Supervision of asset intensive reinsurance in Bermuda: recent enhancements, what is still to come and how regulation of cedents can better capture and mitigate risks

The Bermuda Monetary Authority (BMA) has published a White Paper entitled Evolution of Asset Intensive Insurance - Update to the Supervision and Regulation of Private Equity (PE) Insurers in Bermuda (White Paper).  It shares observations regarding the prudential risks and supervisory challenges associated with asset intensive reinsurance (AIR) and the related growth in strategic alliances between the long-term sector and asset management firms.  It describes:

• the enhancements in regulation and supervisory practices that the BMA has introduced to date in response to these risks;
• ongoing public consultation on further enhancement and clarification;
• prudential risks that still call for a more tailored and agile supervisory approach and possible regulatory enhancement including suggestions for enhancement to regulation of onshore cedents who purchase AIR.

The BMA concludes with the observation that regulators in other jurisdictions should evaluate and if necessary improve their supervisory tools relating to AIR.  Cedents need to be able to identify, measure, monitor, manage and report the risks to which they are exposed in relation to AIR.

The White Paper updates the BMA’s earlier paper, Supervision and Regulation of Private Equity (PE) Insurers in Bermuda, published in December 2023, and draws on observations shared in three market papers focused on the long-term sector, respectively on Private Credit, Collateral and Liquidity Risks, published in August and September 2024.

The White Paper is also important context-setting for two related on-going consultations:

• “Proposed Instructions and guidance on the Application of the Prudent Person Principle (PPP)” in investment risk management (see Kennedys’ article on this); and
• public disclosure of investments by commercial insurers (see Kennedys’ article on this).

Background

Asset-intensive business grew rapidly in Bermuda following the global financial crisis, as the life insurance industry turned to reinsurance for more and varied sources of long-term capital, including private capital, to replace a withdrawal of public capital.  The growth of AIR is linked to another trend, the rising importance of capital from PE firms, institutional investors and alternative asset managers, which grew Bermuda’s long-term statutory capital and surplus over the same period.  As well as adding private capital, this latter trend expanded investment management and origination capability within the long-term industry through strategic relationships and partnerships with asset management firms.

These related trends have produced benefits, including greater capacity, diversification and more sophisticated asset-liability matching capabilities.  But the BMA has observed prudential risks around potential governance, conflict and risk management challenges; and a tendency to invest in higher proportions of illiquid assets which are subject to valuation concentration and complexity risks.  The interplay between the prudential risks and the greater allocation to illiquid assets also poses supervisory challenges as it amplifies the vulnerability of insurers to potential shocks and stresses.

The prudential risks and prudential challenges, and the action the BMA has taken in response, considers is still necessary or encourages regulators in other jurisdictions to consider are summarised as follows:

Culture clash, undue influence and conflict of interest

• Asset managers can influence an insurer’s strategy, asset allocation, growth and capital management. There may be a lack of challenge by the board to inappropriate investments.  These are cultural rather than structural issues.  Indeed, the BMA considers that actual behaviours rather than inadequate structures are to blame for some historical failures.

Response

• The BMA sees room for improvement in investment risk management practices. The BMA expects insurers to establish adequate governance and corporate culture and look beyond systems and structures.
• The BMA proposes to enhance its scrutiny of insurers’ application of the PPP (hence the consultation mentioned above).

Impermanency of capital and focus on the short-term

• Enhanced supervisory scrutiny and tailored supervisory interventions, such as dividend restrictions, liquidity and capital maintenance agreements, higher level of solvency, etc, may be needed where a focus on short-term outcomes could undermine policyholder protection.

Misaligned incentives and value extraction via asset fees (among others)

• Payment of up-front of AUM fees allows the asset manager to benefit in the short-to medium-term while policyholders may lost out in the long-term.

Response

• The BMA sees an opportunity for further research and the development of concrete solutions relating to the appropriateness of AUM fees in the context of asset manager-owned or influenced insurers. For example, some Bermuda reinsurers retain a portion of the AUM fees that are only paid out when liabilities are run off.

Risks from increased competition

• Competition exists in the life market (in the high-interest rate environment where other non-insurance institutions, including banks, offer competing products). Unsustainable crediting rates can drive aggressive risk-taking on the asset side.  Competition also exists between reinsurers in the AIR space.

Response

• Recent and proposed enhancements (enhanced investment reporting and more intrusive supervision of private credit, clarification of expectations for compliance with the PPP and consultation on publicly disclosure of assets) respond to these risks.
• However, the BMA considers that:
  • a yet more tailored and agile supervisory and regulatory approach is needed with AIR to take into account the insurers’ specific characteristics and circumstances. This includes more frequent and detailed on-site inspections, off-site reviews, data requests, interviews with key functions and persons, closer engagement regarding material transactions and bespoke stress tests and associated recovery plans.
  • customized regulatory reporting is needed to allow assessment of liquidity risks – eg identification of PIK assets, poor ALM and maturity transformations, leverage, investment commitments, insurance product design and distribution channels.
  • outside Bermuda, enhanced cross-border supervisory cooperations is needed.

Lack of transparency around value extracted by the asset manager

• There is a risk that pricing may not be on an arms’ length basis.

Response

• Insurers could enhance public disclosure of the extraction and flow of cash and non-cash value between them and affiliated asset manager.

Poor design and execution of contractual mitigations by cedent and/or reinsurer

Response

The BMA encourages cedents to disclose to their regulators their assets of the assets and whether these align with policyholder obligations.

Further regulatory enhancements by cedant regulators

Recommended response in cedent jurisdictions

Regulators in other jurisdictions should evaluate and if necessary improve their current supervisory tools to ensure that they effectively capture and mitigate risks.  The BMA supports initiatives by cedent regulators that require ceding entities to demonstrate to their regulators that they have proportionate but adequate risk management to identify, measure, monitor, manage and report the risks to which they are exposed in relation to asset intensive reinsurance arrangements.