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Funded Re has become an important tool for BPA insurers to manage capital and improve pricing. Reinsurers providing Funded Re tend to take high levels of asset risk with concentrated exposures to illiquid/private assets. Many are new entrants and domiciled outside the PRA’s jurisdiction. Their asset intensive strategies may result in low diversification within individual reinsurers and high correlations between these reinsurers. The PRA expects firms to have adequate resources (financial and non-financial) to manage recaptures and to make appropriate assumptions around collateral and management actions.
A number of risk management requirements are set out in SS5/24 and are quite prescriptive in areas that the PRA believe need particular attention.
The PRA’s overarching concern is that firms should be able to withstand recapture of single and multiple correlated counterparties. As such, firms should set counterparty internal investment limits in order to ensure exposure to Funded Re does not threaten business model viability. The PRA highlights the following requirements and considerations:
It is expected that firms establish collateral policies giving more certainty around the value of collateral on recapture. This should specifically cover illiquid assets and the approach to their valuation, credit assessment, matching adjustment (MA) eligibility monitoring, SCR modelling and investment management on recapture. There will be additional requirements if MA eligibility is assumed.
Recapture plans are to be documented covering costs of actions and ability of execution. This should set out individual steps to recapture liabilities and assets (by asset class) and actions to ensure MA compliance (where assumed). Board involvement is expected, with the extent depending on materiality. ORSA reports are expected to include Funded Re stress testing.
The PRA also sets out measures to address concerns that counterparty default SCR modelling may not always reflect the specific characteristics of Funded Re arrangements and counterparties.
The PRA expects a quantitative risk assessment to be performed on entering new Funded Re arrangements. This should consider basis risk and collateral mismatch risk, with an assessment process proposed by the PRA. Firms need to set a contractual risk appetite.
The requirements of SS5/24 are wide-ranging and will require firms to make changes in several areas, especially their risk management framework. Firms will need to ensure PRA expectations are met through an efficient solution. Whilst they will have existing approaches to managing reinsurance counterparty risk, they are unlikely to currently meet the more demanding requirements set out in SS5/24 in full.
Firms will need to develop an appetite for Funded Re risk and associated metrics. This could be based on firms’ existing risk appetite and/or regulatory solvency impacts.
The collateral policy should provide assurance around the viability of the recapture plan in stressed scenarios, dealing with the value/quality of assets and activities needed for MA eligibility. In developing the policy, firms will need to keep in mind the impact of stricter collateral requirements on reinsurance prices.
Firms must analyse the actions and steps to be taken in the event of recapture, covering the costs and impact of each action and the viability of its execution. Involvement of the Risk function will improve the outcome and credibility of this exercise. Funded Re stress testing should be included in the ORSA report.
Setting PD assumptions in situations where historic and market data is not relevant will be challenging. A methodology will have to be developed for determining the most appropriate proxy data and for making any adjustments to this proxy data. It will be important that both aspects are well justified and documented. There is an expectation that firms model counterparties’ solvency ratios under stress – it is unlikely that firms currently do this and an approach could be developed based on available data. Firms should review whether MA compliance can be assumed on recapture for existing arrangements and adjust modelling if required. This will potentially have a material impact on solvency in the recapture event and further capital mitigants may be needed.
Firms should establish the risk assessment process, scope of the assessment and governance. This will identify sources of basis risk and collateral mismatch risk arising from contracts, modelling and approximations, etc. The assessment should take a holistic view of risks, adding insight and supporting the business to make decisions on new deals. Scope could be extended to cover key qualitative risks, such as operational risks.
Funded Re is itself an important tool for managing risk. Firms will need to ensure the benefits it provides are suitably balanced with the risks it introduces. SS5/24 provides helpful insights on the risks of Funded Re that firms may not previously have considered.
Given the breadth and detail contained in SS5/24, some firms will have significant work to do to comply with it. Firms will need to ensure that solutions are pragmatic, work for the business and can be effectively implemented. They will need to understand the commercial consequences of the more complex aspects.
In the short term, firms must focus on identifying gaps and planning remediation actions for the PRA’s 31st October deadline.
To discuss how Forvis Mazars can support you with meeting the requirements of SS5/24 please contact get in touch.
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