On 16 November 2023, the UK Prudential Regulatory Authority (PRA) released draft measures to address perceived risks in the market for funded reinsurance, which is widely used as part of transactions that shift pension scheme liabilities to insurers.
What is funded reinsurance , why did the PRA issue the warning and should we be concerned for the future of our pension system – and our pensions? This blog sets out to address these questions from the point of view of the unfamiliar reader.
What is “funded reinsurance”.
Funded reinsurance is different from selling on an unwanted insurable risk (such as the risk of people living too long). Historically, large insurers such as Hanover and Munich have swapped longevity risk for an upfront premium with the assets backing the promise remaining with the insurer or pension scheme. The alternative is conventional risk pooling, where the members of the scheme insure themselves.
The PRA does not have a beef against conventional reinsurance but is worried when the risk is parcelled up with funds so that a proportion of the buy-out or remaining pension scheme is shipped out (outsourced). Funded reinsurance effectively buys out the buy-out and means that control of the “fund” passes to a Bermudan insurer. This is not what you’d expect to happen if you were a member of an occupational pension scheme in the UK.
Why is the PRA issuing warnings?
There appear to be three reasons
- The PRA is worried that too much of the risk taken on by a UK insurer is concentrated with a small band of offshore insurers and that a domino effect might lead to a run on the market threatening the solvency of the UK insurer.
- The PRA is worried that the quality of the promise of the reinsurers may not be all it should be. They see risk from the quality of the “collateral” posted by counterparties
- The PRA is worried that insurers are not planning for a “recapture” of the fund in the event of failure. This worry is both about the operational plan (getting the money back) and the reserving plan (if the money doesn’t come back.
Should pension schemes and pensioners be worried?
The Financial Times is not beating around the bush
Scoop from @iankmsmith Big UK life insurers tripled use of controversial reinsurance deals https://t.co/MBUtqkkvBJ via @ft
— Josephine Cumbo (@JosephineCumbo) May 27, 2024
The insurers may have hit treble top on new business volumes, but at what expense to the pension scheme and the pensioner? Most of the annuity risk is from buy-ins and still sits with the pension scheme. For now pensioners have full protection from the PPF
If the buy-in becomes a buy-out and transfers to the insurance company’s balance sheet, the member’s protection is from the untried and unfunded Financial Services Compensation Scheme (FSCS).
Here’s what Stephanie Hawthorne reckons to consumer protections
And here’s what Jade Murray pension partner at Addleshaw Goddard has to add
The risk from “recapture”
The FT quotes PIC, L&G and Phoenix as its sources for the tripling of funded reinsurance. Just and Aviva are also mentioned.
These organisations know how to manage risk and should be able to meet the PRA’s requirements on existing business. But the projections for demand for buy-out in the UK suggest that the temptation to cut corners in future is one that all of us should be concerned about.
In the article mentioned in the tweet above, the FT’s Ian Smith writes that trustees have expressed concern that
…a lack of transparency about funded reinsurance meant fund governors were handing over billions of pounds in scheme assets to life insurers whose financial structure, “they do not understand but are told is ‘iron clad’….
One trustee said
“In what fiduciary management world is it acceptable to give other people’s money to an entity where you don’t understand the risk . . . and that entity can transfer its liability to you to a third party without your agreement,”
Counterparty risk
Those familiar with Everton FC will know of 777 partners, the Private Equity firm looking to buy the club, they may not be so aware of 777 Re- its Bermudan reinsurance arm, set up in 2019 and now part of the half a trillion dollar industry overseen by the Bermuda Monetary Authority.
The new 777 Re was joining a rush to the island that put the Bermuda Monetary Authority, its financial regulator, in charge of more than half a trillion dollars in offloaded US life and annuity reserves by the end of 2021.
I would not expect any UK insurer to use 777 Re as a counterparty, but when there is sewage in the river, anyone can get sick.
Concentration risk
It has always seem presumptuous for the markets to assume that funded pensions – 70+ years in the making , can transfer the assumed risk in a matter of a few risks. Even if they wanted to offload assets and liabilities to the insurance sector, what makes us confident that there is a market for this level of risk or matching assets to reserve against it?
Rather than spreading the risks, accelerating buy-out risks concentrating risks around a few insurers and a large pool of reinsurance – one step removed from UK regulation.
At a time when both major political parties are looking to our £1.5tr DB pension assets to provide economic regeneration, the prospect of shipping large portions off to Bermuda looks politically inappropriate. Indeed, the point of “growth assets” in UK pensions is to get the growth in the UK to fund pensions in the future.
The use of funded reinsurance is as unlikely to get political support as regulatory support, if it continues to increase as it is currently doing.
All of which suggests that we take a long-hard look at buy-out and find ways to diversify the way we pay the pensions we have promised. There is of course space for annuities, and there is space for people to exercise their freedoms, but we need collective pensions too, we need CDC and we need pension schemes to pay members a wage for life with or without reinsurance.
In the comments on the FT Article, MAWS of Guildford writes:
“The interesting thing is for a pension scheme to invest in a buy in they will hand over a portfolio of gilts, a diversified portfolio of investment grade gilts and in effect some of their surplus (which in effect acts as a risk mitigant) in exchange for a ‘promise to pay’ from a single highly rated corporate entity and call that risk reduction.
Yes the promise from the insurer is modelled precisely on its liabilities but you can largely achieve this with a longevity swap and good inflation and interest rate hedging, at lower cost and without what I would say is the increase in investment risk.
I think we should be honest about this. The drive to buy in is driven by the fact that it is a necessary step to buy out, which company sponsors support because it removes any of their liability for the scheme. I struggle to see how you can say it is truly about risk reduction.
I also worry the industry has got itself into a position of seeing buy-in/out as the default answer. I am old enough to remember the saying ‘you don’t get fired for buying IBM’ back in the days when they dominated the IT hardware industry. Basically I think that is true today, no trustee will get into trouble for doing the same thing everyone else is doing, or any adviser for advising that this is the right step (ignoring the fees some will earn for the transaction may give them a conflict). If all goes wrong the regulator’s test is simply was the decision you made reasonable, not whether it was the right one, perhaps understandably. How can you argue that doing what everyone else is doing is unreasonable?”
The problem is that in the past the Pensions Regulator was promoting risk transfer to an insurance company as the “gold standard” for a pension scheme – are they still doing so?
This strengthens the arguments for splitting TPR up – with DC going to the FCA and DB to the PRA.
I am no expert but the race to buy-in and re-insure offshore feels like it has a big resemblance to the disastrous re-insurance process that lead to the near collapse of Lloyds in the 1990s.
The texhnically qualified will poi-poo the’assertion, but. . .
Trading into an unknown cloud.. ….