UK life insurers including Legal & General Group PLC (LSE:LGEN) and Aviva plc are facing heightened scrutiny from the Prudential Regulatory Authority over their use of funded reinsurance (Funded Re) deals.
The PRA worries that the current growth in Funded Re transactions by UK life insurers could cause a build-up of risk in the sector which could ultimately affect policyholders.
The root of the PRA’s concerns revolve around the potential for underestimating counterparty risk in these Funded Re deals.
“Without material improvements, the PRA is concerned that UK insurers may use Funded Re, in volume and complexity, in a way that is not consistent with prudent risk management,” said the PRA in a letter to insurance bosses.
The PRA has therefore set out a list of expectations for all UK Solvency II firms entering into Funded Re transactions.
Summarising the PRA’s expectations, UBS wrote: “When entering into Funded Re arrangements the PRA expects firms to consider basis risk, collateral mismatch risks, time horizons and contraction mitigations.”
UK life insurance firms must submit a self-assessment analysis to the PRA by 31 October.
“We see UK life insurers that write bulk annuities within our coverage as most impacted by the announcement,” said UBS.
“We note that there is a potential for 1) an increase in capital charges and/or 2) reduced use of Funded Re going forward as a result of implementing these changes,” the bank added.
The second outcome could be a positive, reasoned UBS, as “it would lead to greater retention of profits for the market and potentially reduce competitive pressure in the bulk annuity market”.
By UBS’s estimations, around 5% of annuity books at the major life insurers are covered by Funded Re agreements, with L&G and Phoenix most exposed to changes in the market.
Aviva, meanwhile, has limited exposure while M&G, which recently re-entered the market, currently has no exposure.
UBS did not change its stock recommendations (buy for Aviva, L&G, Phoenix, neutral for M&G) following the PRA’s letter, saying it will have “neutral implications” for the sector.