At the end of April this year, the U.K. Government published its Solvency II consultation, seeking views on the potential impacts of a variety of reforms to the E.U.’s 2016 flagship piece of insurance legislation. The consultation closed in July, and at the end of November, the consultation review was published.
The changes that the U.K. Government wants to implement are potentially good news for the country’s pension risk transfer (PRT) market. The headline changes for life insurance companies are changes to both the matching adjustment the risk margin; these reforms could provide a tailwind to defined benefit pension plans (DBPPs) in the U.K. that are looking to close via the PRT market by entering into a full buy-out with an insurance company.
“Risk margin rules at the moment drives insurers to transact a huge amount of longevity reinsurance when they complete a PRT deal,” said Chris Anderson, Head of BPA Consulting at EY in Edinburgh. “Two potential consequences of the proposed changes here are that first, it may encourage insurance companies to carry out slightly less reinsurance, which could be beneficial on price for pension schemes, and secondly the risk margin on what remains will be lower, which also should be beneficial on price.”
The PRT market in the U.K. was already enjoying a solid 2022 before the recent consultation review was published. Data published in September by consulting firm Lane, Clark & Peacock suggested that £12bn of buy-ins and buy-outs were completed in the first half of the year, an increase of 50% on 2021. Part of the reason can be attributed to the rising interest rate environment, which reduces the amount of capital an insurance company needs in order to meet its future liabilities; Anderson says that this is analogous to a rising tide lifting all ships.
“The impact of the rising interest rate environment on well-funded schemes has been lower as they are typically in a well-matched position. But those that were further from buy-out funding levels have enjoyed strong improvements to funding ratios this year. Insurer capital is also sensitive to interest rates, and the rising rates therefore have resulted in lower capital requirements relative to scheme liabilities,” he said.
The impact on funding levels from the rising interest rate environment means that the impact of the planned Solvency II reform on the PRT market won’t be as pronounced as it would have been without the rate rises. But adding the two together provides significant fuel to power the U.K. PRT market.
There’s always a bump in the road, however (sometimes, more than one), and in terms of what 2023 looks like for the PRT market, one of those bumps comes in the form of a lack of talent; not a lack of intellectual capital, more a lack of headcount amongst insurers to absorb the enlarged demand.
“Everyone is trying to find people,” said Anderson. “Insurance companies need people to run the quotation process and to onboard schemes. Employee benefit consultants also need additional staff – everyone is resource constrained.”
Another unknown revolves around the tussle between the U.K. Government and the Prudential Regulations Authority (PRA, the U.K.’s insurance industry regulator) over the sorts of assets admissible for the matching adjustment. Lawmakers in the U.K. want to broaden the types of qualifying assets – infrastructure investments in particular are seen to be a beneficiary of the reforms – although any investments must still have highly predictable cash flow profiles. Even so, limits to matching adjustment qualifying assets may still undermine some of the gains arising from the change in the risk margin.
Additionally, for the PRT market overall, increased activity in the buy-out and buy-in markets may indeed occur, but at the expense of the longevity swap leg of the PRT stool. The former two both obligate the insurance company to assume both the longevity risk and the asset risk previously held by the DBPP; a longevity swap only transfers the longevity risk to the insurance company. It’s a transaction common for DBPPs that are not funded sufficiently to be able to afford a buy-in or buy-out but one that may see reduced traction in the wake of the changing regulations and consequent insurance company balance sheet health.
“Longevity swaps from a pension scheme to an insurer are most likely to be negatively impacted by the Solvency II changes. Some pension schemes that were previously looking at the longevity swap option can now go straight to buyout because the pricing will be better,” said Anderson.
Where longevity swaps could see increased activity is in the PRT reinsurance market. Most PRT deals already reinsure a good chunk of the newly acquired longevity risk and even though a reduced risk margin and a solidified balance sheet (due to rising interest rates) might reduce the need for reinsurance from a pure risk perspective, transferring some of the risk to the reinsurance market means more money for more PRT deals, which in turn creates more opportunity for longevity swaps. It’s a virtuous circle.
Those in the U.K.’s PRT market itching to get a piece of this enlarged pie might have to reign in their enthusiasm, however; at least, for the time being.
“The two key reforms in the U.K. Government’s response to the consultation relate to the risk margin and the matching adjustment. These rules are currently contained in the delegated act, the subordinate legislation of Solvency II that the E.U. originally wrote. To make these changes, the delegated act will need to be changed,” said Nicholas Bugler, a Partner at law firm Willkie, Farr & Gallagher in London. “The government has stated that this will be done primarily by repealing the relevant retained EU law and then replacement of those rules by rules made by the regulators. This process could take several years.”
The repeal of retained EU law in financial services will be done under the new Financial Services and Market bill, which is currently going through parliament and will be done piecemeal as and when new UK rules are ready to be put in place. This means that the PRA will have to change its own rules to ensure that the old EU derived rules are replaced by domestic rules. The PRA usually puts out a consultation of its own for matters such as these, but there are still potential banana skins for the life insurance industry if the PRA feels that primary legislation is too relaxed.
“The PRA would obviously not be able to overrule legislation – for example, the new objective to facilitate the growth of the UK economy in the medium to long term. But if it feels that life insurance companies aren’t paying attention to all of the risks they face and therefore are potentially not being managed prudently they could use other tools to influence behaviour. This is how they would likely approach it if they had concerns that the legislation was too risky. It’ll be interesting to see how that plays out,” said Bugler.
What might speed up the process is that there is arguably political will at the U.K. Government level to get this legislation passed so that they can ‘sell’ it as a Brexit good news story. That’s a supposition, but not an unreasonable one, and Bugler says that in terms of timescales, the PRA might move reasonably quickly anyway.
“The PRA will try to prepare their new rules in parallel with the legislative process in the U.K., so they come into force as soon as reasonably possible. HMT says that “significant progress” on the changes to the Solvency II rules is expected by the end of 2023. But quite when full implementation will be is uncertain at the moment,” said Bugler.
Whatever the PRA rules end up being, the headline reforms remain a good news story for PRT in the United Kingdom, which is currently enjoying its busiest period.
“Pipeline for PRT is at an all-time high. Some schemes that were only 85% funded are now nearly 100% funded and are coming to market, asking for pricing,” said Anderson. “Also, insurers are more solvent – they have seen their excess capital levels increase which means more capital to write deals. It’s the perfect storm of improved demand and supply across the board.”