The Prudential Regulation Authority has growing concerns over how insurers offload their risks to reinsurers – including over how UK annuity providers transfer longevity and investment risks to reinsurers. 

Charlotte Gerken, executive director for insurance supervision at the PRA, outlined issues that expose primary insurers to “complex and concentrated risk”. Speaking at the Bank of America 27th Annual Financials CEO Conference on Tuesday, she cited continued high levels of longevity reinsurance, the emergence of “funded reinsurance” and the continued growth of untraded or illiquid assets in life insurers’ portfolios. 

The PRA continues to see high levels of longevity risk being reinsured – a trend that is unlikely to change even if the Solvency II risk margin is reduced, as reinsurance is part of a firm’s business strategy. 

Gerken warned there is a potential for systemic risk where a large proportion of the UK insurance and pensions industry’s exposure to longevity risk is ceded to a small number of reinsurers.

“Firms may argue that they could reinsure the risk to a different reinsurer, but with a market dominated by a small number of counterparties whose financial position may be positively correlated, this assumption may be unrealistic,” she said.

The PRA estimates over 80% of new business since 2016 has been reinsured at industry level, driven by the introduction of the risk margin under Solvency II and by an “increasingly competitive” marketplace.

The second issue she raised - funded reinsurance - involves the insurer paying a single, up-front premium which is then invested by the reinsurer to make the annuity payments. This allows an insurer to transfer both asset risk and longevity risk associated with pension and annuity liabilities to a reinsurance partner. 

Although funded reinsurance is “far from being common”, Gerken said this business model “can be likened to an ‘originate-to-distribute’ model with upfront gains and a perception of limited retained risk”. 

“Funded reinsurance also appears to be a long way from the traditional purpose of reinsurance, which is to access wider diversification of liabilities,” Gerken said. 

The regulator has a particular focus on recapture risk, according to Gerken, where a ceding company takes back risks that were previously ceded to a reinsurer.

She said: “Given the presence of significant collateral from day 1, the recapture process this time adds the material additional risk that there are insufficient or inadequate assets in the collateral pool to meet liabilities, should a recapture event occur.”

Gerken added the recaptured assets may not always be eligible for the matching adjustment or meet the cashflow matching requirements of Solvency II. 

“Firms may face large and uncertain costs re-establishing MA-compliant portfolios where more exotic collateral assets recaptured need to be replaced, especially in a potentially dislocated market,” she said. 

The legal terms and conditions of these collateral arrangements are increasingly non-standardised and opaque, resulting in collateral recapture processes which remain inherently untestable until the event of an actual stress.

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

She said high levels of funded reinsurance “would render the payment of a significant value of UK pensions dependent upon the strength of a concentrated and correlated group of reinsurers”.

The PRA is also worried some of the risk is passed to overseas reinsurers, which the regulator has no control over. 

“These reinsurers are held to standards set outside the UK. Given our own ongoing efforts to tailor prudential standards for annuity business, standards elsewhere may well not have been designed with UK annuity risks in mind – and so may not yet handle them as effectively,” she said. 

Gerken said the authority intends to strengthen its monitoring of funded reinsurance, for example by analysing structures and the risks that companies pose, in detail. 

She added: “We will think about whether protecting policyholders demands limits on acceptable structures or on volumes of transactions.”

Funded reinsurance is small at present. Two companies that have openly offered such transactions to UK primary firms are Prudential Financial and Pacific Life Re. 

In 2020, Prudential Retirement, part of Prudential Financial, closed a funded reinsurance deal with Aviva in June. The US insurer argued in October that year that the move offered “an additional layer of security, mirroring the insurer’s promise to pay all benefits for as long as the people live”.

In May 2021, Pacific Life Re announced it had completed a £190m funded reinsurance deal with an unnamed UK insurer, saying the deal “protects the insurer not only from the financial risk of an unexpected increase in life expectancy, but also from unexpected losses in the invested assets”.

Gerken noted the majority of the credit risk, if not the insurance or longevity risk, is still retained by annuity firms. 

Citing figures from consultancy firm McKinsey, she said private credit has been growing rapidly, with global fundraising activities reaching $192bn in 2021, 10% up from the year before. 

UK life insurers have been active in this, she said, due to attractive returns tapping into the illiquidity premium, diversification benefits and more bespoke arrangements that match lenders’ appetites to borrowers’ needs. 

But Gerken added that private investments are inherently characterised by the absence of transparent secondary markets.

“Due to the novel nature of many of these assets, it is plausible that not all risks can be identified, let alone measured. These risks could have an adverse impact on the capacity to generate cashflow, and hence real value of these assets,” she said. 

The PRA believes there is a risk of insurers becoming over-reliant on models to drive investment and capital decisions, “models that are inherently reliant on public market performance as proxies and limited history”.