I got to yesterday’s Pension Age conference just as LCP’s Ken Hardman was explaining how capacity for bulk buy-out was expanded by a healthy reinsurance market. When I got home late that evening I found myself reading a speech by Charlotte Gerken, the BOE’s insurance expert– delivered at pretty the same time on the other side of the Capital.
She identified four risks for insurers off-loading risk onto funded reinsurers and concluded that insurers
.. need to approach these arrangements with caution and consider carefully whether their risk management processes are able to deal with these risks adequately. With responsibilities for pension payments for millions of policyholders for decades into the future, insurers need to demonstrate they can execute these transactions prudently and manage their risks over the whole life of the contracts.
The upbeat tone adopted by Ken Hardwick contrasts with the cautious tone from the Bank
“need to balance the short-term financial and reputational incentives to grow rapidly, with long-term and enduring financial strength, to meet the long term needs of policyholders and the economy”.
Insurers that take on pension schemes will need to hedge their interest-rate and inflation risks, which may mean wider risks to financial markets.
“Insurers therefore need to understand, as they take on these vast sums of assets and liabilities, how they may become greater sources or amplifiers of liquidity risk…
the Bulk Purchase Annuity market is in a period of accelerated growth and yes, while we are pleased with the opportunities this brings, insurers should approach this with moderation.
In the meantime , the Pensions Regulator seems to be waking up to the likelihood that between £500bn (BOE) and £700bn (PWC) of pension liabilities will transfer from the balance sheets of UK corporates to UK insurers in the next 10 years. These liabilities are our pensions that will now be paid as annuities not by the trustees of the schemes in which they accrued.
In its annual funding statement , TPR estimates that
around a quarter of all DB schemes may have sufficient funds to buy out their liabilities with insurance companies. Trustees of those schemes will need to consider if their long-term targets remain appropriate, whether that is to buy out, or to examine other endgame options.
And TPR is sounding remarkably chipper about the rest of the DB schemes it oversees.
The majority of remaining schemes are estimated to have funding positions that are ahead of their funding plans. In these cases, trustees should consider whether the existing strategy and level of risk is in the best interests of members. If not, this may be a trigger for trustees to review their pace of funding and level of risk, or to re-order their long-term targets and set new, more ambitious objectives.
What is meant by “ambitious” depends on whether the ambition is to pay better pensions or take even less risk in meeting existing promises.
The reality is that occupational schemes have £500bn less in assets to pay these pensions, that coverage of payments has fallen and that what is left of growth portfolios is largely in illiquid assets that didn’t burn in the LDI fire sale. As Charlotte Gerken was warning insurers, these assets may not be valued at what they are marked up and are not assets insurers should look kindly on. And TPR acknowledge that many schemes invested in pooled funds (presumably LDI pooled funds) will have suffered lasting impairment to their funding strategies by losing assets, hedges or both.
The return of “ambition” to the Regulator’s lexicon
Stuck with fewer marching and growth assets , these trustees may take comfort in research from Ruffer which suggests that while inflation can spike to 10% in a matter of months, it will take on average 10 years to revert to the BOE’s 2% target. The return to the BOE’s long term inflation target doesn’t look like happening any time soon
That would suggest that there is no need for trustees to hurry either. They can consider what “ambitious” means and perhaps accept that their days responsible for a pension scheme aren’t over quite yet.
There is a third and important player in this. The DWP and Treasury have been at loggerheads for some years about whether occupational schemes should be allowed to consolidate between themselves, either operationally (using master trusts) or more fundamentally, through the approval of Superfunds.
As the BOE and PRA warn about capacity and the Pensions Regulator considers “ambition”, perhaps it is time to look at innovative alternatives to de-risking , including the encouragement of open DB schemes, CDC , DB mastertrusts and superfunds.
We have seen what happens when corporate DB schemes adopt a single strategy, diversification has its advantages.
The call for evidence by the work and pensions committee included a question on buy-out. This was our response:
2. Is there sufficient capacity in the buy-out market to meet demand from DB schemes? If not, what are the alternatives?
No. Full scheme buyout has been the exception rather than the rule. In the past decade, a total of just £63 billion of buyout transactions have been completed. There are serious constraints on the human resources side in insurance which will limit expansion of the sector. Given the profitability of this business to the insurance sector, it is to be expected that insurers will increase their capacity to undertake more buyouts over the coming years. However, the scale of this expansion would require a near doubling of the asset size of the insurance market and would suggest that this should be expected to take at least a decade. It also raises an important issue. Rapid increases in written premiums are associated with higher rates of failure of insurance companies, a trade-off that is well-known and often used by analysts as a cautionary tell-tale.
There are two important further issues with the use of insurance buy-out. The first is that the liabilities may be novated, that is ceded to some other insurance company, a process which would usually be motivated by the desire to recognise profits. There are no formal constraints as to the creditworthiness of the purchaser of the pension liability portfolio. This differs from the use of reinsurance, where the ceding insurer is the beneficiary of the cover. We are also concerned with the use of the ‘matching adjustment’ in insurance accounting. This, in essence, is the recognition of future profits from a book of business as profits and capital resources today. It has been described elsewhere as fictive capital.
It is in fact debatable whether transfer to an insurance company improves the security of a funded pension scheme, notwithstanding its greater cost. Clearly it is case and fact specific.
Since submitting that we have seen a powerpoint from Paul Brine of Dalriada which raises many further questions over bulk annuitisation and member security.
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