Costas Yiasoumi looks at the rise of medical underwriting in the pension risk transfer market
Over the past 12 months, two medically underwritten annuity specialists in the retail market have launched bulk annuity propositions for de-risking defined benefit pension plans. With two incumbent bulk annuity insurers now also willing to quote for medically underwritten annuities and one further insurer rumoured to be entering the market, advisers have a credible insurer pool from which to seek competitive quotations.
Is this a natural evolution of the bulk annuity market or will it result in upheaval?
What is a medically underwritten bulk annuity?
Key to pricing bulk annuities is life expectancy. Traditionally this is derived using rating factors such as age, gender, postcode and pension amount blended with experience analysis where credible and adjustments for aspects such as industry type. This leads to broad-based mortality projections for the pension plan or for sub-groups within it.
Medically underwritten bulk annuity specialists adopt a fundamentally different approach - they additionally utilise medical and lifestyle information at individual member level. From this, tailored mortality curves are built for each member, unique by mortality level and shape. Therefore, unlike traditional pricing, which adjusts mortality curves constructed from broad populations with inherent medical and lifestyle characteristics (for example the SAPS tables), medical underwriting specialists start from the mortality profile of a healthy individual and adjust it for medical and lifestyle factors.
Pension plans with poorer medical or lifestyle characteristics get lower pricing and those with better characteristics get higher (albeit arguably fairer) pricing. Cross subsidies between pension plans are reduced.
Medical underwriting has offered a compelling proposition for retail consumers seeking better value for their pension savings and has grown rapidly over the past few years - by 2013 medically underwritten annuities represented over 50% of open market retail annuity purchases (see Figure 1).
Data collection and usage
Medical data collection takes the form of one or more of short or long form questionnaires, GP reports and telephone interviews. Typically the client selects an approach in discussion with insurers. A 'hub' collates data and passes this to insurers, the hub being either the adviser, one of the insurers or a specialist third party.
This approach captures up to 250 medical and lifestyle rating factors per member. However, proportionality applies - so for example GP reports are not sought for members with smaller pensions as costs outweigh the economic impact.
A cut-off date is typically agreed for data collation avoiding uncertain timescales - four weeks is normally sufficient to capture the vast majority of likely responses. Insurers can then process the data to produce medically underwritten bulk annuity pricing.
Retail consumers have a strong incentive to provide medical and lifestyle data if they expect a better value annuity. Except for defined benefit pension plans winding up with a shortfall, pension plan members do not directly benefit from supplying medical and lifestyle data. Despite this, experience is that response rates are good, typically around 80% of contacted members and more than sufficient for a pension plan to be medically underwritten. Importantly, pension members do not feel such data requests are intrusive, recognition of the efforts being made to de-risk their pensions.
New de-risking opportunities?
Pensions Institute research (A healthier way to de-risk, February 2013) suggests medical underwriting can offer savings of up to 10% compared to traditional pricing. Some features of medically underwritten bulk annuities are shown in Table 1 above.
Of course, medical underwriting doesn't always lead to lower pricing. Should the pension plan members have good health and lifestyles, pricing may be higher than a traditional approach. As well as the universally attractive prospect of better pricing, medical underwriting opens up new de-risking options:
Top-slicing: Insuring the members with the highest pensions, for example say the 5% representing 20% of liabilities - experience data for such members is not usually credible and traditional pricing can assume life expectancies at the long end. Top slicing can be done as a standalone de-risking exercise, or incorporated within a larger bulk annuity or longevity swap exercise with any insurance saving from top-sliced members being a useful offset against the premium for insuring the remaining 95% of members with another insurer.
Selective buy-in: Optimising bulk annuity spend by selecting members for annuitisation based on a combination of insurance pricing vs technical provisions and risk reduction. The broader range of member by member pricing following medical underwriting can permit superior optimisation, and as pricing is genuinely individual, the insurer is not concerned with adverse selection. This needs to be balanced against the impact of potentially increased funding reserves and future annuitisation costs if the remaining members are deemed to be longer lived.
The challenges?
Bulk annuity insurers operating traditional pricing: If trustees that believe their members have inferior medical or lifestyle characteristics choose medical underwriting, does that mean traditional insurers will increasingly end up with 'healthier' pension plans? How should such selection be accommodated in pricing? In the retail market, as medically underwritten annuities became more prevalent, pricing for other annuities drifted upwards reinforcing further the move towards medical underwriting.
Reinsurers taking on bulk annuity longevity exposures: Should reinsurers adapt their pricing for pension plan books that have not been medically underwritten to allow for adverse selection? And perhaps reinsurance pricing for pools of members that exclude the largest pensions (that have ended up with the medical underwriters through top-slicing) can incorporate lower risk charges as they will now form more attractive risks.
Pension plan actuaries: De-risking advice will adapt to reflect the opportunities opened up through medical underwriting and bulk annuity processes will consider whether the medically underwritten route is appropriate. But there are challenges requiring careful analysis and explanation, for example, the implications and mitigations should medical underwriting lead to a higher insurance cost.
Medical underwriting specialists: Medical underwriting is a welcome innovation to bulk annuities. It is important to educate the market on where and how medical underwriting adds value including how it complements traditionally priced bulk annuities, leading to better results for pension plans.
The future
To date there have been 14 medically underwritten bulk annuities. The largest was in excess of £35m but this is likely to be materially revised upwards as more and more cases successfully complete.
Like the retail annuity market, medical underwriting is likely to become increasingly prevalent in the bulk annuity market. Unlike the retail market, traditional pricing approaches will also remain relevant due to the size of some pension plans and the different drivers for annuitisation. So the future holds more variation but, financially, an improved overall position for UK pension plans and their corporate sponsors.