Record surplus positions at defined benefit pension schemes have given many companies an opportunity to reduce their pension risk exposure. Trustees are now able to negotiate for an insurance solution from a position of relative strength. In the U.K. alone, the annual premium for bulk purchase annuities (BPA) was about £50 billion in 2023 and lucrative growth prospects have attracted new players to the market. To harness the market's growth potential, some insurers are choosing to cede both the longevity and asset risk obtained via these BPA transactions to reinsurers through funded reinsurance (Funded Re) transactions.

Funded Re has garnered more press and regulatory attention as it has become more prevalent over the past few years. That said, it comprises only a small portion of the total outstanding reserves ceded to reinsurers for the U.K. BPA market. Attitudes toward Funded Re differ among BPA players. In 2023, some players ceded as much as 30% of their BPA premium via Funded Re, indicating an increasing appetite for this type of transaction; meanwhile, others have yet to cede any of their premium via Funded Re.

Although it is still far more common for insurers to transfer only longevity risk to reinsurers, the U.K. and Bermudian regulators have already introduced new measures covering Funded Re. S&P Global Ratings considers that these measures will enhance the resilience of insurers. The new measures will contribute to stronger and more-consistent risk management relating to Funded Re transactions.

Here, we address frequently asked questions related to the U.K. BPA market and the use of Funded Re.

Frequently Asked Questions

Why is the U.K. BPA market growing so fast?

Increased demand from pension scheme trustees to reduce risk has fueled much of the growth. Higher interest rates caused the value of pension scheme liabilities to decrease by more than the value of their assets, putting many defined benefit schemes in a surplus position. This came after a long period in deficit while interest rates were low. Many corporate pension schemes therefore see their improved funding position as an opportunity. As of April 2024, according to the Pension Protection Fund's 7800 Index, the aggregate surplus of the 5,050 corporate pension schemes offering a defined benefit in the U.K. stood at £458.3 billion. The total combined liabilities stood at £939.7 billion, against total assets of £1,398 billion, indicating a funding level of 148.8%, compared with 99.6% as at April 2019. Of the 5,050 schemes, 505 were in deficit (aggregate deficit of £3.8 billion in April 2024).

For some, pension risk transfer deals were previously too expensive to consider. They are now a far more attractive proposition for pension scheme trustees. Overall, we believe that annual premium for U.K. BPA transactions could remain at or close to the £50 billion reported in 2023 for the next three years. Strong growth prospects are attracting new entrants to the market--once these new players have a stable foothold in the market, we expect to see an increase in competition. Recent entrants include Royal London Mutual Insurance Society Ltd., and M&G PLC has re-entered the market. A significant amount of effort is required to entertain BPA business, given the need for operational investment, especially in asset origination, pricing, and longevity risk management capabilities. The major players have already scaled up their internal expertise and are capable of originating bigger deals.

In parallel, new reinsurers have been established to take advantage of the BPA growth story, while others are becoming more active in the life reinsurance market. Even though ample reinsurance capacity is already available from well-established reinsurers, much of this capacity covers only the related longevity risk.

Chart 1

What risk mitigations do insurers that write BPA policies typically employ?

The risks insurers take on as part of BPA deals with pension schemes include investment and longevity risk. Insurers manage their risk profile and their regulatory capital requirements by ceding some of this risk to reinsurers (see chart 2).

Chart 2

Investment risk includes interest rate risk; longevity risk covers the risk that an annuity holder will live for longer than was assumed when pricing the annuity. Many of the insurers cede some of the longevity risk, with some passing a significant majority of their longevity risk to reinsurers.

Over the past three years or so, we have observed more BPA writers transferring both longevity and investment risk via Funded Re transactions, often with reinsurers based outside the U.K. Nevertheless, these transactions still represent only a small portion of the fast-growing U.K. BPA market. Appetite for Funded Re varies among BPA providers--some cede as much as 30% of their annual premium. Certain insurers pay an annual reinsurance premium of as much as £3 billion-$4 billion, in absolute terms. By contrast, other players have no appetite for Funded Re, either because they do not write much BPA business or because they do not think that Funded Re providers offer them access to better asset origination skills, frequent asset valuation capabilities, or pricing and capital management efficiencies.

Insurers may also use Funded Re to transfer the entire risk associated with a legacy life portfolio, especially those that offered guaranteed benefits. This type of use has made Funded Re a well-established form of risk transfer in the U.S. Various life insurers across Europe have also transferred run-off books although, in some cases, the transaction has been halted because it did not receive regulatory approval.

What is the advantage for an insurer of Funded Re versus longevity risk transfer?

For BPA writers, the most important potential benefits of using Funded Re are:

• The opportunity to benefit from reinsurers' asset origination capabilities; and
• The opportunity to free up more capital than can be achieved by transferring longevity risk alone.

In addition, both the insurer and the reinsurer could benefit from improved risk/return optimization. Some insurers use Funded Re as part of their pricing and growth strategy, to improve their competitive position and optimize their BPA market share.

Which reinsurers provide longevity-only risk, and which provide Funded Re?

Most of the large global reinsurers provide longevity risk solutions; for example, Reinsurance Group of America, Swiss Re Group, SCOR SE, Hannover Re, Munich Re, and PartnerRe. In addition, various U.S. primary insurers offer longevity risk reinsurance; for example, Prudential Financial Inc., MetLife Inc., Pacific Life Insurance Co., and Massachusetts Mutual Life Insurance Co. A very small portion of the risk is transferred to capital markets via insurance-linked securities.

Funded Re is mainly provided by (re)insurers that have significant expertise in asset management, including various (re)insurers owned by private equity firms. In recent years, these firms have entered the life reinsurance and insurance space because it offers them an opportunity to make use of their investment capabilities. They have established specialized reinsurers, many of them in Bermuda, to meet the growing demand for Funded Re and similar transactions.

In S&P Global Ratings' view, what are the key risks associated with the use of Funded Re?

As with any reinsurance transaction, we consider counterparty credit risk to be the key risk incurred. Funded Re transactions typically operate either:

• On a funds-withheld basis, where the cedant retains the assets on its balance sheet, but the reinsurer takes on the responsibility of managing the investments and asset allocation; or
• On a funds-transfer basis, where assets are transferred to the reinsurer but held in a custodian account.

A reinsurer will typically set aside collateral for the benefit of the BPA writer, to mitigate credit risk exposure. The BPA writer can recapture this collateral in certain circumstances; for example, if the reinsurer defaults or is downgraded.

If a BPA writer has to recapture the ceded exposure, it will be exposed to the quality of the collateral and the risk of managing it. The reversion of asset and liability risks to the insurer could increase the strain on its capital. Specifically, the BPA writer's regulatory solvency position could come under pressure if the recaptured assets do not qualify for certain regulatory benefits in the U.K., such as eligibility for a "matching adjustment" (MA). MA-eligible assets get preferential treatment in the solvency ratio calculation. This is because the liabilities that match the MA assets are discounted at a higher rate and this improves the capital position. If an insurer has to recapture assets, it may face the operational cost of optimizing the assets to ensure eligibility for the MA.

The scope of MA-eligible assets is expected to increase from June 2024 (see "Solvency U.K. Reforms: Not A Revolution For Insurers," published on May 7, 2024). While these changes may give U.K. insurers an incentive to use less reinsurance, we don't anticipate that the reforms will materially change the number or size of Funded Re transactions.

What types of asset are used to back the U.K. BPA portfolio?

In a recent publication, the U.K.'s Prudential Regulatory Authority (PRA) noted that 50% of the assets backing annuities comprise corporate bonds and gilts, down from 75% in 2018. The PRA also flagged that 38% of assets by market value were rated internally (rather than by external credit rating agencies) in 2022, up from 33% in 2020. Insurers' MA portfolios increase their exposure to illiquid investments, including asset classes such as infrastructure and equity release mortgages (see chart 3).

Chart 3

Why could the assets in Funded Re transactions differ from those originally ceded?

Cedants and reinsurers often operate in different jurisdictions. Funded Re transactions enable them to take advantage of differences in regulatory frameworks, tax regimes, risk appetites, and other capital constraints. The assets transferred, and the risk profile of the portfolio, are unlikely to stay the same as they were when the portfolio was originally ceded. For example, the reinsurer may back its portion of the liabilities with assets that have a longer duration than those originally ceded or may tolerate more illiquid assets than the cedant. That said, reinsurers typically aim to match the asset and liability cash flows. Cedants may have an incentive to place restrictions on the type of assets that the reinsurer may use, but such restrictions are likely to increase the cost of the reinsurance.

How does S&P Global Ratings capture the use of Funded Re in its credit rating analysis?

In general, we consider an insurer's overall reliance on reinsurance when assessing its business model. Our analysis of reinsurance exposure for Funded Re is aligned with our general approach to the risks stemming from reinsurance usage. Concentration risk can arise if an insurer depends on a limited pool of reinsurance providers. Overreliance on reinsurance weighs on our assessment of competitive position--it implies that the insurer's ability to offer a product may depend on the availability of cost-effective reinsurance. It could also suggest a lack of internal capabilities, such as the ability to source and manage long-term assets that match the insurer's liabilities, or a lack of expertise in underwriting the risk.

On the financial side, we capture the benefit of funded reinsurance by measuring exposures on a net basis in our capital model analysis, which is part of our capital and earnings assessment. We also capture the potential credit risk exposure of the insurer to its reinsurance counterparties, based on the credit quality of the reinsurer and the amount and quality of collateral. Furthermore, we consider the effectiveness of the insurer's risk controls; for example, whether they ensure that exposure to a specific reinsurer remains within predetermined limits. Such controls are particularly relevant for managing concentration risk and credit quality exposure.

What are the key regulatory developments relating to the BPA market?

Regulators have a heightened sensitivity toward use of Funded Re. For example, the PRA has recently started to pay greater attention to the use of Funded Re and is undertaking a stress test to analyze the related risks. It intends to publish guidelines for the stress test in June 2024, with a view to applying the test in 2025.

Many of the U.K. life insurers benefit from high regulatory solvency ratios; some reported ratios comfortably above 200% at year-end 2023. That said, the sector's overall solvency ratio receives a significant boost from the use of MA-eligible assets. Without this benefit, some players could see a material drop in their solvency ratio; some could even have a negative ratio. This highlights one of the key risks for BPA writers in using Funded Re. If the BPA writer has to recapture assets that do not qualify for MA treatment, its solvency ratio may take a significant hit.

According to a statement published by the Bermuda Monetary Authority (BMA) in January 2024, the median solvency ratio for Bermuda-based commercial life reinsurers was 261% at year-end 2022. The BMA requires a solvency ratio of 100%; ratios reported ranged from as low as 135% to over 500%. In March 2024, the BMA issued revised prudential rules that are likely to increase the capital requirements for the life reinsurers it supervises, including those providing Funded Re. This could erode solvency ratios, although the impact of the changes will vary by reinsurer. The BMA has also enhanced its governance and disclosure requirements for all Bermuda-based reinsurers.

How does S&P Global Ratings rate the specialized reinsurers that offer Funded Re products?

We apply the same criteria to Funded Re providers as we do when rating other insurers and reinsurers. In particular, we consider the provider's business diversity, risk management capabilities, capital strength, and profitability, among other factors that are relevant to our analysis.

Related Criteria

• Criteria | Insurance | General: Insurer Risk-Based Capital Adequacy--Methodology And Assumptions, Nov. 15, 2023
• Criteria | Insurance | General: Insurers Rating Methodology, July 1, 2019

Related Research

• Solvency U.K. Reforms: Not A Revolution For Insurers, May 7, 2024