Funded reinsurance may be a matter for Pension Schemes

Why trustees and sponsors should take note of the funded reinsurance letter issued by the PRA on 15 June 2023.

Key takeaways:

• Due diligence on the Prudential Regulation Authority (PRA) is not academic.
• Insurers should disclose their use of funded reinsurance to trustees
• Captive insurance is just funded reinsurance. The PRA is most concerned.

I have noted elsewhere a relatively muted response by stakeholders in the risk transfer market to a letter from the PRA to Chief Risk Officers (CRO’s) of the all the UK life insurers (LifeCo’s).  No doubt there are good reasons for this.  But I think it matters for users, potential and current, of LifeCo products to understand some of the tangles of overseeing a LifeCo which manifest over time. This includes the evolutionary, regulatory, governance and market risks of irrevocably and irredeemably taking on a LifeCo as a counterparty. Whether it be for the trustee (buy-in) or, in the final phase of buy-out, for members themselves.

In short…

The PRA has become concerned about a practice of outsourcing all the functions which go on to deliver “member security” to third party insurers (3rdCo’s), for a specific portion of the insurer’s book.  In particular, the 3rdCo’s operate where the PRA has no real purview (because 3rdCo’s are resident, for example, in Bermuda, Gibraltar, Guernsey or some other exotic location). In principle, your carefully chosen LifeCo can effectively transfer an undisclosed portion of the risk management (including assets and liabilities) of members’ policies to a 3rdCo in e.g. Gibraltar.

To be clear, the PRA has alluded to systemic risk potentially being amplified by such funded reinsurance practices: so non-trivial concerns.  Fortunately LifeCos recognise that doing such trades on the same basis as a trustee, i.e. without collateral protection, is inadvisable (and Solvency regulation would prohibit it). These off-shoring trades are done on a collateralised basis.  The quality of that collateral is also a focus of concern for the PRA.

I won’t go into the letter and its specific concerns here. However, I will add that the PRA’s concerns are entirely understandable to trustees: defined benefit schemes and life insurance are very closely related.  Many aspects of life insurance have an exact parallel with issues well known to trustees but, generally, it is just a labelling difference.

The key message behind all this is the concept that the PRA’s framework is not set up to manage an outsourced life company sector.  It is not that it can prevent LifeCos indulging in this practice. Although it can say that it expects strong (complete?) adherence by senior executives to its prudent principles.

Why should this matter to trustees?

Here is an example of why the wholesale governance reliance on the PRA that drives a risk transfer trade might require a little more due diligence. Other than relying wholesale on the notion that “the PRA will oversee members’ interests”.

The PRA has two, complementary, primary objectives in its supervision of insurers:

1. To promote their safety and soundness and;
2. To contribute to the securing of an appropriate degree of protection for those who are or may become policyholders.

This does not mean that the PRA will stop a firm from failing. Nor does it mean that its supervision is guaranteed, nor that a policyholder won’t get hurt!

Trustees might seek to understand how the PRA operates and with what resources.  Think about the questions you would ask in a due diligence exercise on an asset manager for instance. Why should the PRA’s similar capacities and risk management framework not come under your focus?  After all, a lot of member security lies in the PRA doing its job.  Clearly the PRA is not happy about some aspects of funded reinsurance: is it ahead of the curve or behind it?  Does it have the tools / skills to manage the situation?  Why is it making a “public” issue of this?

More specifically, is your chosen (or existing) insurer off-shoring its risk book and to whom?  This should be front and centre of any due diligence exercise on an insurer itself.  How much funded-re has the insurer done and how much does it intend to do?  On what it has done, is the PRA looking into the matter closely?  A non-response to this question should raise some eyebrows.

Why should this matter to sponsors?

I think this has a real impact on the captive market and all its various guises.  It is a given (and perhaps the driver) that setting up a captive will put you front and centre in running, overseeing, paying for a single purpose life company for the foreseeable future. (NB: this is life insurance, very different to simpler Property & Casualty captives).  However, it now seems to be the case that the UK-based fronting LifeCo (FrontCo) is going to be seeking a lot more control. Thus making it more expensive and/or having a super-quality capital pool since captive insurance is just a variant of funded reinsurance.

And, from the PRA perspective, off-shoring to a global reinsurer operating out of Bermuda is likely a different proposition to a special purpose vehicle set up for the purpose in Guernsey or Gibraltar.  This focus by the PRA may well take a lot of asset and pricing control away from the captive (which generally is one of the main reasons to do the trade) and cede it to the FrontCo (upon the PRA’s insistence).

FrontCo can be seen as just renting your (cheaper) capital, but the price at which it will now accept your captive as a counterparty has just gone up, I think.  And, as an aside, UK LifeCo’s have plenty of plain vanilla business being offered. They capture all the profitability of the trade without generating any intrusive regulatory enquiry.

If I am correct, captive backed risk transfer could not be more in the cross-hairs of the PRA’s current concerns.  Any funded reinsurance transaction over £200m needs to be pre-approved by the PRA. Who just might also be interested in the ownership, motives, capacities and capabilities of the off-shoring entity. Or, rather, having the UK fronter take full control.

Disclaimer, from me!

As ever, all the above is just my perspective. It would be great if anyone out there wants to correct me…or indeed speak with me about captives or viable alternatives. Or anything else…

Funded reinsurance represents a complex but critical element of pension scheme management that requires thorough due diligence.

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