The Solvency II capital regime (and, since Brexit, its onshored equivalent) affects trustee de-risking agendas both in the short, and longer, term.
- the price and capacity of buy-ins, buy-outs and longevity swaps; and
- the long-term robustness of the trustee's counterparty (i.e. the insurer) throughout the lifecycle of that transaction.
HM Treasury (HMT) has announced upcoming changes to the Solvency II regime which could have a significant impact on the de-risking market. Industry responses have focused on the potential impact on price and capacity if UK life insurers are allowed to release as much as 10%, or even 15%, of their capital (as HMT has predicted). In these circumstances, trustees would also need to consider how such a reduction in (or other change to) the capital held by insurers could affect the protection available to the scheme and, ultimately, their members both when they transact and in the future. However, until more detailed proposals are issued, it is unclear what form that capital release would take and the timeframe over which it could be realised. Speeches announcing billions of pounds becoming available for infrastructure investment provide good headlines, but they could well be followed by more incremental changes.
Trustees will nevertheless be better placed to make decisions about de-risking transactions if they consider how the proposed reforms could affect pricing, capacity, the terms on which they transact and the insurer's covenant both when they transact and in the future.
Managing credit risk on de-risking transactions
In a typical buy-in, pension scheme trustees will pay a substantial premium to the insurer up-front, for the right to receive regular cashflows from that insurer to meet the payments due to members. Usually, the insurer's obligations will not be collateralised. It is also becoming increasingly common to cover deferred members, who will still be drawing their pension several decades after the deal is signed and the scheme assets have been transferred.
The trustees (and, ultimately, the members of the scheme) are therefore exposed to an ongoing credit risk. There are various safeguards in place to limit that risk, and the insurer's capital position is one of the most significant protections available to trustees and, ultimately, the members of de-risked schemes. Trustees should therefore consider (and be asking their current or prospective insurers) how those protections could change under the new regime and the timeframe over which those changes will occur, particularly while insurers are considering how to respond to any new flexibilities available to them.
It is unlikely that the Government will introduce wholesale reforms. Both HMT and the Bank of England have emphasised that the overall level of policy protection will "remain very strong". If the UK regime deviates too far from its European counterpart, there is a risk that it would no longer be granted "equivalence" by the EU (although this is perhaps a greater priority for general, rather than life, insurers). Making the UK insurance sector internationally competitive is a key goal for the reforms and the Government is focused on safeguarding the UK's reputation as a well regulated and well capitalised financial centre.
The European Commission issued their own proposals for Solvency II reform (as it applies in the European Union) last September, following the first substantial review of the regime since it was introduced in 2016. In this context, the UK reforms could be viewed as keeping pace with the evolution of international standards.
What should trustees be putting on their agenda?
The proposed changes are not so significant that trustees should abandon or delay any current end-game strategies which focus on de-risking. However, trustees should be considering now how changes to insurers' capital requirements could affect these plans and member outcomes both in the short and longer term:
- Pricing and market capacity: HMT have indicated that they may reduce the size of the "risk margin". This could reduce insurers' reliance on the longevity capacity in the reinsurance market and give them more flexibility as to how they write new business in respect of deferred members. HMT are also proposing reform to the "matching adjustment" by (i) reassessing the fundamental spread used to calculate the matching adjustment, in order to better reflect its sensitivity to credit risk, and (ii) giving insurers more flexibility to hold illiquid assets in their matching adjustment portfolios. These changes could also affect the price and market capacity available for de-risking transactions. Trustees should consider adapting their end-game strategies (particularly in relation to deferred) to ensure they are well placed to take advantage of opportunities to transact if pricing and market capacity improve.
- Contractual terms: Insurers need to ensure that the terms they offer trustees reflect the matching adjustment criteria. If the matching adjustment becomes more flexible, insurers may have more latitude in the terms they can offer to trustees.
- Due diligence on insurer covenant: The proposed reforms are expected to give insurers more choice about the type of assets they hold against their buy-in policies and change the incentives to hedge their exposure to longevity risk. Trustees should be asking how providers intend to respond to this additional flexibility and how it will affect their investment strategies and the covenant the offer to policyholders in the longer term.
- Collateral: It has become increasingly rare for trustees to request collateral when entering buy-ins. Depending upon the size and nature of the transaction, trustees should consider whether this additional protection is appropriate for their scheme.
The Government has announced that it will issue a package of reforms for consultation in April, which will be followed by more detailed technical consultation by the PRA later this year. Trustees, like providers, should keep the latest proposals on their agendas.
For further information about these reforms and how they could affect your end-game strategy please contact our pensions de-risking team or your usual Travers Smith contact.
The proposed reforms in more detail
HMT signposted what insurers and policyholders can expect from the reforms in a speech to the Association of British Insurers on 21 February.