The Bank of England (BoE) is hardening its approach on the use of funded reinsurance and offshore financing by UK life insurers, aiming to balance innovation with financial stability as the bulk purchase annuity (BPA) market continues its rapid expansion.
Funded reinsurance allows insurers to transfer both longevity and investment risks for a block of business – typically pension liabilities – to a third-party reinsurer.
While this helps insurers free up capital and offer more competitive pricing to pension schemes, it also introduces new risks for the UK financial system.
The BoE is worried that this is a form of “regulatory arbitrage” that allows insurers to cut the capital they hold while the risk remains the same.
The UK’s BPA market, which involves insurers taking on the pension obligations of corporate schemes, has seen big growth. To meet demand and manage capital requirements, many insurers are turning to funded reinsurance.
However, the Bank’s Prudential Regulation Authority (PRA) is concerned about the potential for concentrated risks.
White said: “The IAIS and others, including the International Monetary Fund, the Bank for International Settlements and our own Financial Policy Committee (FPC), have all called out concerns about leveraging different approaches to valuation and regulatory views of risk. The FPC highlighted that the growing usage of FundedRe could, if not properly managed, lead to a build-up of systemic risk in the sector.
“In a nutshell this is because complexity and lack of transparency in these arrangements mean they have the potential to increase the fragility of parts of the global insurance sector if the underlying vulnerabilities are not addressed.”
So far, the PRA has taken a principles-based approach, highlighting the risks and setting out clear expectations for UK insurers on the standards of governance and risk management appropriate for these types of transactions.
The organisation’s SS5/24 will continue to outline expectations for firms in these contracts, though these may change with market developments, White noted.
However, even if firms meet these expectations, the projected growth of this business to tens of billions in the next decade could pose systemic risk due to correlations and uncertainties.
White noted that insurers have taken advantage of “quirk in regulatory treatments” to decrease the capital held for pension liabilities, adding that the BoE’s aim was to make sure to “act now to get the treatment right for the future.”
She also said the bank is concerned that these offshore deals are “driving investment away from those UK productive assets which support the growth of the UK economy, and towards internationally based reinsurers.”
Potential changes being considered include “explicit regulatory restrictions or limits on the amount and structure of FundedRe, or measures to address any underestimation of risk, or potential regulatory arbitrage,” White stated.
“This is an initial diagnosis and we have not come to any firm views, so we want to explore these issues with stakeholders. We’ll be holding roundtables later this autumn to get to a common understanding of the issue and decide if the right course of action is to change the rules to ensure a consistent treatment across economically similar structures,” the executive explained.
Adding: “We want to explore whether the current bundled treatment of the components of a FundedRe transaction accurately reflects the risks. The key focus for us is seeking insight as to whether the investment component of FundedRe should be ‘unbundled’; in other words, separated from the longevity reinsurance for valuation in the Solvency UK balance sheet.”
Separately, the BoE has included a FundedRe recapture scenario into this year’s life insurance stress test in order to understand the potential for FundedRe to impact the insurance sector and wider economy.
White acknowledged the vital role of life insurers in provisioning long-term security to policyholders and supporting the UK economy through patient long-term investment.
She stressed that the PRA’s goal is not to stifle innovation but to ensure that new capital models, including those involving offshore reinsurers, are both safe and sustainable.
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