Pension buy outs, how safe are insurers?

An increasing number of closed defined benefit (DB) schemes and sponsors are now well on their way to an agreed ‘end game’.

This would typically be a bulk purchase annuity (BPA) buy-in, followed by a buyout with an insurer. For most schemes, the covenant of a UK regulated insurer is viewed as more secure than the existing corporate sponsor, but it’s not risk free. The insurance regulator, the Prudential Regulation Authority (part of the Bank of England), has recently raised concerns about one way in which UK insurers, dealing with capacity constraints, are passing on risks to reinsurers.  

Why is the regulator raising concerns now?  

UK insurers may transfer selected asset, investment and longevity risks to reinsurers depending on their risk appetite. This process, known as ‘funded reinsurance,’ is an established way for insurers to grow their BPA business. It enables insurers to increase the size of BPA transactions or optimise returns on capital. However, it means that counter-party risk is transferred to (and may be concentrated in) other reinsurance companies. With the recent step-change in UK gilt yields resulting in huge demand for BPAs, the PRA has voiced its concerns about the systemic risks posed by inappropriate use of funded reinsurance to meet such demand.  

The PRA recently carried out a review of insurance firms, which included feedback on funded reinsurance arrangements. While noting a positive trend of improvements in insurers’ internal risk frameworks and models, it also highlighted that these firms’ practices showed some material shortcomings in several areas, notably the structuring of collateral portfolios and counter-party risk management, and the PRA expects remedial action to be taken.  

The underlying thematic concern raised by the PRA is a systemic one: that reinsurers are exposed to credit cycles, and a credit cycle shock is likely to cause the deterioration in the reinsurer at the same time as the collateral portfolio.  

A critical feature of the 2007-8 global financial crisis was the dramatic growth in mortgage-backed securitisation, which led to many banks holding mis-priced collateral and counter-party exposures. Drawing on the lessons from the crisis, the insurance regulator is now highlighting that, with the huge growth in the BPA market, systemic counter-party risks in the insurance sector are squarely on its radar.  

How safe are insurers?  

On an ongoing basis, the employer covenant underpins a defined benefit scheme’s ability to take investment and funding risk, which sits within the remit of The Pensions Regulator (TPR). When a pension scheme carries out a BPA buy-in transaction, the annuity is held as an asset of the scheme, and the employer covenant continues to provide residual support within the remit of The Pensions Regulator. It is only at the point of buyout, when individual annuity contracts are issued, that the employer covenant is replaced by the insurer’s covenant.  

In the UK, insurers are regulated by the Prudential Regulation Authority in conjunction with the Financial Conduct Authority. Insurers are subject to intense regulatory scrutiny on their business models and risk appetite, and are required to maintain regulatory capital to support this. However, it’s worth noting that the regulator’s objective is to protect policyholders and the wider financial system, rather than the insurance company. If an insurer is in distress, there may be an orderly wind-down of the business. If an insurer fails, a policyholder protection scheme protects eligible policyholders up to certain limits, although this has not been tested in practice.  

The UK regulation of insurers therefore provides considerable comfort for pension trustees looking to progress to a BPA buyout. However, it’s a misconception that this means ‘all insurers are the same.’ Some insurers sit within global groups with many different lines of business, while others focus on UK BPA business. Each insurer will have its own business model and risk appetite.  

Growth in other options 

The options for trustees approaching their ‘end game’ look set to increase. The DWP has recently consulted on DB ‘superfunds’ which effectively replace the employer covenant with a capital buffer within a consolidator scheme, but so far it has not followed through with legislation. TPR has provided regulatory guidance, setting out the standards that it expects before longer-term legislation is in place, with the Clara pension trust having secured assessment.  

In his Mansion House speech on 10 July the Chancellor of the Exchequer highlighted a range of pensions policies, including introducing a permanent ‘superfund’ regime, and the DWP has now launched a call for evidence ‘to support the development of innovative policy options, to increase protection for DB members, while supporting wider economic initiatives’.  

Trustee strategies  

The recent increase in funding levels for many schemes has accelerated the need for pension trustees to work with their employers in developing agreed ‘end game’ strategies. These may involve several milestones along the way (for instance the Clara fund has been developed as a bridge to eventual buyout) and in some cases buyout may not necessarily be the end game.  

At the end of the day, insurers are businesses and, like any other business, can change their business model, or even fail. So, it makes sense for trustees to carry out ‘gateway’ due diligence on their selected superfund or insurer(s) along this journey.