Brandon Choong and Claire McColl discuss Solvency II reforms and their potential implications for the UK bulk purchase annuity market
On 28 April 2022, the UK government released its consultation on Solvency II reforms, and the Prudential Regulation Authority (PRA) released Discussion Paper 2/22: Potential Reforms to Risk Margin and Matching Adjustment within Solvency II. While the proposed reforms are expected to have wide-ranging impacts on various segments of the UK insurance industry, one key segment that is expected to be impacted more than most is the bulk purchase annuity (BPA) market.
The BPA market is significant to the UK life industry; it has seen steady growth during the past decade as defined benefit pension schemes have sought to de-risk. During the past couple of years, BPA deals have totalled around £30bn per year – and there are no signs that the market is diminishing.
PROPOSALS AND IMPACTS
What are the key areas covered by the proposed reforms, and how could they impact BPA pricing?
The consultation has proposed a modified cost-of-capital approach, with the aim of reducing the current risk margin levels by 60%–70% for long-term life insurers, gross of transitional measure on technical provisions (TMTP).
The industry is supportive of this change, but its theoretical benefits are unlikely to be fully realised in the short term, given the TMTP’s offsetting impact. Our contacts in the industry have indicated that the level of risk margin reduction is unlikely to be sufficient to justify a reduction in the level of longevity reinsurance (the level of which has been highlighted as being of concern to the PRA), as the cost of longevity risk solvency capital requirement itself remains significant.
Fundamental spread calibration in matching adjustment calculation
The consultation explores a fundamental spread methodology that comprises the sum of the expected loss and a credit risk premium that is calculated based on an index spread approach.
Our own analysis suggests that this could result in a reduction to the matching adjustment of approximately 10%–30%, depending on portfolio-specific factors. This will increase the best-estimate liabilities for BPAs and, all else being equal, the price of BPAs.
The proposal also introduces credit sensitivity into the balance sheet, as the fundamental spread will be a function of an index that is potentially averaged over a short duration and of current spreads. With the loss of some of the counter-cyclicality benefit offered by the matching adjustment, firms that are managing towards a relatively stable solvency coverage ratio may have to resort to expensive measures to mitigate this exposure. This will be a drag on business profitability and is likely to result in upward pressure on prices.
Matching adjustment eligibility
The consultation proposes to broaden the matching adjustment-eligible asset classes to include assets with prepayment risk, and to amend the treatment of assets with construction phases, with the objective of promoting investment in long-term productive assets.
While broadening the list of matching adjustment-eligible assets will be welcomed by BPA providers, these asset classes in general have already been used by matching adjustment firms in varying degrees under the current regime, albeit with penal haircuts. Under the reforms, details will be required on the exact treatment of these assets to determine whether this will result in material benefits.
Combined financial impacts
The PRA has estimated that the proposed changes to the risk margin and matching adjustment would result in a release of 10%–15% of own funds, assuming the full run-off of TMTP. However, many in the industry remain sceptical about these estimates. From our own estimates, as well as conversations with industry players, the reduction in the risk margin is expected to be muted due to the extent of longevity risk reinsurance. The PRA has stated that it has assumed 50% of longevity risk is offshored in its calculations, but industry players have suggested that the amount is significantly higher than that, particularly for new BPA business. Therefore, the reduction in the matching adjustment could potentially outweigh any savings in the risk margin, leading to a net negative impact, ignoring any offsetting TMTP impacts. Such an outcome would likely translate to an increase in BPA prices.
Beyond the first-order impact of the reforms on BPA pricing, we believe that the reforms will have a bearing on other factors that could influence the BPA market and its participants.
New business strain and appetite
On the basis that there is a net negative financial impact from the reforms, current balance sheets will suffer a one-off adjustment that reduces the available free capital held by firms (absent any new transitional measures to phase in the reforms). Along with the higher new business strain incurred from writing new BPA deals, this reduces firms’ ability to write the same volume of business without raising additional capital. As a more extreme consequence, the reduced capacity to write new business could reduce the level of competition in the BPA space and may contribute towards rising transaction prices.
While the level of reinsurance being sought may not decrease from current levels, with the matching adjustment benefit in the UK potentially decreasing, it may become preferable for firms to adopt different risk transfer mechanisms. For instance, fully funded reinsurance allows companies to transfer all risk that pertains to the BPA book, including credit risk. Use of these products is increasing, and Solvency II reforms may accelerate the shift from pure longevity swaps to these types of reinsurance structures instead.
Although we have highlighted several factors that could drive an increase in BPA prices, one need only look back to the introduction of Solvency II, when there were concerns about disruption to the BPA market. BPA volumes at Solvency II inception only decreased slightly, before rebounding strongly during the following years. The strength in the industry was maintained in part as firms innovated and moved into higher yielding illiquid assets at the time. Firms may well seek further innovative methods to counteract the financial headwinds introduced by the Solvency II reforms.
Assets such as infrastructure investments are finite in nature; firms that lack competitive sourcing capabilities and management expertise may struggle to acquire these assets, and the benefit of the greater eligibility of assets from the reforms may not be shared equitably across all firms. Some firms are likely to warehouse assets in anticipation, and we are increasingly seeing firms looking to improve their asset capabilities, although this is not solely driven by Solvency II reforms.
Selectiveness of BPA providers
If supply-side BPA activity is constrained due to the Solvency II reforms, providers might focus more on improved margin or lower volumes. This could lead to greater selectivity in scheme size, and smaller schemes may find it increasingly difficult to de-risk in a cost-effective manner.
While we’ve set out some potential impacts of the consultation proposals on the BPA market, it is worth remembering that the designs are yet to be finalised. With the consultation closing on 21 July 2022 and the PRA’s Data Collection Exercise due to close in September 2022, we expect that there is still significant dialogue to be had between all parties, including with the new prime minister and chancellor.
In the meantime, we expect the industry to remain engaged with the consultations and to continue looking forward to understand how any reforms to Solvency II will impact their business.
Brandon Choong is a senior manager in the Actuarial Insurance and Banking team at Deloitte
Claire McColl is a senior manager in the Actuarial Insurance and Banking team at Deloitte
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