Funded Reinsurance: The PRA’s Proposed Changes to Capital Treatment – the Final Landing Place?

Summary

In its consultation paper CP8/26 published on 29 April, the Prudential Regulation Authority (“PRA”) proposed changes to the regulatory treatment of funded reinsurance (“Funded Re”) that would significantly raise the amount of capital UK insurers would be required to hold for Funded Re transactions.

CP8/26 represents a much-awaited (and much-needed) clarification of the PRA’s evolved stance towards Funded Re – a stance that has been unclear since Vicky White’s speech in September 2025. Funded Re has been an area of increasing concern and focus for the PRA since 2022 and its original thematic review. The regulatory approach has moved from a principles-based granular scrutiny of risk management on the part of cedants (with detailed requirements for recapture plans and collateral policies) to a proposed regulatory recharacterisation of Funded Re as a bundled collateralized loan and longevity swap (which has now been dropped) to this apparent final landing place of, essentially, a much higher capital charge on cedants.

In particular, CP8/26 proposes an amendment to the Counterparty Default Adjustment (“CDA”) applied to Funded Re transactions. The PRA estimates that the amendment (discussed in detail below) would require UK firms to increase the capital held for Funded Re transactions from the estimated current level of 2-4% of the value of the underlying annuity liabilities to around 10% on average. The proposals, if implemented in line with the consultation paper, would, therefore, significantly impact the economics of Funded Re and reshape how it is used by UK firms going forward.

In our view, changes to the CDA are in principle a neater and more logical approach than those previously suggested by the PRA in September 2025 (including the previously proposed “unbundling” of the investment component of FundedRe from longevity reinsurance for Solvency UK balance sheet purposes). It seems that this approach has been the subject of much consideration on the part of the PRA and is now, generally, the route that will be taken. We expect that consultation responses will be focused on quantum of the increase as opposed to the proposed general approach.

Certain areas that merit further consideration during the consultation period include:

• Scope of application: The crux of the PRA’s rationale is that the regulatory capital treatment of Funded Re “is not aligned to that of economically similar assets”, which is to say directly held investments (specifically, directly held financial corporate bonds).
  
  While we follow the logic of the requirement that the CDA should reference the fundamental spread, which reflects the risks for such direct investments, an interesting question is how this is being conceptually justified for Funded Re but for no other form of reinsurance. Based on the consultation paper, the rationale seems to be tied entirely to the longer term of Funded Re, the materiality of the underlying assets and the fact that funded reinsurers are often monoline with large exposures.
  
  While we appreciate the rationale and note that a new definition of funded reinsurance is proposed, some might ask whether the PRA has fully thought through the implications of equating Funded Re’s cashflows to a financial corporate bond but not the cashflows of, as it stands, any other type of reinsurance arrangement, whether in the Life or non-Life sector.
  
  The quantum of the capital charge is particularly relevant in circumstances where the reinsurer itself – often located in Bermuda, a jurisdiction enjoying Solvency II equivalence – is required to hold capital against the same risk.

• Direct Investment into the United Kingdom: The wider policy goal of encouraging more investment into UK plc makes certain assumptions about Funded Re’s hindrance or discouragement of the same that could benefit from further substantiating evidence or data.
  
  The CP makes this assumption explicitly, as the PRA has repeatedly on the subject of Funded Re, but some might well argue that further evidence should be supplied of a non-UK bias that would be rectified by insurers being deprived of funded reinsurance in their toolkit. This seems to be a very important overriding Policy point that has raised its head in different ways for many years now in the context of the BPA market, often on the basis of certain misunderstandings as to the integrated nature of pensions, insurance and reinsurance. In parallel and on the Government level, we imagine that increased focus on originating more opportunities for UK productive investment should remain a priority.

• BPA Pricing: We appreciate that it is clear from the consultation paper that the PRA has rightly considered the potential consequence of BPA pricing being impacted. The PRA does not seem particularly concerned that there will be a significant impact on either competition or in most cases pricing. We imagine that some would query this assumption, and argue that by definition the potential removal of a tool that is often used for the precise purpose of price optimisation is going to have a negative impact.

The PRA has not commented further on its Alternative Life Capital discussion paper (which we discussed in a Legal Update) which has already attracted significant industry engagement. The implementation of any of the proposed methods (e.g., changes to the existing ISPV regime) will be complex and likely take significant time to agree and implement.

What Can Firms Do?

Firms have until 31 July to respond to the consultation. Firms may want to use this time to evaluate the impact of the changes to different transaction structures (e.g., funds withheld, funds transferred or hybrid structures), counterparty insurance financial ratings and credit spread environments. Firms could also use the consultation as a chance to test with the PRA how much weight it would give to certain structures, contractual terms or credit protections not specifically referred to in the consultation.

The changes would not apply to transactions where all the risks covered are fully transferred to the reinsurer on or before 30 September 2026 (but will catch new business written after that date). Formal implementation would occur on 1 July 2027.

Whilst transactions already in contemplation / under discussion could be executed prior to 30 September, the PRA has clearly warned firms that it “expects the volume of new funded reinsurance arrangements to be transacted before 30 September 2026 to be consistent with firms’ existing plans.”

The Proposals

The PRA’s proposals come after a period of significant scrutiny of Funded Re arrangements, which it considers has the potential to lead to a rapid and systemic build-up of risks (we discussed this in a previous Legal Update). The key proposals include:

1. Aligning the treatment of counterparty default risk for FundedRe with the treatment UK insurers apply to similar investments (which it considers to be financial corporate bonds)

The PRA is proposing that the CDA applied to funded reinsurance arrangements be equal to the fundamental spread for financial corporate bonds corresponding to the credit quality step (“CQS”) and maturity of each of the funded reinsurance cashflows (the rationale being that insurers’ primary exposure under a funded reinsurance arrangement will be to the reinsurance counterparty, which are by nature financial institutions).

2. Assignment of a CQS for the CDA Calculation

To determine the CQS:

• IFS: Firms would start with the IFS issued for the reinsurer by an external credit assessment institution (ECAI).

• Upward Notching: Firms will then have the ability to apply up to three upward notches that align with the notching criteria used for rating covered bonds and structured finance instruments.

Firms would determine the notches based on the contractual terms of the agreement and one upward notch would be permitted for each below feature present:

• Adequate Collateral: The collateral fully covers the premium at inception and is adjusted only to account for changes in market conditions and claims experience

• Absence of a need for collateral transformation: The collateral is 100% matching adjustment eligible (MA) in line with the firm’s permissions and any mismatch between the cashflows of the collateral and the contractual cashflows of the funded reinsurance do not give rise to material risks
  
  The PRA proposes to use the quality of the cashflow matching of the “worst-case collateral portfolio” and the level of matching adjustment eligibility as proxies for assessing the need for any collateral to be rebalanced or transformed to meet the contractual funded reinsurance cashflows

• Credit enhancing nature of collateral: If the weighted average rating factor of the worst-case collateral portfolio indicates the collateral has a higher credit quality than the counterparty
  
  Firms may use internal rating assessments if these are consistent with the internal rating methodology and processes used by the firm for similar directly held assets. Otherwise, firms should take a prudent approach, such as assigning the unrated assets a CQS of 4

The PRA would expect that a firm’s approach to determining the credit quality step is documented and approved by a Senior Management Function (SMF) holder, in most cases the CRO.

3. Scope of the Regime

The regime would be extended to the funded reinsurance of capital redemption business as well as of annuities, on the basis that these products share similar long-term risk characteristics. Limited exemptions for some reinsurance arrangements are proposed, including for certain intra-group arrangements and for temporary reinsurance used prior to the completion or termination of a Part VII transfer. However, the exemptions are available only where the structures do not increase overall risk or create artificial capital benefits.

Volume Limits

The PRA has decided not to apply volume limits on the amount of annuity liabilities that firms could cede via funded reinsurance arrangements at this stage. However, the PRA would monitor the impact of its proposals if they are implemented and would consider volume limits if it believes that further action is required.