During February, the Prudential Regulation Authority (PRA) twice provided insurance firms with its views on longevity risk transfers.
On 9 February, Andrew Bulley, Director of Life Insurance at the PRA, co-authored a letter with Chris Moulder, Director of General Insurance Supervision, highlighting the PRA’s views on issues connected with longevity risk transfers. This letter was expanded upon when Andrew Bulley spoke at the Investment and Life Assurance Group’s (ILAG) conference, in London, held on 17 February, where he also addressed the topic of longevity risk transfers.
In both cases the message from the PRA was clear. The PRA is monitoring insurers very closely to determine if they are becoming “active in the longevity risk market consistently and solely for reasons other than seeking genuine risk transfer.”
Further, the PRA was also concerned to impress upon firms that longevity risk transfers are not without risks for insurers. This is primarily because there are only a small number of reinsurers in the longevity risk market and so there is the possibility that the insurer will expose itself to concentration risk and counterparty default risk when entering into transactions with these reinsurers.
What is longevity risk and why do insurers seek to transfer this risk?
Longevity risk is the risk that the insurer’s policyholders will live longer than expected.
Firms assume this risk on policyholders when they offer annuities and other life insurance products because there is the risk that they may have to make payments under these products for longer than expected due to increased life-expectancy.
With the increase in the bulk annuity market over recent years, insurers have assumed even more longevity risk as this has been transferred to them in large tranches by pension scheme trustees who have sought to remove this risk from their pension schemes.
Insurers have sought to transfer or reinsure this risk to reinsurers principally to balance their overall risk profiles and also to assist in the management of their capital requirements. Under Solvency II, longevity risk is one of the components of the calculation of a firm’s Solvency Capital Requirement. There is therefore a capital charge associated with retaining longevity risk.
What are the PRA’s concerns?
Whilst the transfer of longevity risk is nothing new for insurers, the PRA is concerned that Solvency II may give firms a new incentive to transfer longevity risk to reinsurers.
Solvency II includes the ability for firms to apply to the PRA to use “transitional measures” in the calculation of their technical provisions. Technical provisions are the sum of a firm’s best estimate of its insurance liabilities and a risk margin. The risk margin represents the amount the firm would expect a third party to be paid to assume the insurance liabilities. The effect of being able to apply transitional measures (for business written prior to 1 January 2016 – when Solvency II came into effect) is that the risk margin component of technical provisions is reduced.
The PRA’s concern is that firms are using longevity risk transfers to reduce the risk margin applying to liabilities which may not benefit from transitional measures, rather than for reasons of genuine risk transfer.
Additionally, the PRA has warned firms that longevity risk transfers are not risk free for insurers and firms should consider:
- the counterparty default risk the insurer exposes itself to when it enters into a transaction with a reinsurer; and
- as there are relatively few reinsurers in the longevity risk market, the concentration risk that firms might assume when entering into a number of transactions with these reinsurers.
What can firms do to address the PRA’s concerns?
The PRA has emphasised that firms should consider the risks outlined above as part of the calculation of their Solvency Capital Requirement. This requirement also applies to firms who have approval from the PRA to use an internal model to calculate their Solvency Capital Requirement.
However, in the letter and the speech at ILAG, Andrew Bulley stressed that it may not be sufficient in itself for firms to hold capital against these risks as part of their Solvency Capital Requirement and they should ensure that their risk management systems are sufficient to identify, manage and mitigate against any risks associated with longevity risk transfers.
The PRA has also highlighted that firms should consider whether it would be appropriate to ask reinsurers to provide collateral as security for the reinsurer’s obligations under the longevity risk transfer. The provision of such collateral is common in longevity risk transfers and, if such collateral is structured in a manner so as to be compliant with the requirements of Solvency II, it can assist firms in reducing the counterparty default risk that they would otherwise be exposed to as part of a longevity risk transaction.
A recommended approach to longevity risk transfers
Whilst each transaction is unique, we consider that firms should take into account the following matters when considering a longevity risk transfer:
- seek to engage with the PRA as early as possible in the process;
- ensure that the transfer is being undertaken for reasons of genuine risk transfer (and not just selective balance sheet improvement);
- make sure that the firm’s risk management policies are sufficient to identify and manage the risks that are associated with longevity risk transfers;
- seek to reduce concentration risk by using multiple reinsurers; and
- as part of each transaction consider whether it is appropriate to ask the reinsurer to provide Solvency II compliant collateral by way of security to assist in the reduction of the counterparty default risk.