The Buy-out Boom: not all good news?
If you ask anyone in the pensions industry what is keeping them busy right now, there’s a high likelihood that they are working on buy-ins and buy-outs. Massively improved funding due to rising interest rates, means many have expected a record breaking 2023. As with any market “frenzy”, trustees should consider if this introduces new and hidden risks.
According to the Pensions Regulator, a quarter of defined benefit pension schemes are now in the position to fully secure their liabilities with an insurer. This is often heralded as the desired endgame for schemes, as the risk of the scheme is transferred from the sponsor and trustees to the insurance company. The company and trustees are considered “off the hook” (although that isn’t always the case but not a topic for this article).
In the eyes of many in the industry, the perfect outcome is the buy-out transaction. It’s considered safer than running the scheme. Once complete – the job is considered done. But as the market moves into overdrive, questions are being raised about whether the market can genuinely stretch to meet demand without any strain to the system.
The strains much talked about are those of insufficient human capital and to a lesser extent assets to act as capital. The areas which is only now beginning to be quietly whispered are the risks behind the scenes. Reinsurance is one issue; illiquids is another.
A key element of bulk annuity insurance is reinsurance of some of the risks, often off-shore to insurers who are not subject to the same robust capital requirements of UK insurers. This doesn’t directly impact the trustees or the sponsor, but it is a key part of the bulk annuity policy being transacted and success of the buy-out policies is dependent on the reinsurance working.
The key risk which is routinely reinsured is the longevity risk i.e., the risk that scheme members live longer than expected. Reinsurance is an important part of the insurance market and nothing new, however, what is new is that the growing demand for transactions which means that insurers may well need to widen the counterparties and scope of reinsurance to keep up with the demands of the buy-in market.
The Bank of England has raised concerns about the use of reinsurance in the past. In April, it warned insurers again of the need to exercise caution as they respond to the record-breaking demand. The Bank of England is concerned the extent to which risk is being reinsured overseas and the risks to the UK insurers if those reinsurance contracts fail – known as re-capture risks. There is some concern that in time reinsurance could become a potential weakness in the bulk annuity market in the UK, rather than an efficient use of resources.
Along with the reinsurance risk, the Bank of England has also raised concerns about insurers accepting too many illiquid assets as part of the bulk annuity premium payment, the concern being that this could create cashflow issues if the illiquid asset is a large proportion of the premium. In practice, insurers do not generally accept such assets unless they are assets which genuinely fit their investment needs. The Bank of England’s warning may dampen hopes of innovation by the insurers to help address the illiquids issue.
What is becoming more prevalent is the use of deferred premiums for trustees who need to sell illiquid assets to pay the full premium in a few years’ time. Although insurers do ask questions about the illiquids before agreeing to a deferred premium, it’s only a matter of time before a trustee board is unable to meet the deferred premium terms as more and more schemes try to offload their illiquids at the same time. This leaves the scheme with only partially insured benefits and an asset whole, with the insurer scaling back the policy and adjusting its asset strategy for that transaction.
Whether or not either of these issues will pose a problem is yet to be seen, but if the Bank of England has already expressed a concern, it should be one that is kept in mind as a part of this market. Many will say that this is the Bank of England’s problem to solve as the insurers’ regulator, but the pensions industry should be mindful of these issues if it is to avoid problems for schemes and their members in future.
Trustees dreaming of buy-out are still going to enter the bulk annuity market, but they should understand all of the potential risks and drawbacks to make an informed decision to sign on the dotted line.