Funded realignment: balancing innovation and risk − speech by Vicky White

Speech

Introduction

Good morning and thank you to Bank of America for inviting me here today.

The UK life insurance sector is undergoing a period of rapid evolution. Against a backdrop of global uncertainty and demographic change, life insurers have an increasingly vital role to play – not only in providing long-term financial security to policyholders, but also in supporting the UK economy through patient, long-term investment.

Our role at the PRA is to ensure that the regulatory framework keeps up with the changes we are seeing in the sector and particularly as the Bulk Purchase Annuities (BPA) market continues to expand at pace. Crucially, we are committed to advancing our secondary objectives to support competition, and competitiveness and growth, in the way we go about ensuring a resilient sector. Or put another way, that this evolution preserves the safety and soundness of firms, and protects the pensions of the growing number of policyholders relying on the insurance sector.

Today, I want to speak about two distinct but closely related topics which engage both our primary and secondary objectives: the growing use of Funded Reinsurance (FundedRe) as a source of capital, and the broader question of how we can support innovation in capital frameworks to ensure sustainable growth in the life insurance sector.

These are complex topics, and we do not claim to have all the answers. But we do believe that now is the right time to take stock, to ask whether the current regime is supporting the right behaviours in a sustainable way, and to engage with industry on how we can collectively shape a future that works for policyholders, firms, and the wider UK economy.

Role of life insurers and BPA in the economy

The life insurance sector has always played a critical role in the global economy. Throughout its history, life insurers have had to respond to emerging developments and opportunities, to support the living standards and choices of people and economies around the world. This is especially true today as we see two significant macro trends: firstly, a rising demand for retirement products given ageing populations in the Western world, and secondly a growing need for patient, long-term investments to meet the infrastructure demands of the future.

The life insurance industry is a key part of the UK’s broader pensions ecosystem. We have seen a lot of activity in the BPA market where insurers are taking over the responsibility for providing pensions to members of company pension schemes. As my colleague Gareth Truran outlined in a speech earlier this year, the underlying drivers of BPA transactions are expected to remain strong.^{footnote [1]} We also see new entrants joining the market, prompting greater competition and innovation in pricing, terms and conditions, and product features.

At the PRA, we do not take a view on whether it is on balance positive or negative for UK growth for pension liabilities to move from company pension schemes to life insurers – there are arguments in both directions and much depends on actual investment choices in the two sectors. But it is the PRA’s job to regulate the management of those pension liabilities that do end up in the insurance sector, in a way that promotes the resilience necessary to underpin sustainable growth over the medium to long term.

Funded Re as a form of capital

As the BPA market has grown in recent years, so has firms’ need for capital. This is one of several drivers of the growing popularity of FundedRe. This is not only a UK phenomenon – similar trends are evident in other markets, as noted for example by the International Association of Insurance Supervisors (IAIS).^{footnote [2]}

The IAIS’s recent consultation on structural shifts in the life insurance sector sets out why some firms are turning to FundedRe. Firstly, it could be about access to additional capital. This seems wholly reasonable, and as I will discuss later, access to capital is something the PRA is keen to support. Secondly, it could be about accessing assets originated by or only available to the reinsurer. We see limited risks to the PRA’s objectives from the use of FundedRe as a means to gain indirect exposure to asset classes beyond the origination capacity of the UK industry. This is of course provided that any arising risks such as potential conflicts of interest are well managed, and the reinsurance arrangement complies with the prudent person principle.^{footnote [3]} Thirdly, it could be about leveraging differences in reserving approaches, capital requirements and investment flexibility. This third reason is more troubling from a supervisory standpoint.

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.^{footnote [4]}

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. Other regulators have also acted, for example introducing new prior consent requirements before firms enter into such reinsurance arrangements^{footnote [5]} and asset adequacy testing for reinsurance^{footnote [6]}.

Our Supervisory Statement SS5/24 will continue to set out our expectations of firms entering into such contracts. Of course, those expectations may evolve over time, in line with market developments. That said, however well firms address our expectations, this type of business which is planned to grow to tens of billions over the next decade could create systemic risk because of the correlations and uncertainties involved. For example, many of the underlying collateral assets backing these transactions are private, complex and untraded assets, with potential for correlated and concentrated risks which may not be immediately apparent.

Moreover, we have to consider if there are some aspects of FundedRe that cannot be addressed through supervisory expectations. Specifically, whether the existing Solvency UK reinsurance framework provides the right treatment for these innovative transactions. The PRA has spoken previously about the issue of FundedRe bundling longevity risk transfer with asset risk, under the Solvency UK reinsurance framework. I would like to say a little more about this today because we think that the beneficial regulatory treatment that FundedRe receives, compared to the way the same risks are treated when not bundled together, is partly why we have continued to see further growth in FundedRe usage.

Why is FundedRe growing so fast?

The question as to why FundedRe is growing so rapidly across the life insurance sector is one worth exploring. Whenever something grows very fast, particularly where it involves complex interactions between regulatory regimes, it should prompt all of us – regulators and regulated alike – to stop and consider whether the incentives driving that growth are misaligned compared to alternatives with a similar economic risk profile.

FundedRe at its core is a transfer of risks associated with a portfolio of annuities to a counterparty, which sets aside capital for the deterioration of said risks. However, the important structural aspect of ‘Funded’ Re compared to more common longevity reinsurance is the funding component. The reinsurer receives one upfront premium and is thereafter on the hook to pay its share of pension liabilities. This is different from more common forms of reinsurance used by annuity writers to manage longevity risk. In those scenarios, smaller payments flow either way from reinsurer to cedent over the lifetime of the contract, to cover actual deviations in experience from central assumptions, but these do not include the expected pension payments.

In FundedRe, the reinsurer invests the large upfront premium in a portfolio of assets which effectively becomes the collateral pledged to the cedent. This collateral pot need not be compatible with UK prudential standards, nor invested in strategies that comply with UK practices, because the reinsurer is typically offshore and not PRA-regulated. Indeed, we have already seen examples of large cashflow mismatches, as well as large unhedged currency exposures in current FundedRe transactions, far beyond what we would see in typical UK annuity firms’ direct investments. As such, the additional value that the reinsurer provides in this transaction, beyond its role as a capital provider, is a collateral wrapper, transforming unstructured and risky collateral into the funding required under the FundedRe contract. However, by extending the label of ‘reinsurance’ to this funding component, Solvency UK treats it as essentially a risk-free construct.

Let us now consider a different approach, where a UK insurer funds its expected annuity liabilities by repayments from a loan it has made to a counterparty, and manages the remaining risk that pensioners live longer than expected with a longevity swap. This portfolio would have a similar economic effect as FundedRe, as my colleague Gareth Truran said earlier in the year.^{footnote [7]} However, under Solvency UK the loan component would be treated as any other risky asset. For example, in a matching adjustment portfolio, there would be an allowance made for the risks that an insurer is assumed to retain, including credit risks. This is very different from the risk-free treatment of FundedRe as a reinsurance arrangement under Solvency UK.^{footnote [8]}

The two (investment) strategies I have outlined are close in economic substance, yet our initial diagnosis is that they receive very different regulatory treatment simply because one is labelled ‘reinsurance’, but actually ‘bundles’ a collateralised loan with more common reinsurance in the form of a longevity swap. We wouldn’t expect the solvency regime to ignore the risks in the second approach, so we are asking ourselves why it is appropriate in the first. In other words, Solvency UK requires capital held against loans by an insurer, for retained risks including downgrade and defaults; however, FundedRe, as currently structured, does not attract a similar charge for the loan component.

Relevance to our objectives

The PRA (and FPC) have clearly set out why extensive and poorly managed usage of FundedRe presents a risk to our primary objectives. Let me now discuss the risks to the PRA’s secondary objectives.

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.

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).

PRA’s long-term aim

Where firms are not yet meeting our existing supervisory expectations, we have been engaging with them to seek enhancements to their practices, and we will continue to do so. But the concerns I have set out here are more forward looking. They are 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.

As a regulator, our interest is naturally piqued by instances of economically similar transactions being treated in different ways. If the bundled treatment understates the risks, then it could be driving excessive use of FundedRe. In our previous communications, have been clear that this type of underestimation of risk might lead us to act.^{footnote [9]} This could include, for example, consideration of 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.

As I said above, 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. 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, to help us understand the potential for FundedRe to impact the insurance sector and wider economy now, we have included a FundedRe recapture scenario in our life insurance stress test this year. This is part of establishing our capabilities to test and monitor this market, if usage continues to grow and create the systemic risks we have articulated. The results will be published later this year; however this is separate from our work on the appropriate framework for FundedRe.

I want to reassure you that we do not seek to prohibit the usage of FundedRe as a modest part of a firm’s overall funding strategy. We recognise that some use of FundedRe may provide a valuable source of patient loss-absorbing capital, and may allow firms to access a broader portfolio of appropriate assets that they would find difficult to originate themselves. Rather, our intent is that the regulatory treatment of FundedRe is appropriate and consistent with other economically similar transactions. This would ensure more uniform treatment of capital on firms’ balance sheets and promote greater fairness and diversification in the BPA market.

To reiterate, that what we are aiming for is getting the regime right for the future. Should we conclude that any adjustments to the treatment of FundedRe are required, they would be subject to our usual consultation processes. We would also only look to apply these to future business. Where firms have transacted in the past based on different rules, we would allow those to continue to receive the current reinsurance treatment. Our aim is not to disrupt firms’ existing arrangements. Of course, during any such policy development period supervisors will be continuing to closely monitor firms’ FundedRe activities to ensure new deals are consistent with pre-existing plans and appetites.

Focussing on the future

Let me put FundedRe to one side and return to the need for capital and innovation in the UK life insurance sector. We view innovation and responsible risk taking as key drivers behind both the historical and future growth of the UK life insurance market and its contribution to the wider economy. Therefore, we are always on the look-out for opportunities to foster greater innovation and growth in a way that supports both firms’ objectives and our own. For example, the changes we have made to support insurers’ productive investments by streamlining our Matching Adjustment (MA) approach, where we have supported firms’ usage of Internal Models to calculate their regulatory capital, or our new mobilisation regime to support new entrants into the UK market. We are keen to continue and promote such innovation going forward.

Another example of this is our recent consultation on amendments to rules to facilitate even more investment in UK productive assets through the Matching Adjustment Investment Accelerator (MAIA). For those of you waiting for our Policy Statement on this topic, I am pleased to say we are looking to publish this by the end of October. We will be able to accept firms’ applications for MAIA permissions as soon as the PS is published.

With regard to capital in the BPA sector, we have not identified through our discussions with market participants that there is a systemic shortfall in capital available to support that sector. Rather, the volumes of capital deployed both by existing firms and new entrants in the UK life insurance sector reinforces our view of the availability of capital and the dynamism of the sector. However, we have heard from some market participants that there is appetite for alternative sources of patient capital.

With such patient capital, the investor is willing to forgo an immediate return in anticipation of more substantial returns over time. The capital backing pension obligations benefits firms, and the system as a whole, from being patient. It needs to be commensurate with the long-term nature of insurers’ annuity liabilities. It also allows higher yielding UK productive investment to be developed over time, rather than seeking assets already originated by others in global markets. It reinvests in growth and avoids a concentration of counterparty risks.

However, there are signs that patience is eroding from more traditional forms of capital like equity and debt. Our discussions with industry indicate, for example, that public equity capital is perceived to be relatively more expensive with high return expectations in the form of dividends and share buy-backs, and low appetite for year-on-year volatility. Private capital, such as private equity or reinsurance, is not without flaws either. For example, the lack of transparency and potential for conflicts of interest in the private equity business model has been noted by the FPC;^{footnote [10]} additionally, private equity ownership of insurers can also lead to a greater allocation to non-UK assets. Debt capital is rightfully limited by broader factors like leverage constraints and the need for adequate credit ratings. All these factors are leading listed life insurers globally to seek a more ‘capital-light’ business model without retreating from their core customers and markets, relying increasingly on reinsurance to support the writing of capital-intensive business.

Of course, it is ultimately for firms to determine the sources and uses of their capital. Their decisions will involve commercial considerations that are far beyond the scope of prudential regulation. But identifying any unnecessary regulatory hurdles to such capital entering the market and removing them would be positive for our objectives, industry and the UK economy.

And as the BPA sector grows, so will its need for sustainable capital-raising frameworks. We are open to innovations that facilitate the raising of capital in a way consistent with Solvency UK, supporting both resilience and growth.

Alternative life capital options

Developing alternative life capital options in a way that preserves protection of policyholders, enables access to cheaper or more patient capital and supports growth, will require more focussed attention.

Therefore, we will separately be discussing with the sector in the near future the topic of facilitating such alternatives. We are aware that it is not the regulator’s role to force market innovation and propose new solutions. However, we are interested in understanding whether there are regulatory barriers to more capital entering the sector, for the benefit of our primary objectives and the UK economy. And, in line with our secondary competitiveness and growth objective, we can help by putting in place the right frameworks for new developments to happen safely.

One such potential alternative that may have a role to play is the insurance special purpose vehicles (ISPVs) framework. ISPVs are vehicles that offer a legal and regulatory framework through which insurers can tap into capital from outside investors. The attraction to investors is to gain exposure to a specific part of the business of an insurer without taking on all the risks of the firm as an equity shareholder would have to. ISPVs are also flexible, enabling different approaches to risk sharing, including excess of loss or quota share covers.

For life insurers there may be ways this could be used to provide additional capacity alongside more common longevity reinsurance or to specifically cover components of asset risks on insurance balance sheets. Most importantly it could unlock a different source of patient long-term capital.

Historically, ISPVs have not been considered suitable to support annuity-type business, given the prudential and economic challenges for a vehicle with finite capital to provide effective risk transformation for long-term market and credit risks. These are real concerns that lead us to tread carefully, and our current position is that it is difficult to see how they could be used under our current framework.

However, being aware of these risks and having listened to initial industry feedback in response to our most recent consultation on the ISPV regime, as summarised in the recent Policy Statement PS9/25, we plan to consider whether and how the ISPV framework could be made more accessible to UK life insurers.^{footnote [11]} Recently, the PRA has been working with HMT, culminating in the publication of HMT’s consultation on the Risk Transformation Regulations, which should serve to facilitate greater use of these types of vehicles.^{footnote [12]} We are aligned in our ambition to reform the functioning of the UK ISPV regulatory regime, while keeping policyholder interests forefront in our minds.

The PRA will therefore continue to work with industry and HMT on further reforms and expects to publish a discussion paper on the topic of alternative life capital options which will consider how the ISPV framework (or other structures) could be made accessible to UK life insurers.

Firms may have other structures in mind, and we are very open to suggestions. Any new structure will present new trade-offs. For example, while they may offer flexibility and access to patient capital, they may also introduce risks related to a more finite funding period or some limitation to the risk transfer. The PRA is keen to investigate these structures further, with a view to identifying opportunities to advance our secondary objectives in a sustainable way – while maintaining our commitment to safety, soundness, and policyholder protection.

Conclusion

To conclude, the UK life insurance sector is competitive and fast growing. We’re proud of the role that we as a regulator play in making sure that the UK market is resilient and is an attractive place to do business. Supporting insurers as they provide long-term capital to, in turn, support economic growth was at the core of our Solvency UK regulatory reform package last year.

More generally, we always seek to ensure that firms are resilient and able to provide the products and protections that policyholders need over the long-term. As the sector grows, the number of policyholders who rely on insurers to provide secure retirement income also increases. Ensuring the life insurance industry has the financial resilience to continue to meet those critical long-term commitments to policyholders in good times and bad also becomes more important than ever. Subject to that, we endeavour to make sure we are enabling safe growth and innovation in product structures and the type of capital that can enter the market.

Of course, some forms of innovation might bring risks that we and firms are required to mitigate. For example, I’ve noted the risks associated with FundedRe and its current regulatory treatment and explained the questions we are seeking to answer as we contemplate what action might be appropriate. At the same time, if there are other ways in which long-term capital can safely support the market, we want to facilitate them.

It remains important to us that the sources of capital are there and that the quality of capital of UK life insurers does not deteriorate as the industry grows. We want to facilitate the sector’s growth by ensuring that it has access to the best capital for its needs. We view our exploratory work across FundedRe and other alternatives as being paramount to that.

We look forward to engaging with BPA firms and other stakeholders over the next few months on these two important topics and hope to continue working collaboratively with you going forward.

Thank you.

I am grateful to Dan Georgescu, Alwin Luchmaya, Andrew Britton, Robin Swain, Adam, Jorna, Manuel Sales, Min Wei Chan, Anthony Brown, Alan Sheppard, Lisa Leaman, David Bailey and Gareth Truran for their assistance in preparing this speech.