The executive director insurance supervision of the Prudential Regulation Authority has found some “material shortcomings” in re/insurers’ practices when dealing with recapture risk, one of the regulator’s main concerns with funded reinsurance.

Charlotte Gerken’s comment came as she provided feedback on the findings from a preliminary thematic review on funded reinsurance, a process of transferring both asset and longevity risks associated with pension and annuity liabilities from an insurer to a reinsurer.

She has repeatedly raised the issue of recapture, the possibility that any risk insurers have ceded might come back to their own balance sheets.

In a letter to life insurance chief risk officers on Thursday, Gerken said that “firms’ practices showed some material shortcomings” in areas such as structuring, risk management and capital requirements. 

Based on a selection of funded reinsurance transactions executed since 2019, one of the key risks arising in funded reinsurance is that firms recapture sub-optimal portfolios with “depressed values and with limited ability” to be transformed effectively to the firms’ preferred portfolio, she said.  

Gerken was also worried about whether some firms have sufficient financial and operational resources on recapture. 

She explained that the PRA had observed improvement in firms’ internal risk frameworks and internal models to capture these aspects but added: “These need to be more closely connected to the terms of the contracts. Moreover, there remains a high reliance on management actions under stress both within internal models and in risk management frameworks. These need robust challenge as such actions might not be viable in all market conditions.”

She asked companies to consider the findings of the letter and “take the appropriate remedial actions”, including continued compliance with the PRA supervisory statement SS1/20 – Solvency II: Prudent Person Principle, and SS20/16 – Solvency II: reinsurance – counterparty credit risk. 

“The PRA will continue to challenge these areas where we see weaknesses within firms or inadequate justification for the assumed effectiveness of management actions,” said Gerken.

She noted “significant potential risks” to the PRA’s objectives from the systematic use of funded reinsurance to meet the increase demand for bulk transfer of defined benefit pension liabilities. 

Gerken concluded: “The effect might be to accelerate these transfers in the short run, but it would come at a cost of creating a systemic vulnerability in the form of a concentrated exposure to correlated, credit-focussed reinsurers, and an opportunity cost in the form of UK productive investment foregone. We will examine these factors further as we consider the case for further policy proposals in this area.”