Over the weekend, I tried to get my head round the Solvency Capital Requirement and the case for broadening the assets that can be used to match DB liabilities. In my laboured way, I concluded that there is another important consequence to reducing the cost of insurance, and that is in the calculation of the buy-out price for UK DB pensions.

The solvency of DB pensions (on a buy-out basis) is directly linked to the cost to an insurer of insuring them. I know this will seem blindingly obvious to people like Steve Groves and Con Keating and understand these things intuitively. But to me , it is a thing of wonder that a small tweak in solvency legislation or a few bps on gilt rates can turn a lousy DB scheme into a good one.

So what need to change? From my very limited knowledge, there seem to be several key aspects to all this- and I don’t understand any fully.

Sadly almost everyone I speak to has a vested interest – I  even spoke to a retired regulator  who admitted that loyalty to his former bosses was in  his/her DNA. . Certainly we need to be wary of  politicians claiming to be even-handed.

But if this vitally important stuff is to be changed for the UK, we need it properly explained and the changes discussed in parliament and properly explained to us.

The first thing that needs looking at is the Solvency Capital Requirement.

The Solvency Capital Requirement  is just over a month old and already it is under threat of a.

The solvency capital requirement is the amount of funds that insurance and reinsurance companies are required to hold under the European Union’s Solvency II directive in order to have a 99.5% confidence they could survive the most extreme expected losses over the course of a year.

Insurance bods that I speak to , tell me that many of the assumptions used are unreliable. But most insurers  get round this by using their own internal model. It is a bit like having an unsuitable MFR but allowing insurers and regulators to agree what suits them. Which definitely needs review!

The second thing that needs looking at is mortality risk

Mortality risk especially needs review given the imminent offloading of most DB liabilities. I know that the UK holds good data on mortality (Covid has made us aware of the depth of understanding of this subject at the most granular level). But to predict accurately the future of life expectancy is a matter of great expertise. We are currently reviewing the state pension age, let’s hope that coming out of that review will be a review of mortality risk.

The third thing that needs looking at is the risk margin

The risk margin is the discounted value of the future cost of capital relating to risks (other than hedge able market risks) required to be held under Solvency II rules by the hypothetical transferee company (called the reference undertaking under Solvency II).

I would appreciate more help in understanding this, I am sure that the calculations can be made in the light of investment practice which is moving the goalposts for the risk margin (and indeed the solvency capital requirement). The Treasury paper on the Financial Regulatory Framework (published last July) helps us get our heads round the new – post Brexit – world we are in , but it did not go far enough to help people like me understand what should be done.

The fourth aspect is the Matching Adjustment which also needs review

Under Solvency II, insurers are required to calculate the value of their liabilities using a risk-free interest rate. The matching adjustment is an upward adjustment to the risk-free rate where insurers hold certain long-term assets with cashflows that match the liabilities.

This seems to be the crunch, where the battle between the Europe and the UK will be most fierce. As I understand it, the matching adjustment was always a big fudge. It allowed the U.K. to write annuity business at a decently low price – but the UK had to convince the EU to allow what it saw as bending the rules.

Now we want to bend them more. It is all pretty much a fudge on a fudge. And the final answer will be a balance of fudges. Superfunds are another fudge in the same space, but at least what they are doing is  based on sound principles and explicit and public modelling.

This is a ripe  for a battle between financial economists like John Ralfe and pragmatic actuaries like Kevin Wesbroom. It will pit insurance actuaries against  pensions actuaries.

To the man/woman on the Clapham Omnibus, all the talk of member security is pretty spurious, there is more chance of the Omnibus crashing and killing all aboard than an annuity provider not being bailed our by FSCS and the tax-payer. But on this question the future of DB pensions in the UK may be decided.

What are the implications for workplace pensions going forwards?

Although a review of all these things is likely to lead to a decreased cost of buy-out, I doubt that any savings to sponsors of DB schemes will be passed on as better funding of DC workplace pensions. The shareholder will rightly ask to have some of the value it has given to its DB schemes back, if only in not having to transfer more funds to those in employment.

But a relaxation in solvency rules would make for annuities that look more like what many of us have in mind for CDC. Indeed CDC could become the middle ground not just for institutional but for retail pension plans.

One issue is whether the big insurers will be able to pivot fast enough to pick up on this , or whether it will be the master trusts or superfunds who will seize opportunities resulting from Britain’s determination to find a Brexit dividend for financial services.

Posting over the weekend on Linked in, Steve Groves, Chair of Mobius wrote

Set capital requirements too high and insurance becomes too expensive so people self insure (e.g. drawdown v annuity)

Set capital requirements too low and perversely society self insures, when an insurer fails the rest of the industry or treasury step in, both are funded by wider society.

There’s a sweet spot where insurance is affordable, the risk of systemic failure very low and the complexity manageable. Neither side of the debate will find it on their own as it needs both Yin and Yang to find that balance…….it needs that tension to get to a sensible result so I agree with Mick McAteer

Mick McAteer calls for this debate to be public and transparent, so do Steve and I. I suspect that that is a starting point for a new consensus that will emerge, but it won’t be easy.