Mr Glen speculated:
“But I expect there to be a material capital release… possibly as much as 10% or even 15% of the capital currently held by life insurers…”
This reads as good news on the face of it. I think it will be positive news overall for bulk annuity (buyout) insurers and my expectation is that the overall package of reforms, if anything like those highlighted in the speech, will lead to some reduction in premiums for pension schemes looking to buy out.
However, I believe that the change in insurer pricing will likely be modest, and we might see most change in the behaviour of UK insurers in several key areas.
In this blog, I’ll focus on the following:
· A reduction in the “risk margin” by around 60% to 70% for long-term life insurers.
· A significant increase in flexibility to allow more investment by insurers in long-term assets such as infrastructure.
Reduction in risk margin
In simple terms, the risk margin is one layer of money an insurer needs to hold to cover the liabilities it has. Two useful facts to know about the risk margin are:
1. It is more material for long-term insurance products such as bulk annuities, which have significant longevity risk attached to them, than for short-term insurance products.
2. It is sensitive to the interest rate environment. Insurers see it as burdensome in the current low interest rate environment.
The risk margin is the primary reason why most bulk annuity insurers choose to reinsure the associated longevity risk, i.e., pass it on to reinsurance companies. Many reinsurers are based in territories which fall outside the Solvency II regime. This has been a long-standing concern of the PRA and effectively means that UK insurers are effectively asset managers and are taking very little insurance risk.
Because of this behaviour, the risk margin for UK insurers is already more modest than it might otherwise be. Therefore, any reduction in the risk margin will likely only have a modest impact on their pricing.
However, rather than seeking to make insurers’ pricing more competitive, I suspect the main objective of the Government and PRA is to try to achieve a better balance of what risks the insurers are taking. Making the risk margin less onerous will not eliminate the need for insurers to purchase reinsurance, as such behaviour was extremely common prior to Solvency II coming into force and reinsurance is seen as a good risk management tool. Reform might lead to insurers choosing to retain more longevity risk on their own balance sheet than is currently the case.
I think it is also unlikely that such a change in the level of longevity risk being reinsured would materially reduce insurers’ pricing, as reinsurers are unlikely to have vastly different views on pension scheme members’ life expectancies to those of the insurers themselves, but a better mix of risks ought to improve diversification, which should lead to insurers needing to hold less capital overall.
Investment flexibility
Investment in a wider universe of assets being permitted should lead to lower pricing but, again, my expectation would be for any pricing changes to be modest. Alongside more investment freedom, Mr Glen’s speech indicated the Government would try to reduce the “red tape” around insurers being able to get regulatory approval to invest in new asset classes.
Combining greater investment freedom with less red tape might change bulk annuity insurers’ behaviour in a way that helps pension schemes, more so than any impact on pricing. The most obvious way this might help is by insurers more easily being able to accept assets in-specie from pension schemes, illiquid assets in particular. There is currently a “liquidity kink” where a pension scheme and an insurer each see the advantages of holding illiquid assets either side of a transaction with each other, but at the point of trading, the scheme must liquidate those assets to pay the premium.
Although there are ways to mitigate this problem, it is far from ideal.
However, I suggest that any increased flexibility is likely to only be a help to larger schemes who might hold assets directly rather than via pooled funds. Even if possible in theory, I very much doubt that we will see insurers being willing to take pooled funds in-specie, no matter what regulatory changes are made.
Conclusions
I’m very positive about the direction of travel for insurance regulation, as Solvency II certainly wasn’t designed with UK insurers in mind. I think the proposals are likely to make bulk annuities even more affordable to pension schemes.
However, a scheme’s ability to afford a buyout is not only driven by insurer pricing, but also by the scheme’s assets. Often, the volatility between these assets and insurer pricing is the main driver behind affordability. My advice to trustees and sponsors is that if you can afford buyout you should press ahead now rather than wait for the impact of the proposed reforms.
Adam Davis, Managing Director, K3
