The UK bulk buy annuity (BPA) market is rising, and there may be nonetheless demand for insurance coverage options from outlined profit (DB) pension schemes and company sponsors. UK BPA life insurers are more and more utilizing funded reinsurance to help their BPA methods. Regulators have turned their consideration to the use and dangers of funded reinsurance, with the Prudential Regulatory Authority (PRA) releasing a ‘Expensive CRO’ letter in June and a session paper (CP24/23) in November. However what’s funded reinsurance, and what are the implications of CP24/23?
What’s funded reinsurance?
Below a funded reinsurance construction, the cedant pays an upfront premium to the reinsurer, which invests this to make annuity funds to the cedant. The cedant carries on making funds to policyholders. The cedant transfers asset and longevity dangers to the reinsurer – the primary distinction between funded reinsurance and longevity swaps, which solely switch longevity threat (Determine 1).
Counterparty publicity can also be a lot larger in funded reinsurance than in longevity swaps, so funded reinsurance constructions are collateralised to guard the cedant from reinsurer default. The collateral funding pointers are often a serious space of focus throughout negotiations, with corporations needing to stability the reinsurer’s funding flexibility towards potential dangers on recapture – for instance sustaining matching adjustment compliance.
Since Solvency II was put in place, UK BPA life insurers have usually used longevity swaps to handle the longevity threat solvency capital requirement (SCR) and threat margin. The elevated use of funded reinsurance is a current growth for the UK BPA market, though some corporations did use it previously, to a restricted extent. Funded reinsurance’s primary impact on the cedant’s Solvency II stability sheet is that it removes market threat and longevity threat SCR (partially offset by a rise in reinsurer counterparty default threat), with a corresponding discount within the threat margin.
Why funded reinsurance?
UK life insurers use funded reinsurance for a number of causes, together with:
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As a capital or threat administration software
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To supply belongings by leveraging the reinsurer’s asset origination capabilities, significantly the place corporations can’t supply belongings by themselves according to their plans
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To enhance front-end pricing to DB pension schemes and value extra competitively for various segments of the BPA market (similar to deferred pensioners or ‘jumbo’ schemes).
There are 9 insurers within the UK BPA market, so there’s a comparatively restricted provide of capital to satisfy DB pension schemes’ rising demand for UK insurance coverage options – significantly underneath current market situations, which have improved many DB schemes’ solvency positions. The funded reinsurance market has been an additional supply of capital for the UK BPA market.
What are the PRA’s key factors?
In its CP24/23 paper, the PRA proposes a brand new supervisory assertion setting out expectations for funded reinsurance and protecting three broad areas: threat administration, modelling of the SCR, and structuring.
Threat administration
The paper units out a number of issues for setting inner reinsurance counterparty limits. Reinsurance counterparty publicity methodology has just lately been an space of focus for BPA corporations; many see it as a key industrial problem, since reinsurance is crucial in most corporations’ BPA methods.
UK BPA corporations use a spread of approaches to measure reinsurance counterparty publicity. The CP24/23 proposals are more likely to require corporations to revisit these approaches, probably resulting in extra consistency.
Companies additionally set totally different reinsurance limits: some have each particular person counterparty limits and a single complete restrict for funded reinsurance, others have solely particular person counterparty. The extra limits proposed might constrain the quantity of funded reinsurance on which cedants transact.
The paper proposes corporations have a collateral coverage that features setting out the credit standing evaluation and valuation method for illiquid belongings. Some funded reinsurance preparations have funding pointers that permit a big proportion of collateral to be held in illiquid belongings, and the cedant might not have entry to sufficient info to have the ability to assess the ranking and worth of those belongings. The CP24/23 proposals might lead cedants to request extra info from the reinsurer, or to scale back urge for food or exclude sure kinds of illiquid belongings if they can not acquire sufficient info.
Most UK BPA corporations with current funded reinsurance preparations have a recapture plan, which they’re more likely to revisit in mild of the CP24/23 proposals. Companies might want to decide the extent of element and granularity required to explain recapture processes, on condition that reinsurance recapture is an unsure and distant occasion.
SCR
The proposals on counterparty default threat SCR are more likely to lead some corporations to revisit their calibrations. Most UK BPA corporations use an inner mannequin to calculate the SCR and there may be variation in how they calibrate the parts used to calculate counterparty default threat SCR, similar to chance of default (PD), loss given downgrade and default (LGD), and correlation between reinsurers.
The undiversified counterparty default threat SCR is usually a small share of reinsured greatest estimate legal responsibility for funded reinsurance (primarily as a result of collateralisation and the applying of the PD to the LGD). The proposals might result in the strengthening of SCR calibrations, however it’s unclear whether or not the quantity of SCR will improve to a cloth stage. Many corporations know that their counterparty default threat SCR is unlikely to cowl losses underneath a termination occasion. This implies different instruments, similar to counterparty limits, are extra essential for managing counterparty default threat.
Structuring
Companies contemplating entry to funded reinsurance preparations might want to contemplate how they negotiate recapture and collateral phrases to swimsuit their threat administration functionality and threat urge for food. This may occasionally have an effect on the industrial phrases they may settle for.
CP24/23 proposes that corporations develop an internally authorised contractual threat urge for food assertion and minimal pointers on contractual options for funded reinsurance transactions. Some corporations haven’t but formalised these areas. For some, the information round funded reinsurance structuring could also be concentrated inside a small variety of people who’ve been concerned in previous transactions.
The proposal that corporations develop a risk-based collateral haircut coverage might have an effect on transactions. Over-collateralisation is comparatively frequent in longevity swap transactions –it’s much less so for funded reinsurance transactions. Funded reinsurance transactions in future might want to contemplate this level, and there could also be extra cases of over-collateralisation.
Extra to be accomplished
Total, there may be extra to do, and corporations are nonetheless working by the proposals and their implications. To some extent, CP24/23’s results will depend upon which proposals stay within the closing supervisory assertion and the way the PRA implements them.
Some corporations are already contemplating the proposed necessities within the context of their structuring, threat administration and SCR methodology. Nevertheless, the way in which through which CP24/23 will have an effect on the expansion of funded reinsurance stays to be seen.
Kenny Cheng is a senior supervisor in EY’s Actuarial and Threat companies crew, specializing in capital and optimisation