9 November 2020
A recent Financial Times (FT) opinion piece had the headline “Pension buy-outs carry needless credit risks” suggesting that trustees “are being unusually trusting with their members’ hard-earned savings” in that they “are making ultra-cheap, unsecured, long-term loans to insurers”. This has created a lot of discussion amongst my clients and within LCP.
Insurers vs. banks
There are important and distinct differences in the way in which banks and insurers operate, given the parameters of the regulatory framework they both operate under, which I explain below.
If a pension scheme were to lend its assets to a bank, the bank would be able to leverage itself by lending those assets out to other customers, often on different payment terms and periods. It is this type of mismatch that led to banks getting into trouble in 2008, when confidence in the banking sector fled and clients wanted their money back – i.e. “a run on the bank”.
In contrast, the life insurance regulations are much more restrictive. When a pension scheme pays a buy-in premium to a life insurer, the insurer:
- has to ensure the liabilities and assets meet strict conditions around liquidity and matching (for regulatory purposes), as a buy-in fully hedges all investment and longevity risk.
- cannot leverage itself and/or mis-match its assets and liabilities, so there cannot be a “run on an insurer” (unlike a bank).
- will put forward their own shareholder’s money as additional reserves – the more risk the insurer runs the higher the reserves required. The level of these reserves is scrutinised by the Prudential Regulatory Authority (PRA).
- cannot simply sell the buy-in policy to another insurer (it can only be transferred via a “Part VII” transfer process, which involves approval by the High Court).
- has to treat policyholders as priority creditors - in a default scenario the policyholders would be paid out before any payments to loan creditors.
Insurance regime is tried and tested
Whilst the past is not necessarily an indicator of the future, it is of more than passing note that, to date, no life insurer has been unable to meet its obligations and, as a result, the Financial Services Compensation Scheme has never had to bail out a life insurer. It’s also worth noting that the life insurance industry held up well in both the 2008 banking crisis and, to date, through the Covid-19 crisis. Not least because of the strong focus on matching assets and liabilities under the insurance regulatory regime.
In contrast, the global banking system nearly collapsed in 2008 due to liquidity issues and the FSCS has paid over £20bn in compensation for banking failures.
Buy-ins are not always unsecured
The article’s suggestion that buy-ins are “unsecured” and, if the insurer defaults, the scheme “cannot recover its investment”, is simply not true for all buy-ins. Many of LCP’s larger clients have agreed surrender values with insurers – ie they can take back their assets if the insurer fails to pay the pensions due – and a number have collateral security where the buy-in is over £500m.
Some schemes, following advice, decide not to pay for the extra security that surrender values and collateral provide. They are comfortable with the insurer’s counterparty risk exposure, given the existing layers of protection and regulatory safeguards in place (which I’ve summarised above).
Finally, the article also accuses insurers of "essentially manufactur[ing] equity” through the Matching Adjustment, which allows use of a higher discount rate when setting their best estimate liabilities. To exclude the Matching Adjustment and insist on a risk-free discount rate in best estimate calculations, would seem to be gold plating an already stringent regime. The insurers put up significant reserves (on top of their best estimate liabilities). Asking insurers to reserve even more cautiously would push up the price of buy-ins or buy-outs, putting further pressure on pension schemes and their sponsors.
The FT article does not acknowledge many of the points I have mentioned. But they are key – and help to explain why so many trustees have chosen to insure their scheme’s liabilities over the last 12 years, having spent the time to understand the insurance regime and undertake detailed financial due diligence. No one is claiming that buy-ins are risk-free, but, if I was looking for a safe place for my “members’ hard-earned savings”, then I think I would be hard pressed to find a much safer home than the UK insurance regime.