The PRA is the part of the Bank of England responsible for regulating firms like banks and insurers. Credit: iStock
The Prudential Regulation Authority (PRA) is looking at funded reinsurance (FundedRe) amid fears the growth of this type of insurance is having a negative impact on both UK growth and bulk purchase annuity (BPA) market competition.
In a speech at the 30th annual Bank of America Financials Chief Executive conference yesterday (18 September), PRA director for prudential policy Vicky White said FundedRe transactions – which are increasingly being used by BPA providers – receive "very different regulatory treatment" to a standard approach to funding annuity liabilities because of the way they "bundle" a collateralised loan with more common reinsurance in the form of a longevity swap.
She said the PRA would not expect the solvency regime to ignore the risks in the more standard approaches, so was asking itself why it is was appropriate when it came to FundedRe.
White said: "We recognise the value of diversification, including geographic diversification, and that there are good reasons why insurers will want to invest in a mix of UK and overseas assets when constructing their portfolios. Nevertheless, we consider that FundedRe has a potentially distorting effect on this investment mix. In practice, assets held in FundedRe collateral are predominantly not UK assets.
"Therefore, not only is there an argument that FundedRe may be posing risks to our primary objectives because of a quirk in regulatory treatments, but it is also possibly impacting on our secondary competitiveness and growth objective (SCGO), skewing firms' investment incentives. FundedRe appears to be driving investment away from those UK productive assets which support the growth of the UK economy, and towards internationally based reinsurers. This seems to suggest an unlevel playing field, and our role is to facilitate, or create the conditions for, the international competitiveness of the UK economy."
She added: "Furthermore, we recognise that the increasingly competitive BPA market may drive some forms of competition with undesirable characteristics. Some firms may use FundedRe, despite the risks, to outprice their competitors, sacrificing long-term earnings and investment capacity to offshore counterparties to gain an advantage through the beneficial regulatory treatment of FundedRe. We view this dynamic as negative for our secondary competition objective (or SCO)."
White said that, as a regulator, its interest is "naturally piqued by instances of economically similar transactions being treated in different ways".
And she warned that if the bundled treatment understates the risks, then it could be driving excessive use of FundedRe – an underestimation of risk that might lead the PRA to act.
She said measures that could be 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, inherent in these transactions.
White said its work so far was an "initial diagnosis" and that the PRA had not come to any firm views as yet.
It said it would explore these issues with stakeholders – noting it would 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.
White said: "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."
She added: "[This is] less about the risks in FundedRe volumes today, and more about making sure that we act now to get the treatment right for the future, so that unmitigated risks do not rise to a level where they could put the resilience of the sector and its policyholders in peril."
