PRA draws a line in the sand on Funded Reinsurance

August 2024

The Prudential Regulation Authority (PRA) released its final policy and Supervisory Statement (SS5/24) on Funded Reinsurance (FundedRe) while simultaneously publishing a strong Dear CEO letter (PDF 185 KB).  

Whilst insurers have made improvements to their risk management following the PRA's thematic work (PDF 220 KB) and Consultation Paper (CP), these fall short of regulatory expectations with regards to the volume and complexity of transactions and compliance with the Prudent Person Principle (PPP).

The PRA has signalled its readiness to use its full toolkit of supervisory powers, including explicit regulatory restrictions on the amount and structure of FundedRe and capital add-ons. Further rulemaking seems likely, including when informed by the collateral recapture scenario as part of the 2025 life insurance stress test.

The final rules largely mirror the CP, including expectations to establish:

• Internal investment limits with immediate recapture metrics;
• Investment limits for single counterparty exposures, simultaneous recapture from multiple highly correlated counterparties, and aggregate exposures;
• Collateral policies, with detailed policies for illiquid assets in collateral pools; 
• Board approved recapture plans; and 
• Clarification of Solvency Capital Requirement (SCR) treatment.

There are several helpful improvements in the final rules, including recognition that risk management should reflect the materiality of FundedRe to a firm's business model, proportionality in modelling complexity, and clarification that the board's role is to set the high-level principles for recapture plans and to challenge assumptions.

The SS came into effect immediately upon publication and, in addition, all firms with FundedRe arrangements must provide to the PRA, by 31 October 2024:

1. A self-assessment of current risk management processes against SS55/24, including justifications for areas of non-alignment; 
2. A summary of board approved limits;
3. Summary and timelines of remediation activities to date as well as what activities will be undertaken going forward;
4. With regards to the level of confidence in modelling, an overview of internal model output at transaction level, including how this has been used to shape investment limits; and 
5. The board's steps towards limiting its risk appetite for the amount and complexity for FundedRe.

The board-level approach needs to be informed by an independent opinion from the Risk function.

While the PRA does not expect renegotiation of exiting treaties, some negotiation may be needed to achieve compliance with the SS.

It's now up to insurers to decide how to balance the use of FundedRe, alongside enhanced oversight considerations, with the threat of further intervention if the PRA is not satisfied. 

A more detailed summary of the final rules follows below.

KPMG professionals could support you with:

• Assessing your FundedRe programme against expectations in the SS;
• Getting ready for the 31 October 2024 deadline, including check and challenge of the independent opinion from the Risk function;
• Designing or refining the risk management framework for FundedRe programme, including the preparation or review of recapture plans;
• Designing methodology for modelling the capital implications of the immediate recapture metric, including implications for the MA;
• For reinsurers, meeting annuity writers' evolving demands on how FundedRe transactions are structured;
• Training sessions for boards to facilitate effective challenge of FundedRe strategy, risk appetite and key underlying assumptions.

Main changes from the PS are highlighted below:

The PRA has decided not to make any material changes to the draft policy in this area but has made the below clarifications:

Singular recapture limit threshold

The PRA has clarified that it is up to the firms to determine the level of potential loss that would constitute a threat to their business models in line with its risk appetite, risk management policies, risk tolerance limits and investment strategy alongside its overall business strategy. 

The PRA has maintained its position that the limit should be presented before considering the mitigating impact of any management actions.

SCR-based investment limits

The PRA has clarified expectations around considering periods of high SCR coverage in the final SS, stating that this analysis should consider the impact of FundedRe exposures on firms' long term target SCR coverage ratios.

Diversification allowances

The PRA has clarified that whilst firms may identify some diversification benefits from their FundedRe portfolios which result in lower SCR or make higher investment limits appropriate, the PRA expects firms to be prudent in recognising such benefits.

Board involvement with recapture plan

The PRA has adjusted the proposed policy here, updating the final policy to state that board involvement is expected in setting the high-level principles underlying recapture plans and reviewing inherent uncertainties. Additionally, the level of board involvement in reviewing and approving the recapture plans should be proportional to the level of risk being taken. 

Investment limit expectations

With regards to tail value at risk (TVaR), the PRA has updated the SS to include that alternative approaches, such as stress and scenario testing could also be used.

For the `worst-case' collateral portfolio, the PRA has maintained the expectation that firms consider the risks that they recapture a `worst-case' collateral portfolio but has clarified that rebalancing and trading costs could be allowed for separately from the MA spread.

With regards to credit ratings, the PRA has clarified that it does not expect firms to rely solely on external credit ratings which may take longer to react to underlying changes in risk than internal assessments. The PRA has maintained the position that firms be expected to supplement these ratings with additional analysis for FundedRe arrangements. 

Collateral policy expectations

The PRA has clarified a number of matters in relation to the Collateral Policy firms are expected to have in place, mainly that:

• The level of detail in the policy should reflect the materiality of exposures;
• Ongoing monitoring of collateral should reflect the characteristics and materiality of the collateral assets;
• The base analysis referred to is expected to reflect prevailing economic conditions at the time of the analysis;
• The collateral policy is expected to consider potential investment management approaches under different circumstances; and 
• Firms should consider the nature of the collateral they are accepting exposure to, and factor this into their limit setting processes.

Own Risk and Solvency Assessment (ORSA) stress testing

The PRA has clarified that firms are expected to analyse their FundedRe exposures annually and only include specific stress testing around FundedRe in the ORSA report where exposures are material.

Proportionality and Materiality 

With its policy, the PRA aimed to capture all material risks measuring the counterparty credit risk capital charge in a firm's' internal models or partial internal models. The PRA has adjusted expectations to address uncertainty in the modelling of the risks associated with FundedRe, which promotes better risk management and decision-making.

Probability of recapture, linked to dispute and termination clauses

In the CP, the PRA had proposed that firms should consider the occurrence of any credit event set out in the transaction documentation when calibrating their probability of default. In the final policy, the PRA clarified that firms should consider the interaction between solvency ratios and termination triggers without detailed modelling but has not changed its policy.

Validations

In the CP, the PRA proposed that firms should develop validation processes to specifically explain the sources of any day one new business gain generated by entering a FundedRe arrangement. The PRA has also clarified how this could be done for example, by comparing the premium charged by the reinsurer with the premium that would have been charged by the insurer and reconciling the difference.

Other Areas 

• Management Actions: the PRA emphasised a prudent approach i.e. that firms should make their own assessment of their ability to carry out specific management actions and should be prudent about actions where there is limited or no historical precedent to justify the action.
• Recapture in MA Portfolio: in the PS, the PRA proposed elements that need to be considered when assuming a recapture within the MA portfolio and maintained that firms must demonstrate compliance post-recapture.
• Additional Validations: whilst acknowledging the need for additional validations, the PRA did not mandate specific validations for all firms.

Haircut policy

With the CP, the PRA proposed firms use clear risk based collateral haircuts linked to the risk being addressed and allow for over collateralisation. The PRA has made several changes in this chapter, with revised wording stating that the PRA expects firms to use clear risk based collateral haircuts or over collateralisation linked to the risk being addressed and list circumstances where haircuts may be more appropriate and where over collateralisation may be more appropriate. 

The PRA has also clarified that haircuts and over collateralisation should be calibrated and expanded the wording around broader risk considerations to add clarity. Wording around key drivers has also been altered. 

Frequency of collateral rebalancing

During the consultation, the PRA had proposed that where the margining is undertaken only on an infrequent basis (for example quarterly), it expects firms to consider the risk that large shortfalls emerge at recapture. In the final policy, the PRA has removed the example frequency and expects the firms to justify the frequency of rebalancing.

Reassessment of contracts

The CP was unclear on the extent of reassessing required for the existing contracts and arrangements. The PRA clarified that firms are expected to assess the risks on the arrangements if it has not been carried out as expected by the PRA in the SS. Additionally, the PRA has clarified that it does not expect firms to renegotiate the terms of contracts with counterparties, but firms must consider continued compliance with existing rules and requirements, including in their risk appetite. 

Proportionality and materiality to counterparties

The PRA agrees the proportionality and materiality are relevant considerations and has adjusted a number of areas including the expectations around collateral policies and SCR modelling.