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31 August 2023
The current surge in UK bulk purchase annuity (BPA) transaction volumes is attracting the interest of an increasing number of potential new market entrants.
New capital may be deployed into the BPA market in an increasing variety of ways – as a newco BPA insurer; an offshore reinsurer; or perhaps by providing fresh capital to the established BPA firms. Newco UK insurers will intend to enter the uncharted regulatory waters of writing material volumes of BPA business with a (temporary) Standard Formula approach to capital requirements. The Prudential Regulation Authority’s (PRA) supervisory posture in this scenario has not been recently tested, and this briefing explores the potential consequences and how best to prepare for them.
SECTION 1
Deploying capital into
the UK BPA market
Whilst the UK BPA business model is currently well-established, those looking to deploy capital into the market for the first time are now presented with several potential routes to entry. The most obvious one is creating a new UK insurance firm that will directly compete alongside the established BPA insurers.
The projected growth in BPA transaction volumes will surely create the space for additional BPA firms. However, a new BPA firm faces some potentially daunting competitive challenges:
- the established BPA firms have established track records and strong reputations with defined benefit (DB) pension funds and their advisors;
- they have developed asset origination capabilities that are particularly well-suited to matching long-term illiquid pension liabilities; and
- they have the regulatory approvals that allow them to make capital-efficient use of those assets in BPA asset portfolios.
Each of these important capabilities have been developed over several years.
Are there alternative routes to deploying capital in the BPA market that may be quicker and/or cheaper to implement than launching a new UK insurance firm?
Quite possibly. Recently, the most popular alternative BPA capital deployment route has been to provide offshore ‘funded reinsurance’ (funded re) to the primary BPA insurers. In this model, the BPA insurer effectively acts as an outsourced business development function for a reinsurer. This approach has generated significant transaction volumes in 2023, suggesting that BPA insurers are able to generate a healthy fee margin in this ‘originate-and-distribute’ role.
The unexpectedly high recent volumes of funded reinsurance has attracted the attention of the Prudential Regulation Authority (PRA), which has set out its concerns in a recent letter1 to UK BPA firm’s chief risk officers. However, the concerns expressed in the letter may be adequately addressed by some technical improvements in BPA firms’ counterparty credit risk management processes and models.
It therefore seems unlikely that these concerns will trigger the immediate end of use of offshore funded reinsurance in the origination of new UK BPA deals. It may, however, prompt some tightening in the contractual terms that accompany these reinsurance deals and an increase in the amount of counterparty credit risk capital held by BPA firms using funded reinsurance.
It is also worth noting that much of this reinsurance business has been written out of Bermuda, and the Bermudian insurance regulator, the BMA, is currently proposing to harden some of its own regulatory capital rules2.
It is plausible that the regulatory focuses of the PRA and the BMA may jointly have a knock-on effect on funded reinsurance pricing and hence on the level of demand from UK BPA insurers.
There may also be some ‘third ways’ of deploying capital into the BPA sector: superfunds, insurance sidecars, capital-backed journey plans…
There is considerable potential for new innovations in pension risk transfer that could profoundly impact on the shape of the BPA market in the coming years. However, the path to deploying billions of capital via these routes is currently less straightforward and may therefore be less appealing to those looking to deploy capital at scale now.
The direct entry approach, whilst potentially demanding, is arguably the most straightforward way of participating in the BPA market in significant volume over the short to medium-term. The CEO of a new UK BPA insurer will naturally have a focus on sales and business development in this highly competitive market:
How can the newco quickly be credible to pension funds? What does ‘good’ look like to the consulting firms that advise those pension funds? What services are integral to a successful BPA proposition in today’s market.
Member support services; pension administration; the flexibility to quote and transact quickly across the full range of pension benefit types found in the market - these are all increasingly ‘must-have’ capabilities for a competitive UK BPA firm.
However, pricing remains paramount. Being able to price competitively whilst generating adequate returns on capital crucially relies on asset origination capabilities and the regulatory capital treatment of those assets.
Below we explore this topic further from the perspective of a new entrant UK insurance firm.
SECTION 2
BPA regulatory capital from
a new entrant's perspective
The regulatory capital treatment of a UK BPA firm’s asset portfolio is driven by two distinct elements:
MA applications may also include details of how the firm intends to value the asset and, where relevant, the process by which the asset’s MA Credit Quality Step (CQS) will be determined. The firm may be required to demonstrate in the application that it has the relevant skills and capabilities to appropriately manage the assets and its related risks in a way that is aligned to the requirements of the MA.
An internal model may be used for all or part of the SCR, and components of the model may be updated over time to ensure they appropriately capture the firm’s risks on an ongoing basis.
These two regulatory elements are distinct but related. A credit-risky asset’s SCR contribution is generally materially reduced by an MA approval, as the SCR will make an allowance for how the MA discount rate is expected to increase in credit spread stress scenarios. An internal model is not a prerequisite for an MA approval, but all the major UK BPA firms have internal model approvals for the market/credit risk elements of the SCR.
The MA application/approval process has attracted some industry criticism in recent years, particularly in relation to the pace at which the PRA makes approval decisions. However, most of the negative experiences in this area have been associated with a small number of MA applications for asset types or structures that have not been the subject of an MA application before. The steady accumulation of MA approvals across a range of diverse asset types since 2016 means there is now a quite broad universe of assets in MA portfolios.
The PRA emphasises that there is no ‘green list’ of pre-approved assets and that MA applications are as much to do with a specific firm’s risk management capabilities as they are about the economic characteristics of the asset.
Nonetheless, the risk of unexpected costs and delays relating to an MA application will be greatest when seeking approval for an asset type that is novel and precedent-setting in the context of the MA. BPA new entrants may be grateful that at least some of the hard work in determining what is likely to be an MA-eligible asset has already been done by the established BPA firms.
The internal model application (and major model change) process for market/credit risk capital requirements is typically longer and more costly than an MA application process and it comes with greater timing and cost uncertainty. This is particularly true in the presence of the MA, as the need to model the MA discount rate in stress materially increases the complexity of the internal model. It is not unknown for an established BPA firm to find it takes two or more years to upgrade the modelling of vanilla corporate bonds in their internal model. The modelling of private credit asset classes will generally create additional modelling challenges.
The significant time and expense typically entailed in building an internal model may have important implications for a new entrant who is at the beginning of their internal model journey. Related to this, it is important to note that the PRA has proposed some important changes to the internal model approval process as part of the Solvency UK reforms3. These changes, if implemented, would lead to a less binary model approval outcome. This suggests a shorter and less uncertain path to an initial form of conditional internal model approval.
SECTION 3
BPA new entrants and the
Standard Formula/internal
model journey
For a BPA new entrant, the uncertainty in internal model approval timelines presents a potentially worrisome hurdle to entry. If internal models are a necessary part of a BPA firm’s risk management capabilities, and it’s likely to take several years to get to an approved internal model that covers the range of assets typically found in today’s MA portfolios, what does that mean for new entrant’s ability to write business over their first two or three years?
The answer to this question hinges on the role that internal models play in the overall regulatory capital process. Technically, the Standard Formula (SF) is available to any firm that assesses it to be appropriate for their risk profile, and the SF has a MA component that recognises the capital benefit that can accrue from MA discount rate increases in stress.
Impact of the key differences for new entrants
The net impact of these differences will tend to result in an internal model SCR for BPA insurers that is materially lower than that produced by the SF. The extent of this difference will depend on the composition of the MA asset portfolio and the specific features of the approved internal model. There is limited public disclosure on the quantitative impact on BPA firm’s SCRs of shifting from their approved internal model to the SF. What disclosures are available suggest the internal model SCR might be some 20% lower than that produced by the SF.
However, new entrants should be cautious of overly relying on this quantitative estimate – it is the result of some complicated and undisclosed modelling that may reflect some quite firm-specific circumstances.
The higher capital requirements associated with the use of the Standard Formula will put new entrants at a competitive disadvantage until they obtain an approved internal model. A circa 20% capital loading may be viewed as a manageable short-term cost of entry. New entrants may be prepared to initially accept the lower returns on capital that are implied for new business that is written at prevailing market rates with these higher capital requirements.
However, there is one potentially interesting twist in the tail. No one has ever written meaningful volumes of UK BPA business with a purely Standard Formula capital approach before.
When Solvency II was originally implemented in 2016, most major firms had an internal model approved for use on day one. It is somewhat unclear what the PRA’s current supervisory posture would be if an insurer writing billions of pounds of BPA business assesses that the Standard Formula is appropriate for their risk profile. It is feasible that the PRA will require firms to hold material capital add-ons in excess of the Standard Formula SCR in recognition of where the firm has risk exposures that are not adequately captured by the SF.
This might seem like a slightly perverse outcome given established firms’ IM approvals show that the SF will tend to produce higher capital requirements than that required by an acceptable internal model. However, until a firm has done the work to develop its internal model, it can’t take credit for what it is likely to generate.
So, new entrants should be prepared for the possibility of this initial ‘double whammy’ SF SCR impact - extra capital may need to be held to compensate for the SF’s shortcomings; without any capital release in recognition of where the history of industry’s internal model (IM) approvals indicates the SF may be prudently calibrated.
SECTION 4
Closing thoughts
The PRA’s supervisory posture in relation to the use
of the Standard Formula for material volumes of
BPA business is currently untested.
New entrants should anticipate the possibility that the (temporary) use of the SF may require significant capital add-ons. Firms should proactively prepare their own view of appropriate levels of SF capital add-ons and be ready to engage with the PRA on this topic at the earliest opportunity.
When viewed together with the uncertainty around internal model development/approval timelines, the capital requirement generated by use of the SF may constitute one of the more significant hurdles for aspiring BPA insurance new entrants. Established BPA insurers expect the forthcoming September PRA consultation on its proposed updates to the MA rules to be the most important moment for them in the Solvency UK reform process. However for BPA new entrants, the potential for the PRA’s proposals in their June consultation to substantially mitigate some of the current uncertainty in internal model approval timelines could mean that it is the earlier consultation that proves to be the more consequential of the two.
The Fundamental Spread
Reforming the UK’s implementation of Solvency II into a tailored solvency UK system is now underway, and is likely to have significant implications for businesses across the country.
Find out more
Reserving for annuities
In a significant period of change, the implementation of the Solvency II Matching Adjustment (MA) framework has created a complicated system for reserving and assessing capital requirements for annuities.
Explore moreReferences
1 Feedback on the PRA’s preliminary thematic review work on funded reinsurance arrangements (bankofengland.co.uk)
2 Explanatory Memorandum (bma.bm)
3 CP12/23 - Review of Solvency II: Adapting to the UK insurance market | Bank of England
4 Article 181, Solvency II Delegated Regulation
5 Solvency II: Internal models - modelling of the matching adjustment - SS8/18 (bankofengland.co.uk)
References
1 Feedback on the PRA’s preliminary thematic review work on funded reinsurance arrangements (bankofengland.co.uk)
2 Explanatory Memorandum (bma.bm)
3 CP12/23 - Review of Solvency II: Adapting to the UK insurance market | Bank of England
4 Article 181, Solvency II Delegated Regulation
5 Solvency II: Internal models - modelling of the matching adjustment - SS8/18 (bankofengland.co.uk)