Playing it safe
Written by Lynn Strongin Dodds
Lynn Strongin Dodds explores what’s happening in pension insurance, from the impact of Solvency II to the buy-in and buyout markets
When Solvency II was first mooted in 2009, there were fears that the new regulation would cast a long shadow over the buyout and buy-in market. While the changes will be significant, industry participants do not believe that pricing will increase dramatically. They are more worried about the effect the unfolding eurozone debt crisis and the possibility of a double dip recession or prolonged sluggish economy will have on asset values.
At the moment, uncertainty lingers on all fronts. European policy-makers are trying to devise a solution while regulators are still hammering out the finer details of Solvency II. Intense lobbying by the insurance industry though has made the rules less onerous than initially feared. One of the major bones of contention was the discount rate with the original blueprint having required liabilities to be valued at a “risk-free” rate benchmarked on sovereign bonds rather than corporate bonds rated AA as required by accounting rules.
According to research by BlackRock, valuing buyout liabilities under these proposals would have increased the level of reserves by as much as 20 per cent even before the higher solvency capital demands of Solvency II were taken into account. The knock-on effect would have been soaring buyout prices as insurers would have either been forced to raise significant new capital, or curtail their future underwriting activities, or both.
The revisions include the likelihood of insurers using swap rates rather than government bond rates for discounting purposes. Historically, swap rates have been higher than government bond rates, although this has not been true for longer-term swap rates since the financial crisis exploded onto the scene.
The BlackRock report also notes that insurers are expected to incorporate a liquidity premium into the discount rate on long-term policies, such as annuities, where the policyholder has paid the premium entirely in advance and has no incentive to let the policy lapse. The European Commission may also consider the inclusion of a ‘matching premium’ through which insurers would be able to discount liabilities at the expected rate of return of the underlying assets in cases where the two are sufficiently well matched.
“The latest changes should not have a big impact on affordability and insurers are already factoring in the new regulations into the pricing of their bulk annuity business,” says LCP partner Clive Wellsteed. “The exact impact on pricing will vary by insurance company and will depend on their own investment strategy but we do not think that overall pricing levels will change too much. Even the insurers impacted most signifi-cantly by the latest regulations should not see a price increase of more than three to five per cent.”
Punter Southall’s head of the buyout research team Adam Gillespie concurs, adding: “A year ago, there were more concerns over pricing but some of the technicalities have been watered down and as a result we think that the impact will be small. Many insurance companies are already pricing in the increases.”
Not surprisingly more worrying is the havoc being wreaked by the unfolding eurozone debt saga and concerns over slowing economic growth in the Western world. This could have a far greater effect on the pricing of the bulk annuity industry. As Gillespie put it: “The impact of Solvency II is relatively small compared to the impact of the general market volatility on the affordability of buyouts.”
Hymans Roberston senior consultant James Mullins echoes these sentiments. “As insurance companies have more information and clarity, they are including their best guess estimate into their pricing.
I do not expect to see a dramatic pricing shift as a result of Solvency II, but current market conditions, competition from new players such as Nomura and the direction of long-term interest rates will have a much greater impact.”
The best time to have sealed a deal would have been in the second quarter of this year when the combination of strong asset gains, narrowing deficits and the closure of defined benefit schemes created the most attractive pricing environment for buy-ins since 2008, right before the Lehman bankruptcy, according to the LCP pension buyout 2011 report.
Buy-ins are when a defined benefit pension plan purchases an annuity contract with an insurance company and in return receives annuity payments equal to the monthly pensions payments made to members of their scheme. It includes the transfers of interest rate, inflation and longevity risk from the pension plan to the insurance company. By contrast, a buyout is where an entire scheme is offloaded to an insurer.
According to the LCP report, the typical premium of a buy-in was zero to five per cent over the funding reserve compared to 25 per cent for buying out non-pensioners. The difference was that even though deficits had tightened due to improving market conditions in 2010 and the first half of 2011, they still had a long way to go before buyouts were deemed affordable by some schemes. Industry experts reckoned that equity markets would have needed to rise to a level of 6,500 or 7,000 in order for a full buyout to become a reasonable proposition.
The industry may now have a long wait before equity markets regain their equilibrium. The summer saw wild swings with the FTSE 100 losing 10 per cent and dipping below 5,000 points. Fresh hopes for a rescue package pumped markets back up in late October, with the market surging above 5,700 points. However, the roller coaster ride has continued with few industry experts willing to call the rest of the year.
Prices though had held steady in the beginning of the summer with events such as the US credit rating downgrade from Standard & Poor’s and the reappearance of the euro zone sovereign debt crisis having little effect on bond yields – which primarily drive the price of buyouts. Sentiment began to change as the European saga continued and a steady stream of negative economic news deluged the markets.
Research from Pension Insurance Corporation reveals that bulk annuity affordability for pension funds plunged by 14 per cent between July and the end of September. The buyout market was within touching distance of the lows seen in March 2009. Buy-ins fared better. They were off their recent highs of affordability, but still remained an appealing option for schemes holding gilts.
Not surprisingly it is difficult to predict whether the bulk annuity market will surpass the £10 billion mark that industry experts expected for this year. Estimates had shown that half of the deals would be buy-ins with the rest split between buyouts and longevity swaps, when schemes transfer the risk of members living longer than expected. Last year transactions totalled £8.2 billion, far below the forecast figure of £15 billion.
Market participants though are still optimistic about the prospects of the buy-in market. “The buyout market is now more expensive compared to the scheme asset values than in June because of the equity movements and low interest rate environment which have substantially increased liabilities,” says Pension Insurance Corporation co-head of business origination Jay Shah. “However, buy-ins have become more attractive for schemes holding gilts. For those schemes though who are holding equities rather than gilts, the affordability of doing a buy-in or buyout is today more expensive. In general though we expect schemes to first do a buy-in and then move to a full buyout.”
Wellsteed agrees that schemes invested in gilts are in a strong position to do a buy-in but admits that current volatile market con-ditions will have an impact. “I expect the fourth quarter of this year to be busy but many deals will not be announced until January next year. As for pricing, I think it will remain competitive for the time being, although you can see a time when the supply and demand balance is tipped in favour of the insurance company.”
There is plenty of scope for activity. Despite the increased levels of deals, large scale buyouts and buy-ins still remain an expensive option for the vast majority of pension schemes. Industry figures show that the £20 billion worth of deals carried out since 2007 represents less than 1.5 per cent of the total estimated £1.45 trillion potential buyout liability of private UK final salary schemes.
Written by Lynn Strongin Dodds, a freelance journalist