FOR PROFESSIONAL INVESTORS – May 2019
2018 saw buy-in/buy-out volumes reach a record £24.2billion¹. With pension funding levels having improved since the financial crisis, mature corporate defined benefit (DB) schemes are increasingly seeking to transfer these risks from their balance sheet to the insurance sector. A contentious issue is the extent to which the insurance sector can absorb these increasing volumes, it is widely recognised that significant capital raising will be required to support such enhanced levels of activity.
Since pricing is, in part, a function of capital costs, longevity reinsurance capacity and the availability of suitable investments, it is not surprising that in recent years insurance companies have been moving from gilts and corporate credit to private credit. Asset classes such as senior infrastructure debt, affordable housing and commercial real estate debt offer enhanced returns, dampen portfolio volatility and, under Solvency II regulations, offer capital benefits. The crucial issue for the insurance sector is whether there is sufficient volume in the market for these transactions to meet the burgeoning demand.
An alternative for DB schemes seeking to de-risk is to create a captive insurance subsidiary in order to transfer the retirees’ assets and liabilities. In most cases, this process can help reduce the corporate pension risk and enables the consolidation of multiple schemes. For individual members of the scheme there are also benefits with the captive approach, which is subject to regulation from the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) as opposed to the Pensions Regulator.
Examining the options available in more detail, one option for pension schemes is to adopt a ‘self-sufficiency’ approach to funding by blending cashflow driven investing (CDI) and liability driven investing (LDI) assets to match liabilities. In effect this replicates the investment strategy undertaken by the insurance company. The disadvantage of this approach is that the risks remain tied to the corporate balance sheet, albeit in a different way.
The traditional approach to de-risking, however, sees the scheme seek a buy-out provider. As highlighted, the pricing of this reflects a number of components that the insurance company has to consider - namely capital costs, return on capital, longevity reinsurance risk, operational risk/capacity and the availability of suitable matching assets. As a consequence of this, buy-outs may come at a cost of 125% of current actuarial liabilities or higher.
In contrast, forming a captive insurance wrapper simply does not have to bear all the capital costs associated with the insurer’s profit margin and can typically be a cheaper option. The result is that the retiree pension liabilities are – fully or partially – transferred to the captive insurance company with the dedicated assets invested in a ‘self-sufficiency’ blend of LDI and CDI assets. The additional benefit that is accrued means that any surplus derived from excess returns is not paid to the insurance company but can be used to pay a dividend back to the corporate and/or cover additional member benefits. Such structures can typically be achieved at a much lower cost, creating an immediate saving from the upfront sunk cost associated with a buy-out, with these costs recouped through outperformance of the liabilities over the structure’s life.
¹ Are we at the tipping point? LCP pensions de-risking report: Buy-ins, buy-outs and longevity swaps – March 2019
From the perspective of the trustees and the individual plan members, there are numerous benefits, including; surplus returns through profit-sharing, an improved solvency II regime (versus traditional pensions regulation); longevity risk management (through a re-insurance solution); and an enhanced sponsor covenant with a tailored portfolio of CDI and LDI assets that better match member cashflows.
The principle draw-backs of creating captive insurance solutions are that they can take time to understand, structure and implement. Nevertheless, traditional de-risking strategies can also take time to structure, since pricing is, to an extent, based on the availability of a clean dataset of members to be transferred and on the annuity supply by life insurance companies.
BNP Paribas Asset Management’s Multi-Asset, Quantitative and Solutions (MAQS) team is well positioned to assist in the modelling, feasibility and implementation phases of the creation alongside legal, fronting insurance and actuarial partners. On completion BNPP AM’s Private Debt and Real Assets (PDRA) division is able to source, structure and manage diversified private credit portfolios to generate a CDI portfolio as agreed between the trustees and the corporate sponsor.