in the UK to limit their exposure to reinsurance.

In November 2023, the PRA proposed that firms should set limits to their exposures to funded reinsurance counterparties as they may be highly exposed to illiquid assets and their investment profiles may be too closely correlated to one another.

The regulator also said that given the growth in the bulk annuity market, as companies seek to offload pension schemes from their balance sheets, life insurers may be placing more investments with the reinsurers “without adequately recognising the inherent uncertainties and risks involved”.

Then in a ‘Dear CEO’ letter sent to insurers in January 2024, the Authority said that it continues to “pay close attention” to the role of funded reinsurance in the UK life market as it believes funded reinsurance has the potential to “introduce significant risks to our objectives of safety and soundness and policyholder protection”.

It said: “These are complex transactions which give rise to contingent exposure via recapture risk, and it is essential firms limit the scale and structure of such transactions to retain high confidence in their ability to safely recapture the transferred risks under stressed conditions.”

“These are complex transactions which give rise to contingent exposure via recapture risk, and it is essential firms limit the scale and structure of such transactions”

Prudential Regulation Authority (PRA)

It added that its thematic work found risk management weaknesses across life insurers transacting funded reinsurance and it set out how it expects firms to manage the risk associated with funded reinsurance at both an individual transaction and an aggregate level.

This included the expectation that firms place limits on activity necessary to ensure sound risk management.

It added that supervisors of firms that have undertaken or plan to undertake funded reinsurance transactions, should engage closely on the prudent scale, structure, and risk management of funded reinsurance.

Stress tests to take place in 2025

In the letter, the PRA also confirmed the next stress test will take place in 2025, adding it will continue to engage with the industry on the technical, operational and communication aspects of the exercise, aiming to publish in 2024 an approach document to the stress test.

Craig Turnbull, partner, insurance and longevity at Barnett Waddingham, said that scenario testing is a key tool in the regulator’s arsenal.

“This type of exercise asks insurers to consider and illustrate the impact of a range of potential situations, i.e. what is the exposure to reinsurers under different types of scenarios? What are insurers assuming of their reinsurance counterparties under extreme scenarios? In the event that insurers have to unwind the reinsurance arrangement, what assumptions are being made about the collateral portfolios that revert to the insurer?” he asked.

Turnbull said that by asking these questions, the regulator will build a holistic picture of the UK insurance market’s exposure to funded reinsurance and in turn, place the right risk management expectations on firms to ensure policyholders are adequately protected.

Michael Abramson, partner at Hymans Robertson, said that seeing as the PRA has previously noted concern regarding possible systemic risks associated with funded reinsurance, it would make sense for the impact of failure of funded reinsurance arrangements to form part of their industry-wide stress testing “although this stress testing is designed to look at risk at a macro level rather than solely per insurer”.

“The PRA did announce in September 2023 that it expected to mandate disclosure of these stress testing results on an individual basis for the largest life insurers. It isn’t clear yet if results of this specific stress testing would fall in scope of this,” he said.

”In any case, it’s not a given that this stress testing would reveal material risk exposures in relation to funded reinsurance, considering the various related protections that insurers have in place such as collateral and concentration limits – but if it did, this could put pressure on any affected insurers to reduce the scale of funded reinsurance they use,” Absamson explained.

Systemic risks

Matthew de Ferrars, partner at Pinsent Masons, said: “The Bank of England is right to be scrutinising the role that funded reinsurance is increasingly playing in insurers’ risk transfer deals with UK pension schemes.” 

He said that the concern is about the degree to which funded reinsurance is being used for this. He acknowledged that funded reinsurance certainly has a part to play in an insurer’s diversified approach to managing the risks associated with providing pensions. However, he said there is a justified concern that if funded reinsurance is used excessively, it will expose UK pensions to new systemic risks.

The main risks according to de Ferrars would be those arising from the failure of a UK insurer’s overseas counterparty reinsurer, and the consequential liquidity and capital risks.

He said: ”The Bank of England’s plans to stress test whether funded reinsurance is being used appropriately are therefore sensible.”

It is also helpful to pension scheme trustees when deciding to put their trust in the UK insurance regulatory regime when buying in and buying out their pension schemes, Ferrars continued.

“We would expect the focus of the stress testing to be on the impact of an insolvency of an overseas counterparty reinsurer, relative to the UK insurer’s overall book of pension liabilities and the ability to access collateral in order to maintain the liquidity required to pay pensions,” he said.

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