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Funded reinsurance: the future for the annuity market or a regulatory timebomb

As part of our session in partnership with Insurance ERM, ‘Funded reinsurance: the future for the annuity market or a regulatory timebomb’, our Head of Business Development for the UK and Northern Europe, Nick Reilly, was asked a range of questions on his views:

What are the risks associated with an insurer using funded re?

I am answering from my time as Head of Reinsurance at a UK insurer. In simple terms the Risk is that they don’t have the assets to meet their liabilities!

The liability is on their balance sheet (the annuity/ pension payments they must make to their customers). Using Funded Re, and transferring assets, increases the risk that there are not sufficient assets to meet these liabilities.

There are of course, may reasons to use Funded Re. Funded Re is one tool available to insurers as part of their strategy within the BPA market. However, risk arises by removing the assets from their direct control, and replacing them with an alternative asset (reinsurance asset, loan note etc).

The risks (and remedies) follow in a logical order:

1) Default of counterparty. 

There are a range of solutions to mitigate this, but the aim is to maximise the probability that the assets return to you on default. Keeping the assets on your balance sheet removes this risk, but if you need to transfer the assets to the reinsurer, you need to add layers of protection. There have been many ways of adding this protection historically, such as placing the assets in trust, setting up Special Purpose Vehicles (SPV’s), use of custodians, use of Loan notes etc.

2) Removal or reduction of collateral. 

To prevent any ring fenced collateral (assets) being removed by the reinsurer, any access to the collateral is restricted. The reinsurer can add assets to the arrangement, but any removal must be agreed and approved by the insurer. This can also include the use of third parties, for additional layers of security, and robust internal processes must be set up and followed.

3) Asset shortfalls.

The agreement will specify the types of assets and limits within the collateral. This may include restrictions on certain assets, locations of assets, or haircuts on certain classes of asset. Reviews will be regular, including a full basis review, but there will also be triggers for reviews on market shocks. This reduces the risk of the collateral falling below the liability prior to a default.

4) Delay on wind up.

Key to an insurers balance sheet is ensuring that any delays between a default, resulting in the loss of the reinsured asset, and the asset transfer are minimised. This may also include any time delays in transferring back any assets held in trust overseas.

5) Regulation risk

As with all insurance business, regulation may change making previous decisions less economic, or onerous, over time.

6) Strategic risk

Insurers need to decide what to do with the additional risk if the reinsurer defaults. They will now be facing the full range of risks that they faced before they decided to reinsure and they must have a strategy for this in advance. Clearly this will evolve massively if a reinsurer actually defaults, as the market, options and counterparties remaining would be impacted by the situation.

In summary:

There is a balance between the cost (to both parties), in time and money, and the benefits, for the complexity of the arrangements put in place.

Get this risk management, reporting and oversight correct, and what could have been a loss of billions can be reduced to a negligible residual amount (but with many sleepless nights and lots of hard work should the worst happen!).

How can regulators and supervisors strike the right balance in overseeing the risks of funded re?

Again simple terms:

Follow the approach that large, credible insurers take already. After all, many insurers already use Funded Re to some degree as part of their business strategy, and many of them have managed this risk effectively for some time.

Line 1, the business, identifies the risk, and manages it appropriately. This requires the experts closest to the transaction to highlight the key risks and issues, and to suggest suitable mitigants. Any plans and proposals then include oversight and challenge from Line 2. This is where good risk management really counts.

You need to understand the residual risks, and not the headline pre mitigant risks.

Audit and Board oversight is then key, as any Risk Register will have the original risk as 'red as red can be', but post mitigants it should be green. The use of regular independent challenge should ensure that the checks and balances work correctly and are in place, to ensure the residual risk remains green.

Any transaction will have sections within the ORSA, and the detail, oversight and disclosures of such transactions should satisfy regulators of good risk management within the current regulatory framework.

By following the approach used by credible insurers, regulators will be able to build a risk environment that is already robust and effective. However, if they implement materially more requirements, then they run the risk of overregulation, excessive costs, and removing the benefits from Funded Re altogether.

Risk pooling is the bedrock of insurance (with insurers traditionally running the risk pool). Nick Reilly, Our Head of Business development for the UK and Northern Europe, shares his thoughts and insights. He looks at how this could develop, in a world with AI, from the work he is doing with the Institute and Faculty of Actuaries.

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