The UK government is preparing to shift away from the EU’s insurance regime Solvency II, making it potentially less onerous for bulk annuity providers. How could the changes impact defined benefit schemes looking for buyout? 

 

The UK’s exit from the EU means it can define its own regime for insurance companies, and the government last week responded to a consultation it held earlier this year on adapting Solvency II, saying it wants to put more emphasis on principles and less on rules. 

 

Among others, it is keen to reduce the risk margin that is linked to interest rates, which have reduced since the regime was devised. It argues that this “would diminish the incentive to reinsure longevity risk outside the UK. It would allow insurance firms greater flexibility to manage their balance sheets and the pricing and range of the products that they provide.” 

 

 

If the risk margin requirements change, some insurers may use the flexibility not to have to reinsure longevity risk - which is now typically held offshore where Solvency II does not apply – and could instead choose to keep it on their balance sheets.  

 

Insurers have been lobbying for this change since Solvency II was first introduced, says Tiziana Perrella, a professional trustee at Dalriada Trustees. “It’s not new,” she notes; what has changed is that Brexit now allows government to listen to those concerns. Nonetheless, she thinks any changes in the regime will be “more akin to tinkering than massive reform”, particularly given the UK’s input to Solvency II. 

 

Perrella does not expect major price reductions to flow from the new regime. “Insurers have been very good in price reductions, but any changes will be downwards; it’s just about what the quantum will be,” she says. 

 

 

The bigger impact for schemes could be elsewhere. Solvency II has made it harder for schemes to secure certain benefits, such as underpins or fixed early retirement factors, which currently have to be converted before a buyout. This is because under the ‘matching adjustment’ rules of the regime, insurers need to match a fixed expected cash flow, “so something that can be ‘either/or’ is uninsurable”, she explains. Under the new rules a cash flow that is not be completely fixed but highly predictable might be permitted and benefit conversion would no longer be necessary.. 

 

She also sees a possibility that deferred premiums could make a comeback, whereby employers pay only part of the premium up front. “Anything that makes it easier to offer that structure, even just an easier process to get it signed off by the PRA” would be helpful, she says, as sometimes insurers are put off from offering certain options because of the regulatory hoops they would have to jump through to provide a structure. 

 

The expectation that pricing will improve raises the question why schemes should agree a buyout now, before the changes come into effect. 

 

However, Perrella expects there to be several consultations – the government has said there will be a study by the PRA this year and a consultation next year, pointing to much to and fro with industry, where not all insurers agree on every aspect. “We’re not talking a matter of weeks, it’s probably months and even years,” she notes. 

 

The changes will also not be as big as post-Brexit rhetoric might suggest, and so capital requirements will likely remain as they are – meaning she does not expect many new market entrants. Another factor stopping firms from entering the market is a shortage of actuaries and other experts. “There are not enough bodies doing pricing,” she notes. 

 

 

A further reduction in bulk annuity pricing would almost certainly be bad news for superfunds, at least as long as capital requirements are unchanged, because their key selling point is their greater affordability, speculates Perrella.  

 

Should capital requirements be weakened, however, then insurers are arguably no longer the ‘gold standard’ they are currently held out to be, she says – making superfunds look more attractive than they do at the moment. Much will also depend on the timing of primary legislation for the vehicles, which has been delayed. 

 

 

The Solvency II review “has been in the works for some time” and the recent consultation and response are only the first stage, says LCP partner Charlie Finch, who thinks it is unlikely that any changes will come into effect before 2024, if not later. “We’re all waiting with interest what changes will come through and what the impact on bulk annuities will be,” he says. 

 

Even if the risk margin comes down, some insurers will still want to use longevity reinsurance, he predicts, but others will start to retain risk on their balance sheets. The reforms that are expected could mainly do away with some impractical rules, he agrees, such as insurers having to have capital for periods where the reinsurance was not in place at the same time as the bulk annuity. “Going forward that gap will not be so important... it makes everybody’s life easier to execute” a transaction, he says.   

 

As for pricing, “insurers are keeping their cards quite close to their chest”, says Finch. “My best guess is that the benefits of pricing will be limited.” 

 

This, and the timing of reforms mean there are “not going to be material benefits in waiting” with a transaction as clarity is still several years away, and the benefits will be “more in easements and flexibility rather than a step change in pricing”. 

 

Adam Davis, managing director at buyout consultancy K3 Advisory, is also uncertain whether the changes will lead to improved pricing of bulk annuities. “It might, but some insurers are already allowing for the expectation that the risk margin will reduce and so I think any pricing changes will be small,” he argues, pointing out that pricing is currently already very attractive.  

 

He does not expect changes in risk margin requirements to affect how superfunds can compete with insurers, as the current keen pricing, coupled with high funding levels among schemes thanks to bullish equity markets, mean many can afford bulk annuities. “Three of our recent clients have found themselves in surplus to buyout,” he notes. 

 

“We continue to wait for the Pensions Regulator to formally add one (or more) of the superfunds to its list of assessed providers, which is taking much longer than I expected,” he adds, saying the current superfunds should be more concerned with competition from alternative solutions that will specifically target the same market as them, whether they are offered by insurers or other sectors; last year saw the emergence of a private equity firm as a third-party funder for ‘capital-backed journey plans’, while insurer Legal & General has started offering an ‘insured self-sufficiency' solution.