The PRA have set out their expectations on the future use of funded reinsurance in Supervisory Statement SS5/24 which took effect from the date of publication (26th July 2024) – and imposes a relatively short Board assessment and PRA reporting deadline of 31st October 2024. The new rules are applicable to all UK Solvency II firms and insurance / reinsurance undertakings that have a UK branch (third-country branch undertakings) where they hold, or are intending to enter into, funded reinsurance arrangements.
For an issue that sits very much within the remit of the CRO, the fact the PRA have issued a ‘Dear CEO’ letter to accompany the Supervisory Statement should be an immediate warning to all board members – this is not a matter you can leave to your risk function to manage in isolation. In the eyes of the PRA it is an issue that sits at the heart of the strategic decision making and governance function of the board. If you are a board member of such a firm, or responsible for briefing the board on your firms’ use or intended use of such arrangements, it is important to understand not only the technical provisions of the new rules, but the governance aspects of those.
The New Rules – A Board Member’s Summary
Funded reinsurance is a complex area but with the increasing concern abouts its use and the exposures it could bring to the market as a whole in the event of adverse events, the PRA is making it clear that it expects board members not only to have a clear understanding of the issues, but to be directly involved in setting a clear framework for its use, and being able to justify that approach as part of their PRA engagement.
“The PRA expects to seek assurance on firms’ practice in a proportionate way, focusing on the exposures which in the PRA view present the greatest risk. The PRA may consider this as a topic in a firm’s Periodic Summary Meeting (PSM) or, where appropriate, look to commission a Skilled Persons review under s166 of FSMA.” (PS13/24 – Funded reinsurance)
In broad terms, the new rules cover three areas:
- Ongoing risk management
The risk management processes that firms are required to have in place to identify, measure, monitor, manage, and report the risks to which they are exposed in relation to their funded reinsurance agreements. It covers counterparty internal investment limits, collateral policy and recapture plan. - Solvency capital requirements
Firms’ assessments of risks associated with funded reinsurance arrangements with the aim of capturing all material and quantifiable risks in their SCR when taking into account the effects of funded reinsurance as a risk mitigation technique. It needs to cover the probability of default, loss given default or downgrade, collateral and recapture within MA portfolio (for firms with MA approval.). - Entering into and structuring of funded reinsurance arrangements
This section covers risk assessments, basis risks, collateral mismatch risks, time horizons and contractual mitigations.
It’s worth noting at this point that the PRA is certainly not advocating against the use of funded reinsurance – it is clear that it sees the use of such contracts as an important part of the risk management process. Its concerns arise from:
- A belief that counterparty risks may be underestimated as a result of the risk profile of the counterparties;
- the complexities of the arrangements; and
- the uncertainty around the effectiveness of management actions in stress.
In assessing your firm’s response, these are the core PRA perceptions that need to be addressed.
Board Responsibilities
Accountability for this issue has been placed firmly with the board of life insurance firms, whilst recognising that your risk function will be undertaking much of the work. If your firm makes use of Funded Reinsurance transactions, or is intending to enter into contracts to do so, your board must consider your firm’s alignment with the Supervisory Statement as soon as practicable.
The board is required to provide your PRA supervisor, by 31st October 2024, with the following:
- A self-assessment analysis
An assessment of your firm’s current risk management practices against all the expectations set out in SS5/24, including a justification if there are areas where your firm has not aligned fully with the expectations of the Supervisory Statement, but where the implemented framework is considered to achieve the same outcome. - Limits
A summary table of your firm’s board approved Funded Reinsurance limits for individual counterparties, for correlated counterparties and your firm’s aggregate limit. The PRA has been clear that it intends to build a picture of the aggregate exposures across the market. How it uses that data will need some careful thought, given the risk of negative perceptions that could arise if it is not done very carefully. - Remediation activities
A summary of the activities that your firm has carried out and intends to carry out to meet the expectations set out in SS5/24, with a timeline for doing so. - Level of confidence in the modelling
An overview of the board’s perceived level of confidence achieved in your firm’s internal model output, at a transaction level, and how this has been used to shape your Funded Reinsurance investment limits. This is an area where independent oversight could prove invaluable to the board. - Risk appetite
An overview of the steps your board has taken to limit its risk appetite for the amount and complexity of Funded Reinsurance transactions over the coming months, where gaps exist against the expectations set out in SS5/24.
Whilst the PRA require boards to be informed in their assessment of these issues by an independent opinion from the Risk function, boards may wish to consider an independent review of the risk function approach to help mitigate against the possibility of a S.166 review being required. The PRA clearly has significant concerns with the use of Funded Reinsurance in general and firms may consider being proactive on that front a sensible approach to help give confidence to the regulator that their approach has been appropriately thought through and tested.
Timelines
The new rules have taken effect from the date of publication – 26th July. Existing and intended Funded Reinsurance arrangements are in scope with immediate effect, albeit there is regulatory recognition that time is required to analyse and implement the rules. That pragmatism extends only to 31st October though, being a hard deadline by which the board must complete its analysis and report to their regulatory contacts.
The word of caution is to remember that the obligation to act arises for any firm that has – or is considering using – funded reinsurance.
Conclusions
The PRA action has squarely placed accountability for the actual or intended use of Funded Reinsurance within the remit of the board. With a hard deadline of 31st October that cannot be ignored, and the Summer holiday period likely to mean there will be limited opportunities for the issue to be properly briefed to and debated by the board ahead of the 31st October deadline, there can be no delay in starting work on the issue. That in itself will be an additional timing challenge for firm’s risk functions and leadership as they navigate the new expectations.
The PRA are of course rightly concerned about the aggregation of risks for firms – and the market as a whole – that arise from the use of Funded Reinsurance. The inclusion of the reporting requirement that is expressly designed to allow the PRA to gain a much better understanding of the aggregation exposures is a clear indicator of the systemic risk concerns that exist. The inclusion of the new rules into the next life insurance stress test (LIST 2025) which will incorporate a Funded Reinsurance recapture event will be an early opportunity for the PRA to test scenarios that reflect the data it will by then have access to. With the increasingly sophisticated use of data by our regulators, it is very conceivable that firms, either individually or collectively, can expect further developments in the way the use of funded reinsurance is regulated.
If you would like to discuss an independent review of your firms’ approach to the new rules ahead of finalising your board report to the PRA, please do speak with the author or your usual ICSR contact.
