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The Actuary The magazine of the Institute & Faculty of Actuaries

Buying in bulk

UK life insurers need profitable new business lines with growth opportunities. Bulk annuities fit the bill perfectly. Traditionally, this market has been seen as high-risk, low-reward, and best left to others, but this is not the case today. The market is immature, profitable, and in need of new entrants. The risks that have been keeping providers out are less significant than first appeared and the opportunity is large up to £300bn in new premiums over the next ten years, constrained by supply not demand.
In this article we address three issues for a new market entrant to consider:
– Is there significant customer demand for bulk annuity business?
– Is it going to be profitable?
– What skills and competencies are needed to be competitive?

Customer demand
There are various factors that point to healthy market growth (see table 1), but there are also several inhibitors to overcome.
In our view, the pros outweigh the cons and the market has enormous growth potential. Current sales are between £1bn and £2bn a year, a fraction of the £1,300bn buyout cost for private sector schemes. Current players estimate the ultimate market to be between £200bn and £300bn. Recent ABI research agrees, indicating that annual sales could peak at six times those of individual annuities.
However, this assumes sufficient supply. The capital resources of the current players cannot fund this supply. It is also arguable that further concentration of longevity risk is undesirable, although reinsurance or annuity bonds may help. The lack of supply is, of course, helpful to potential new entrants, mitigating fears about access to distribution.

Bulk annuity profitability is higher than in the individual market at around 5% of premiums, though it varies significantly by market segment. An important factor is the ability of a life office to match illiquid liabilities with bonds and thereby access the liquidity premium within the credit spread. Many believe annuity profitability to be overstated because of unrecognised credit risk being accepted on the balance sheet. Our analysis shows that this is not true annuities are inherently profitable and margins are further enhanced by the liquidity premium earned on the assets.
An important aspect of profitability is, of course, risk. Uncertainty exists around mortality levels, particularly longevity improvements. Mortality research is critical to risk management, but we know more about mortality and its levels, causes, and future patterns than ever before. The impact of mortality improvement variations on annuity margins are less than many think. The critical point is to divorce the balance sheet impact of changing improvement assumptions from the profitability impact. The balance sheet impact can be large as the existing liabilities are written up, all at once, to reflect changing assumptions. However, profitability changes resulting from any reasonable flexing of improvement assumptions are generally within the profit margins mentioned above (see table 2). The investment spread assumption is much more important.
Longevity risk is uncorrelated with most other risks run by a life insurer; stand-alone economic capital requirements can be reduced by up to 95% in a well-diversified insurer. There is also some offsetting against the mortality exposure within protection portfolios. Thus introducing longevity risk may have only a minor impact on the overall risk position of the business.
For those still unconvinced, it is increasingly possible to reinsure longevity risk, in contrast to the situation a couple of years ago. Our recent research shows that reinsurance capacity does exist, for the right price, and that life office and reinsurer pricing is converging as information and analysis of mortality have improved. Moreover reinsurers’ terms and conditions are not overly restrictive and a range of structures is available reflecting the immaturity of the market as well as polarised views and business models regarding longevity and asset risks. Generally there is no minimum age restriction or maximum term and deal capacity for many reinsurers runs into several hundred million pounds.

Skills and competencies
The bulk annuity market is different from individual business. Market entry requires capabilities in three main areas mortality prediction, investment, and operational efficiency.
Understanding the likely future mortality profile of new business is an important element of the pricing process. It is crucial to future profitability that the deal is priced to reflect the characteristics of the particular scheme, rather than the market generally. Pricing bulk annuities is about understanding both the initial mortality level of the block of business, particularly important for older books, as well as future mortality trends, which are more important for business with a younger age profile. Because mortality prediction in the bulk annuity market is both important and difficult, it is a clear source of competitive advantage. Life insurers who are not currently large annuity providers need to invest to overcome their disadvantage, by both bolstering initial underwriting capability and by a commitment to future research.
The investment challenges of the individual annuity market are naturally present in the bulk market principally the shortage of suitable sterling-denominated backing instruments. The bulk market brings the additional challenge of ‘lumpy’ volume and finding backing assets for large schemes can be a significant hurdle. Moreover, asset liability management is of great significance to profitability. However, insurers can overcome the investment hurdles through developing a range of capabilities in alternative asset classes such as property leases or non-sterling corporate debt markets. A large gain can also be made through developing or improving bond origination skills using contacts to prompt issuance in target sectors with the appropriate term and cashflow profile.
Sound operational skills are required in new business quotations, administration and distribution management. Fewer than half of quotations convert into buyouts, although we expect this to increase as the pricing assumptions used by pension actuaries converge to those of the life insurers. Nevertheless, the quotation process will remain long and complex involving significant amounts of individual data, active co-ordination with investment colleagues and possibly reinsurers, simplification of obscure benefit designs, and careful mortality pricing. Each deal can be large and completion typically takes several months. Thus there can be significant strain on the pricing function, which needs to be controlled through efficient processes and careful risk management.
Developing a reputation for excellence in administration is vital. Administration is one of the most important factors in the eyes of trustees and their advisers. While administration is a hygiene factor for individual products albeit an important one for bulk annuities it is a competitive differentiator. Getting the administration right in the bulk annuity market is not easy the volumes are lumpy and the original scheme benefits often complex. New entrants may therefore consider outsourcing to be a viable option.
Distribution in the bulk annuity market is dominated by large employee benefit consultancies (EBCs) which have sophisticated provider requirements and tend to be very influential in any deal. EBCs consider a number of different capabilities, in addition to price, when considering placement of a scheme, such as administrative competence, willingness to tailor benefits, transfer value terms, and financial strength. The bulk annuity market is not price-driven to the extent of the individual market. To be successful, providers must demonstrate their all-round operational capabilities and these are, in many ways, different from those a successful player in the individual market will have. Assuming a new entrant builds appropriate contact with the small number of distributors, tender requests can be immediate.

A profitable market awaits
The bulk annuity market offers significant opportunities for profitable business growth over the next decade. Premiums are significant and the market is set to grow strongly. Margins are high and are expected to remain at the upper end of the life and pensions market. Longevity risks are somewhat overstated and misunderstood; viable hedging options are increasingly becoming available and capital requirements are not onerous. There are certainly operational challenges, but we believe they are surmountable, whether via outsourcing, buying in expertise, or by developing internal capabilities. The reward is certainly worth the effort.