FundedRe - Too Much of a Good Thing?

The PRA are concerned about potential systemic risks from excessive use of Funded Reinsurance. Insurers need to determine whether their current capital model addresses the PRA’s concerns.

FundedRe landscape

Funded Reinsurance (also known as ‘FundedRe’, ‘Asset Intensive Reinsurance’, ‘Asset Backed Reinsurance’ and ‘Coinsurance’) is a well-established risk management tool in the US that has recently been gaining traction in the UK market. It is effective when used for Bulk Purchase Annuity (BPA) transactions as it helps insurers minimize their exposure to both market and longevity risks which can materially reduce the capital requirements associated with a BPA transaction. In some cases, this can also lead to the unusual position of new deals having a negative capital strain. This makes BPA pricing more competitive and has allowed firms to increase the size of schemes they can transact with. However, the use of FundedRe will generally increase two material risks for the insurer: Counterparty Default Risk and Recapture Risk.?

FundedRe reinsurers’ asset origination capabilities can be more sophisticated than those of UK insures, which can widen the universe of credit assets that UK insurers are exposed to. This, when coupled with regulatory and tax arbitrage, increases the attractiveness of FundedRe for insurers through competitive pricing. However, this means monoline FundedRe counterparties are likely to be correlated with each other due to their similar business models and investment strategy. This leads to a significant recapture of risk if those counterparties default at the same time.

The counterparty default risk and recapture risk may not be well captured by existing capital models. This is because many insurers who use FundedRe have approved (partial) Internal Models. These were approved before the extensive use of FundedRe and have not yet been through a model change process to fully incorporate the extra considerations needed for FundedRe. The Prudential Regulation Authority (PRA) is concerned that some (partial) internal models may not be fit for modelling FundedRe transactions because these models are potentially understating the risks associated with FundedRe, particularly probability of recapture, and concentration and correlation of default.?

The PRA have included FundedRe as one of their top priorities in 2024 stating they expect these transactions to only play a limited role in companies’ risk mitigation. Firms can expect further PRA engagement over 2024 on their use of FundedRe and whether they are meeting the PRA’s expectations in the upcoming supervisory statement that is expected to come in force from Q2 2024.

Industry trends

Over 2023, the UK market experienced growth in the use of FundedRe for BPA transactions. 2023 saw new entrants into the market such as Resolution Re, which completed its first deal in October 2023 which was quickly followed by a second deal two months later. Some FundedRe deals were facilitated by new, smaller reinsurers that have tended to be based in overseas jurisdictions and more focused on taking on asset risks. Due to these new cedants being less willing to take on material longevity risk, we may start to see some FundedRe transactions with the transfer of asset risks and a small proportion of longevity risk.

We are also seeing larger and more established players in longevity-only reinsurance considering entry into the UK FundedRe market in 2024.

Proposed requirements in the PRA’s consultation paper (CP24/23) may reduce the capital efficiency of FundedRe. Some firms have already kicked off deep dives into counterparty risk modelling to identify the areas where they need to develop the model and whether these developments would be classed as major or minor model changes.

PRA’s proposal

Risk Management: Efficient risk management of counterparty exposure. The PRA are setting out expectations that include a combination of counterparty limits, collateral policy and recapture plan.

Solvency Capital Requirement (SCR): Firms should hold enough capital to withstand recaptures. The PRA also sets out additional expectations on key assumptions in the SCR calculation, including Probability of Default, Loss Given Default, collateral portfolios and recapture within the MA portfolio.

Structuring of FundedRe: In line with Prudent Person Principle requirements, the PRA are suggesting a 4 step framework to help firms quantify the risks of FundedRe and have appropriate structuring arrangements in place.

1. Risk management

The key risks from FundedRe are Counterparty Default Risk and Recapture Risk. To monitor and mitigate these risks, the consultation paper proposes firms consider counterparty internal investment limits, collateral policies and recapture plans.

Counterparty internal investment limits: The PRA proposes that firms should have an ‘immediate recapture’ metric. This would measure the impact of a firm’s SCR ratio in a scenario where all ceded business from a counterparty is recaptured. This would ignore the probability of the event and ignore the impact that management actions could have.

When developing the PRA’s proposed immediate recapture metric, firms should:

• Assume the recaptured assets are poor quality assets;
• Consider stressed conditions beyond a 1 in 200 level; and
• Consider exposure limits to both individual counterparties and an aggregate counterparty limit.

Collateral policies: Firms should also have clear collateral policies in place which are linked to their risk appetite. This would specifically include detail on illiquid assets used and address the following topics: approaches to credit assessment, valuation methodologies, whether assets in the collateral pool are Matching Adjustment (MA) eligible, SCR modelling and the recapturing process.

Recapture plan: Firms should have board-approved realistic recapture plans. In the event of recapture, the cedant insurer takes ownership of the ringfenced assets and liabilities. These assets will often include exposure to illiquid credit, some of which may also not be eligible to go directly into the insurer’s MA portfolio without some form of structuring and/or new features approval.

To mitigate the risk, the recapture plan would include monitoring counterparties’ financial soundness; the recapture process; the asset transfer process; steps to ensure MA compliance; and areas of uncertainty.

2. Solvency Capital Requirement

The PRA’s proposal focusses on four areas:

1. Probability of default: Firms may be underestimating the likelihood of recapture events and not using appropriate data to set assumptions. Typically, with the FundedRe contract there are recapture clauses where insurers start to recapture the assets and liabilities prior to default. The trigger for this could be based on the reinsurer’s credit rating or solvency ratios going below a certain level. These events should be modelled by insurers to understand the realistic probability of recapture.
2. Losses given default or downgrade: Firms should consider the impact that recapture will have on their balance sheets. This can be summarized as impact on risk margin, impact on ceded liabilities, and management actions that meet PRA’s expectations.
3. Collateral portfolios: These should be stressed on a look-through basis with asset and liability mismatch being considered. Also, firms may not be realistically considering the ability of counterparties to re-collateralize after a stress event or where the counterparty has become insolvent.
4. MA eligibility of recaptured assets: Firms should assume that recapture is done in line with their current MA approval, and any assets outside of their current approval should be assumed to sit in the non-MA portfolio on recapture, which will need assessing to determine any additional capital strain from recapture.

By focusing on these four areas, firms should be able to understand the true impact of using FundedRe as a risk mitigation tool.

3. Structuring of FundedRe

The PRA is concerned that firms are not demonstrating the Solvency II Prudent Person Principle requirements when entering FundedRe deals. Firms should pay particular attention to basis risk; collateral mismatch risk; a contract’s time horizon; and the contractual mitigations of each potential new deal. The PRA have proposed the following four-step framework to quantify the risks of these transactions:

1. Identify all basis risk and collateral mismatch risk.
2. Stress risks that cause basis risk or collateral mismatch risk.
3. Assess whether this transaction is within the company’s risk appetite. A firm’s risk appetite should state the maximum loss they would accept at an individual FundedRe contract level.
4. If the deal is outside of the risk appetite, firms should consider modifying the proposed FundedRe contract.

Main challenges for insurers

Essentially, the PRA is looking for insurers to increase sophistication in their assessment of risks associated with FundedRe. One way to better understand the quantum of their risk exposure is through improvements to their capital modelling. The capital model is the best tool insurers have to understand the risks they are taking on and to inform their key decisions. However, improving this model does not come without its challenges.

Reinsurers may also need to consider the impact of insurer recapture when selecting assets for the collateral portfolio, specifically the likelihood of MA eligibility in the case of recapture. This may lead to a more restrictive set of criteria for selecting assets for the collateral portfolio, with potentially lower investment returns and hence a more expensive reinsurance premium.

Challenge 1: Data

In modelling the capital required for FundedRe, the difficult part will be having appropriate data for base assumptions. Overall probability of defaults will be easier to manage, however detailed modelling of other recapture events is required and this will call for a more nuanced approach. The level of detail needed for this modelling exercise may not be readily available as it will be bespoke to the specific treaties in place.

Information on the collateral pool will also be required to model the balance sheet impact of recapture. However, it is not clear if reinsurers will be willing and able to fully share this data with cedants, and suitable proxy assumptions will be difficult to determine.

Challenge 2: Model development

To model FundedRe risks, companies should be looking to develop bespoke models that can determine the impact of recapture events. Modelling the probability of recapture, concentration risk and other elements can be challenging, particularly when conducting this modelling within the existing Internal Model framework.

Given longevity risk is considered non-hedgeable, changes to capital modelling for FundedRe to allow for recapture of liabilities will also have knock on implications in the Risk Margin calculation that need to be considered.

The proposal also specifically mentions that in setting the investment limit firms should consider risks beyond a 1 in 200 level, potentially through Tail Value at Risk (TVaR) calculations. Again, this methodology may be new for insurers and require development.

Challenge 3: Capacity

These proposals will affect both the Risk and Capital functions of insurers. Insurers will have to develop the new FundedRe risk management metrics and embed these within their existing processes.

Some insurers may also have to deliver a major model change. This is dependent upon the sophistication of their current model as well as the firm’s level of exposure to FundedRe both now and in future planning projections.

Many UK insurers are in the process of making internal model changes, so adding this to an already long pipeline of model improvements (as well as the expected implementation of SUK reforms to the MA during 2024) is a real challenge for both insurer and regulator capacity.

Challenge 4: MA Eligibility

The PRA’s proposals may also affect the cost of FundedRe in the market, particularly for insurers who do not have as wide a range of MA eligible assets as their peers. In terms of the assets held in the collateral portfolios, there are two potential outcomes from the proposals:

1. Reinsurers decide to only hold assets that meet the cedant’s MA eligibility criteria in their collateral portfolio. This could reduce the yield reinsurers get on their portfolio.
2. Reinsurers may continue to invest in non-MA eligible assets, which will increase the required capital that is held by the cedent insurer.

These would lead to an increase in the cost of FundedRe for some insurers but would give a competitive advantage to insurers who have a wider choice of MA eligible assets.

Next steps

Direct insurers that embrace the PRA’s proposals will have a better understanding of their risk profile and will be more effective in managing their reinsurance contracts, bringing further security to their balance sheet. This will allow insurers to grow with a balanced view of the risk and reward of FundedRe.

Reinsurers should consider adjustment to the investment strategies to ensure the commercial offering remains competitive and meets the needs of direct insurers regarding the capital efficiency.

We, at WTW, have vast experience of risk management development, a strong track record of capital modelling capability and insight from reinsurance transactions. Therefore, we are uniquely positioned to help both insurers and reinsurers address these challenges.

The PRA is still in the consultation phase of these proposals, but has identified what it sees as a systematic challenge to the UK insurance market that the industry needs to address.

We recommend insurers take action to understand the gaps in their internal modelling and risk management frameworks. WTW can help firms understand what is needed for their internal models and implement the changes to help firms better manage the risk exposures of FundedRe.

We also recommend that reinsurers consider the implications on their investment strategies and how to optimize their commercial offerings.

If you would like to discuss any of the above in more detail, please get in touch.

Authors

Monty Iliev, Director, Retirement and Decumulation, Insurance Consulting and Technology, [email protected]

Weihe Qin, Director, Insurance Consulting and Technology, [email protected]

Muhammad Amjad, Director, Private Asset and Capital Management, Insurance Consulting and Technology, [email protected]

Contact us

Amanda McKinney-Hosken, Director, Reinsurance Lead, Insurance Consulting and Technology, [email protected]

Anthony Plotnek, Director, Private Asset and Capital Management Lead, Insurance Consulting and Technology, [email protected]