Occasionally I find myself as an intermediary for clever people who’d prefer to discuss matters in a public way while remaining anonymous. These people often send me direct messages on twitter whats app and Facebook Messenger and the discussion continues on my blog. On this occasion, a hoary actuary has asked questions of Con Keating in just such a way. I am respecting the hoary actuary’s anonymity.
Con Keating has responded and I hope the result makes sense as a kind of socratic dialogue
Private Sector Pension Indemnity Insurance
This blog replies to a set of questions related to our earlier blog on DB scheme valuation which were posted on Twitter and forwarded by Henry. The questions are shown in italic
….always enjoy Con’s articles.
The blog and the earlier paper published by Long Finance are joint work with Anna Tilba and Iain Clacher. These responses were produced by me alone. These questions go well beyond the ambit of our recent blog which was simply concerned with the correct accounting for DB pensions (though the technique can and should be applied to CDC schemes). Most of these questions are concerned with private sector pension indemnity assurance, which, of course, the PPF should have offered.
My questions are:
- is there any control over the contract? Can an employer offer 1/80 final salary and the contribution require a return of say 12%?
We envisage a privately insured scheme which may impose conditions as a policy condition. The cover is full benefits.
An employer offering a pension with a contractual accrual rate or cost to it of 12% would be unusual in current circumstances. To put some indicative numbers to these responses I will, for simplicity, consider the pension as if it were a single lump sum forty years from now and show some relative values.
Such a high rate would mean a very low contribution rate – just 1.20% of the pension benefits (about 2.7% of wages) and would also mean that the potential debt service cash flow demands on the employer are low in the early years and very high as maturity approaches – just 0.14 % in the first year and 10.75% in the final year – an unfortunate risk profile for an insurer to consider.
Let us further suppose that we expect returns to be 4%, then the reliance on the employer is 8% pa. Suppose then that our standard premium for a scheme in balance with a credit standing of the employer’s quality is 0.5%. Then the premium amount for the initial cover would be 5.4 times the premium rate. To put this in cash terms for ultimate benefits of £100, a scheme funded at the 4% level would pay an initial premium of £0.11 for the first year. The 12% scheme would pay £0.58. These rise to £0.48 in the penultimate year for the 4% scheme and £0.98 for the 12%. This would probably give the employer pause if, as it is, the annual insurance premium is approaching the initial contribution rate.
2. is there any market for the insolvency insurance? Does the need to insure the insolvency risk over many years act to constrain (1)?
Currently there is no market providing insolvency insurance of this type though it exists in other countries. Occasional transactions have been undertaken in the UK. With appropriate indications from the DWP it could be up and running within 12 months – there are significant pools of capital available for insurance of this class of risk.
It is possible that the pricing of the risk will tend to constrain the behaviour of employers (above for example). Covenants may be introduced restricting the range of actions of the employer – for example by specifying maximum deficit repair periods. Breach of such conditions would permit the insurer to step in and take over the scheme at the (immediate) expense of the employer.
If section 75 were not repealed, the section 75 value is a significant overstatement of the true claim, and depending on the level of recoveries would enhance the profitability of the indemnity assurer.
However, in general the insurer should be accommodative to distressed employers – work-out and reorganisation are generally preferable to liquidation.
3. what exactly is insured? The amount needed to buy out the contractual benefit less the assets available or less the amount recognised in the company accounts?
The full benefits as promised by the employer sponsor with continuity of discretionary practices recognised on trigger by the issuance of individual annuities to members.
There are two insurance companies involved – a credit insurer and a life company to manage the pensions portfolios under common ownership. Both may reinsure some of their risks but the key is that on insolvency they step in to pay pensions.
The credit insurer’s risk is essentially as described – the buy-out value less assets available in the scheme fund. Technically with this insurance in place there may be no recognition in company accounts as the current position is that it is deficits or surpluses which appear. The pension scheme would be relegated to a footnote, though they may have to introduce a contingent liability for the requirement to pay premiums in future. The insurance policy is an asset of the scheme, which is countercyclical with respect to the scheme valuation.
4. Are benefit payments made by the employer or out of the assets of the scheme. If the latter and they are exhausted before all liabilities are met does the sponsor then pay the pensions? In extremes until insolvency.
Benefit payments would be made by the scheme. If the sponsor is delinquent with respect to their obligations to the scheme, then the insurer will enter into negotiations with the sponsor with restructuring in mind. In the event that there are no assets left in the scheme and the sponsor is unable to meet its obligations, it and the scheme are insolvent and then the insurer steps in, becoming a creditor of the insolvent estate.
5. Is any annual monitoring done to assess the performance of the assets against the accruing accounting benefit?
This is already done by the scheme trustees.
6. And by the insurer to reassess their liability and premium?
The annual premium may be set in a number of ways. Fixed as a rate for the life of the scheme would probably prove most popular – say 0.5% of the liabilities of the scheme where the scheme is in balance and the scheme CAR is reasonable, or of the insurer’s risk exposure. So, the rate is fixed but the amount will vary from year to year.
The premium rate is a measure of the sponsor employer’s creditworthiness.
7. Are the premiums annually reassessed or fixed in any way?
The premiums may be assessed annually as above or fixed for some term . This latter case may involve the employer entering into various possible covenants with the insurer.
This is more like a new idea to rank alongside CDC (although is totally different of course) than something that is simply DB. It is CDB.
Private Sector Pension Indemnity Insurance really is not new. It is simply insured DB. It could and should have been done by the PPF and still could be. It has existed for decades in other jurisdictions such as Sweden and there it operates for totally unfunded schemes.
You are trying to do things which are impossible, to find guarantees where there aren’t any!
The only insurance for a DB scheme is the buy out, using full liability driven investing (LDI).
Anything else would be impossible in todays’ Capital adequacy rules for insurers as they are now in Europe. No insurer would like to hold huge amount of capital on the balance sheet and earn nothing on it. You see the capital that you do not have in the pension scheme, by taking equity risk, would need to be held by someone else (the insurer), if the insurer writes a guarantee policy! It is just moving the problem from one to another!
You are in danger of making yourself look foolish with that comment.
As numerous surveys have found scheme members want the guarantees of DB arrangements. All that I am proposing is reinforcement of those guarantees by indemnity insurance. Similar insurance guarantees exist widely already – just consider surety bonds. It is also what the PPF does albeit imperfectly.
The second part of my proposal – the issuance of annuities by the life company is indistinguishable from a bulk annuity player other than in the means of acquisition of those liabilities.
This is not impossible. Such an insurer has existed for over 80 years in Sweden. It insures over 1400 schemes – a very significant part of the Swedish economy. With an average premium of 0.3% of liabilities, it has proved extremely profitable. In recent years it has even been able to dividend back to member shareholders more than their annual premium.
It faces and more than complies with the very capital adequacy rules that you claim makes this impossible – perhaps you would like to explain that.
I should tell you that I have been involved in capital adequacy rule making discussions since the 1980s Cooke Committee and the original NAIC regulations. This has continued through Basel II and the Lloyd’s ICAS regime of the noughties to the most recent development and application of Solvency II and Basel III. There is nothing in those which precludes the pension indemnity assurance model I propose – we see ever more bulk annuity players and no shortfall of credit insurers writing surety bond and other guarantees.
You are making a most basic error. The regulatory capital of an insurer (or bank) does not sit idle earning no return, it is invested in some of the assets which make up the other side of the balance sheet.
It is not moving the liability. It only steps in once the original obligor fails.