The legal terms and conditions of these collateral arrangements are increasingly nonstandardised and opaque, resulting in collateral recapture processes which remain inherently untestable until the event of an actual stress. 3. Funded reinsurance also introduces material wrong-way risk, in that the performance of the counterparty and the collateral posted are likely to be positively correlated. Page 5  In an increasingly competitive market place, with limited capital to support a rising volume of new Bulk Purchase Annuity (BPA) transactions, we are alive to the potential for growth in the use of funded reinsurance. This may result in a greater concentration to a limited number of lessdiversified, asset-intensive reinsurers. Moreover, indirect exposure to foreign credit markets also adds to cross-jurisdiction complexities and introduces contagion risk. This is a developing part of the market with each incremental change bringing more complex valuation, operational and legal risks that need to be carefully assessed and managed. Funded reinsurance is small at present, but it could pose a risk to our objectives if it were to become routine. High levels of funded reinsurance would render the payment of a significant value of UK pensions dependent upon the strength of a concentrated and correlated group of reinsurers. These reinsurers are held to standards set outside the UK. Given our own ongoing efforts to tailor prudential standards for annuity business, standards elsewhere may well not have been designed with UK annuity risks in mind – and so may not yet handle them as effectively.
Through the transfer of the risk, the insurer reduces its longevity capital and risk margin[1], but takes on an exposure to the failure of its reinsurance counterparty. Chart 1 [see Annex] illustrates the impact of the transfer on the insurer’s capital position. The combination of adequate collateral, a high credit rating, and sufficient capital resources from the reinsurer means that the resulting counterparty risk capital charge for the insurer is typically low – an attractive arrangement. Reinsurance is an important component of well-functioning insurance markets, where reinsurers themselves have the financial strength to absorb the risks they are taking on. From a risk management perspective, it allows insurers to achieve the balance of underwriting and credit risk in line with their risk appetite while continuing to deliver for their clients. It allows reinsurers to gain indirect access to diversification or natural hedges that might not arise on their own balance sheet. For example, a reinsurer with large books of protection business featuring mortality or morbidity risk might welcome longevity risk as a natural (albeit not perfect) hedge[2]. Diversification of different[3] sources of callable capital also enhances the efficiency of insurance markets. All of these factors could help to improve the pricing that insurers can offer. However, in recent years, the UK life market has become reliant on this method of freeing up capital to improve pricing. We estimate that over 80% of new business since 2016 has been reinsured at industry-level.