The executive director for insurance supervision at the Prudential Regulation Authority has asked insurance senior managers to consider the risks and uncertainties when they transfer both asset and longevity risks associated with pension and annuity liabilities to a reinsurer.

The mechanism, known as funded reinsurance, uses third-party capital and capacity to support transactions that are capital-intensive and put a strain on in-house asset origination capabilities.

The PRA’s Charlotte Gerken first raised the issue with the reliance on third-party capacity in September, but at a speech today, she said the regulator was increasingly focussed on several aspects with funded reinsurance. 

For instance, she reiterated the issue with recapture risk, meaning the risk that any risk insurers have ceded might end up back on their own balance sheets. Default of the reinsurer is one of the reasons for recapture risk, she said, and voluntary and automatic contractual termination triggers linked to solvency coverage ratios, credit ratings or legal and regulatory environments bring “material uncertainty” to the recapture triggers.

Funded reinsurance also introduces wrong way risk – the risk that the performance of the counterparty and the collateral posted are likely to be positively correlated.

Gerken said: “We have observed the emergence of reinsurers with newer business models narrowly focussed on credit markets where diversification benefits might be less evident. This introduces a wrong way risk as the quality of the collateral portfolio is likely to deteriorate as the financial condition of the reinsurer falls.”

Collateral management is another concern. Gerken said the two risks are magnified by the increasing use of less liquid assets in collateral portfolios such as structured products, commercial mortgages and private credit. 

“Here, credit rating, valuation and matching adjustment eligibility uncertainty might exist which may not be adequately mitigated by valuation haircuts and margining practices,” she said. 

Another uncertainty is what management actions are available to estimate the cost and mitigate the effect of recapture risk. 

Gerken said: “This might include the cost of entering replacement contracts, asset portfolio rebalancing with potentially high transaction costs, unpredictable prices as market liquidity dries up, and unwinding or replacing large cross-currency hedging exposures. 

“These bring material uncertainty, as estimates of the costs and benefits in stressed conditions are inherently difficult to predict accurately.”

She said senior managers need to reflect on these considerations when making business decisions. 

“They need to approach these arrangements with caution and consider carefully whether their risk management processes are able to deal with these risks adequately. With responsibilities for pension payments for millions of policyholders for decades into the future, insurers need to demonstrate they can execute these transactions prudently and manage their risks over the whole life of the contracts,” she argued.

Gerken also queried whether this mechanism aligns with the government’s objective to increase UK long-term investments under the Solvency II reforms. 

She said: “Within the objectives of the Solvency II reforms, it is not clear that the incentives of third-party capital providers are aligned with UK insurers’ role in making investments in UK-based long-term infrastructure and productive assets. Both the PRA and insurers need to think about the opportunity cost of funded reinsurance – in terms of UK direct investments foregone – as well as the benefits and risks.”