Moderation in All Things

This article is an abridged version of the original, which can be found at https://www.bankofengland.co.uk/speech/2023/april/charlotte-gerken-speech-bulk-annuities-conference

A lot is happening in the Bulk Purchase Annuities (BPA) market: pension scheme funding levels have greatly benefited from the rise in interest rates^[1], and the UK insurance industry is preparing itself for record levels of bulk purchase annuity transfers^[2].

De-risking corporates of their legacy defined benefit schemes brings substantial benefits to UK plc, and the additional capital insurers inject contributes to the security of pension scheme members. This structural shift in the provision of retirement income also gives insurers an increasingly important role as long term investors in the UK real economy. Insurers therefore need to balance the short term financial and reputational incentives to grow rapidly, with long term and enduring financial strength, to meet the long term needs of policyholders and the economy.

Market developments – Accelerated growth

From historic lows of 0.1% in December 2021, the UK Bank rate rose to 4.25% in March 2023. While it could hardly be described as plain sailing for pension schemes or their sponsors, the rise in interest rates has generally reduced the value of their liabilities and boosted funding ratios (see chart 1). This has greatly improved the affordability of buy-outs for many pension schemes.

At the same time, trustees of pension schemes are reported to be increasingly viewing buy-outs as a long-term target^[3]. Increased affordability and a decreased appetite to retain this risk have led to a growing appetite for schemes to transact in one go, rather than perform staged buy-ins spread over several years^[4]. So called ‘jumbo’ schemes may also present exciting opportunities for the insurers. This all points to a material increase in pension schemes’ demand for BPA in 2023. But I’d note that this is an acceleration of the existing demand for BPA in a large but finite market in run-off (see chart 2 and 3).

This heightened demand from pension schemes might lead you to think that there is enough new business for all insurers to get their fill, leading to competitive pressures easing up. In practice, given the lumpiness and finite nature of this market, I see strong incentives for insurers to stretch their supply capabilities in the short term, to capture as much of the new business while they can, before leaner years arrive. So, let us move to the main course, and examine three areas where we see this stretch arising in practice.

An expansion of risk appetites

As deals become larger and increasingly focused on buy-outs of complete schemes, we observe BPA writers expanding their risk appetite, sometimes outside their current core expertise. Firstly, our supervisory work suggests there is an increased appetite to insure deferred pension scheme members: the younger, not yet retired individuals. They bring several additional risks for insurers including much greater uncertainty in the longevity risk, as assumptions have to be made over a much longer period of time, together with risks stemming from policyholder options, such as cash commutation, flexibility on retirement age and transfers outs^[5]. This appetite is supported by reinsurers, who provide both pricing expertise and capital.

Secondly, the disruption in the UK gilt market last autumn resulted in some pension schemes being overweight in illiquid assets^[6] as gilt values fell significantly, and schemes sought to reduce their leverage under liability driven investment strategies^[7]. We see insurers increasingly developing solutions to accept illiquid assets as part of the BPA premium, as pension schemes may be reluctant to dispose of these assets in the open market, potentially at a large discount. This requires significant due diligence, and we are seeing insurers seeking more advice from third party specialists such as property valuation experts both for illiquid asset valuation and to calibrate adequate market value haircuts. Alternatively, we have seen deferrals of premiums incorporated in deals giving pension schemes time to dispose of such assets in an orderly fashion^[8]. These premium arrangements can be complex and potentially capital intensive due to the increased uncertainty they can create.

The PRA welcomes innovations in this market as insurers seek to better support their clients. At the same time, we want insurers to understand the additional risks and uncertainties when accepting premium that includes such assets. Even if firms use external expertise to price or manage these deals, Boards remain accountable for the decisions taken. They need to understand the basis for advice from third parties and to challenge the advice robustly. Straightforward questions need good answers: are these risks within appetite? have the bespoke features of the deal been considered over the full lifetime? how has the inherent uncertainty present been captured within the decision-making process? As noted in our 2023 Supervision Priorities letter^[9], we are carrying out a thematic review to assess whether BPA writers’ risk management processes are keeping pace with their growth ambitions and expanding risk appetites.

A reliance on third-party capacity

The second area is the use of third-party capital and asset origination capacity, known as funded reinsurance, to support these large new business transactions that are both capital-intensive and put a strain on in house asset origination capabilities. In principle, attracting new capital to support BPA liabilities is positive – so long as the capital is aligned with the long-term risks it is intended to support.

Our work so far has focussed on the evolving contract and collateral structuring, the counterparty risk management frameworks, internal model approaches and firms’ stress and scenario testing.

We are exploring these aspects carefully and are increasingly focussed on four key elements:

1. Recapture events: We have looked at the circumstances under which the risks that insurers have ceded might end up back on their own balance sheets. Default of the reinsurer is only one of them. Voluntary and automatic contractual termination triggers linked to solvency coverage ratios, credit ratings, or legal and regulatory environments bring material uncertainty to the recapture triggers.
2. Wrong way risk: We have observed the emergence of reinsurers with newer business models narrowly focused on credit markets where diversification benefits might be less evident^[10]. This introduces a wrong way risk as the quality of the collateral portfolio is likely to deteriorate as the financial condition of the reinsurer falls.
3. Collateral management: The latter two risks are magnified by the increasing use of less liquid assets in collateral portfolios such as structured products, commercial mortgages and private credit. Here, credit rating, valuation and matching adjustment (MA) eligibility uncertainty might exist which may not be adequately mitigated by valuation haircuts and margining practices.
4. Management actions: On recapture, insurers have to estimate the cost and mitigating effect of the management actions potentially available to them. This might include the cost of entering replacement contracts, asset portfolio rebalancing with potentially high transaction costs, unpredictable prices as market liquidity dries up, and unwinding or replacing large crosscurrency hedging exposures. These bring material uncertainty, as estimates of the costs and benefits in stressed conditions are inherently difficult to predict accurately.

Taken together, these four elements are significant and should factor into the industry’s risk appetite for using third party capital and their asset origination capabilities. Senior managers therefore need to reflect on these inherent uncertainties when making business decisions. They need to approach these arrangements with caution and consider carefully whether their risk management processes are able to deal with these risks adequately. With responsibilities for pension payments for millions of policyholders for decades into the future, insurers need to demonstrate they can execute these transactions prudently and manage their risks over the whole life of the contracts.

More broadly, the long-term implications for the UK economy of these arrangements bear examination. Within the objectives of the Solvency II reforms, it is not clear that the incentives of third-party capital providers are aligned with UK insurers’ role in making investments in UK based long-term infrastructure and productive assets. Both the PRA and insurers need to think about the opportunity cost of funded reinsurance – in terms of UK direct investments foregone – as well as the benefits and risks.

Greater interconnectivity with wider financial markets

Related to that point, the third area I would like to touch on is a key aspect of the changing pensions and insurance landscape. One industry estimate, suggests that the UK life insurance industry could onboard more than £500bn of pension liabilities – and associated assets – over the coming decade^{[11] [12]}. This is a big structural change in the control of long-term investments in the UK, and the decisions that insurers make now will have long term consequences for the performance and development of the broader economy.

In line with the Government’s objectives for Solvency II reform, insurers’ investment strategies have an important role in supporting sectors that require certainty of funding over the long term, including education, social housing and infrastructure, and where financing the transition to net zero such as via renewable energy infrastructure and technologies requires patient and deliberate commitment. Making such investments can also generate a competitive advantage in a market where ESG credentials are increasingly valued by trustees^[13].

This could generate material benefits to society – and to insurers – provided they maintain discipline in their leverage, that is, the extent to which they deploy debt capital and use reinsurance to back their promises to policyholders. Taking on new BPA business in volume, over a relatively short period, will also involve significant hedging programmes via interest rate, cross currency and inflation swaps, more complex investment arrangements, and will increase interconnectivity with the wider financial market. Insurers therefore need to understand, as they take on these vast sums of assets and liabilities, how they may become greater sources or amplifiers of liquidity risk.

In this context, insurers need to focus on the feasibility of their own management actions under stress. Our 2022 Life Insurance Stress Test feedback^[14] noted that concurrent reactions in stress can reduce the effectiveness of any assumed management actions. Better and more frequent information, improved modelling capabilities and enhanced liquidity management will inform this, but firms cannot fully resolve these uncertainties via these methods. Senior management therefore need to limit their need to rely on trading and rebalancing in stress, as such activities may destabilise financial markets further, which would be to their own detriment.

Conclusion – Desired outcomes

The BPA market is in a period of accelerated growth and yes, while we are pleased with the opportunities this brings, insurers should approach this with moderation.

A healthy and sustainable life insurance market is a long-term value creator for the whole economy. It is in everybody’s interests to work together to ensure a dynamic vibrant industry for years to come. One that serves the needs of, and provides protection for, customers, and makes the strongest contribution it possibly can to investment in the wider UK economy.

Charlotte Gerken is Executive Director for Insurance Supervision at the Bank of England