The Prudential Regulation Authority (PRA) has identified several risks in the growing use of funded reinsurance (FundedRe) within the bulk purchase annuity (BPA) market, as it aims to balance innovation with the need to safeguard policyholders and ensure sustainable growth.

Speaking at a recent event, PRA director for prudential policy, Vicky White, explained that as the BPA market has grown in recent years, so has firms’ need for capital, highlighting this as one of several drivers of the growing popularity of FundedRe.

“This is not only a UK phenomenon – similar trends are evident in other markets," she said, noting that, in addition to access to capital, the increased use of FundedRe could be about accessing assets originated by or only available to the reinsurer.

However, she noted that a "more troubling" driver from a supervisory standpoint has been the idea that it could be about leveraging differences in reserving approaches, capital requirements and investment flexibility.

White therefore confirmed that the PRA is now looking to ensure it has the right regulatory regime in place for the future, amid concerns that the growing usage of FundedRe could, if not properly managed, lead to a build-up of systemic risk in the sector.

In particular, she cautioned that FundedRe arrangements, where reinsurers, often offshore, invest premiums into collateral pools, may be receiving preferential treatment under the Solvency UK framework.

She also pointed out that examples are already being seen of large cashflow mismatches and unhedged currency exposures within current transactions - well beyond what would typically be expected from direct UK annuity investments.

“In FundedRe, the reinsurer invests the large upfront premium in a portfolio of assets which effectively becomes the collateral pledged to the cedent,” she explained. “However, by extending the label of ‘reinsurance’ to this funding component, Solvency UK treats it as essentially a risk-free construct.”

By contrast, economically similar arrangements, such as a UK insurer that funds its expected annuity liabilities by repayments from a loan it has made to a counterparty, and manages the remaining risk that pensioners live longer than expected with a longevity swap, would be treated as a risky asset under the same regime.

“The two strategies are close in economic substance, yet our initial diagnosis is that they receive very different regulatory treatment simply because one is labelled ‘reinsurance’,” she said.

The PRA is therefore exploring whether the investment component of FundedRe should be “unbundled” for valuation purposes; in other words, separated from the longevity reinsurance for valuation in the Solvency UK balance sheet, to ensure risks are captured more accurately.

However, White emphasised that "this is an initial diagnosis and we have not come to any firm views", with plans to hold roundtables with industry later this year to discuss the issue further.

In addition to concerns under the PRA's primary objectives, White said that the growing use of FundedRe could also present concerns for PRA's secondary objectives.

In particular, while acknowledging the value of geographic diversification, White warned that FundedRe may be encouraging investment away from UK productive assets and towards offshore reinsurers, distorting investment incentives and competition within the BPA market.

"Not only is there an argument that FundedRe may be posing risks to our primary objectives because of a quirk in regulatory treatments, but it is also possibly impacting on our secondary competitiveness and growth objective, skewing firms’ investment incentives," she stated.

White suggested that the "increasingly competitive BPA market may drive some forms of competition with undesirable characteristics".

"Some firms may use FundedRe, despite the risks, to outprice their competitors, sacrificing long-term earnings and investment capacity to offshore counterparties to gain an advantage through the beneficial regulatory treatment of FundedRe," she explained.

Given these concerns, White stressed that the PRA is looking to take action now, "so that unmitigated risks do not rise to a level where they could put the resilience of the sector and its policyholders in peril".

Seperate from the PRA's work on the appropriate framework for FundedRe, White also confirmed that the PRA has included a FundedRe recapture scenario in its 2024 life insurance stress test, with results expected later this year.

This comes after the Financial Policy Committee (FPC), International Association of Insurance Supervisors (IAIS), and others previously highlighted concerns that complexity and lack of transparency in such arrangements could amplify systemic risk.

“Our aim is not to disrupt firms’ existing arrangements,” White clarified, however, confirming that the PRA will be working to closely monitor firms’ FundedRe activities to ensure new deals are consistent with pre-existing plans and appetites

"Should we conclude that any adjustments to the treatment of FundedRe are required, they would be subject to our usual consultation processes. We would also only look to apply these to future business," she added.

"Where firms have transacted in the past based on different rules, we would allow those to continue to receive the current reinsurance treatment."

Alongside its focus on FundedRe, White confirmed that the PRA is also considering how insurers can continue to access sustainable sources of long-term capital to support the BPA sector.

White said that while the regulator does not believe there is a systemic shortfall of capital, there is industry appetite for “patient capital” aligned with annuity liabilities.

However, she noted that traditional equity and debt sources are increasingly constrained by high return expectations and volatility sensitivities, while private capital and reinsurance carry their own risks, including opacity and offshore concentration.

One potential solution under consideration is the insurance special purpose vehicles (ISPVs) framework, which could allow insurers to tap into capital from external investors in a targeted way.

According to White, ISPVs may be used by life insurers to provide additional capacity alongside longevity reinsurance or to cover asset risks, unlocking a different pool of patient long-term capital.

However, she acknowledged that, historically, ISPVs have not been considered suitable to support annuity-type business, given the prudential and economic challenges for a vehicle with finite capital to provide effective risk transformation for long-term market and credit risks.

"These are real concerns that lead us to tread carefully, and our current position is that it is difficult to see how they could be used under our current framework," she stated.

Despite this, she confirmed that the PRA, in collaboration with HM Treasury, intends to publish a discussion paper on alternative life capital options later this year, including how ISPVs or other structures could be made more accessible to life insurers.

"We do not claim to have all the answers," she added. "But we do believe that now is the right time to take stock, to ask whether the current regime is supporting the right behaviours in a sustainable way, and to engage with industry on how we can collectively shape a future that works for policyholders, firms, and the wider UK economy."

---