Pension consolidators vs insurance: what's the fuss about?
17 Apr 2019 - Estimated reading time: 5 minutes
Recent comments in the press suggest pension consolidators are cheaper substitutes for insurance solutions, like buy-in. But they’re not perfect substitutes. Here we explore the reasons behind the differences in price, and why there’s much more to the consolidators vs insurance debate than price alone.
The Financial Times opened a recent article by stating the emergence of pension consolidators has sent “shockwaves” through the insurance industry. The commentary that followed included several quotes from various insurance industry commentators such as “terrifying” and “retirement roulette”. Not to mention a mildly unflattering insinuation that the DB consolidation proposition relies on "regulatory arbitrage" to offer an insurance equivalent, at a cheaper price.
If you've been following the development of The Pension Superfund and Clara-Pensions, you might be surprised to hear such a negative reaction. After all, innovation in any market should cultivate a richer choice of services and products. It is natural that the insurance industry will perceive consolidators as an emerging threat to their business models, but the hyperbole in the financial press are a distraction from building a more informed view of the differences between these “end game” products.
With that in mind, trustee decision-makers would want to assess consolidator vs insurance routes on much more than price alone. As with any Trustee investment decision, it is a case of finding the balancing fulcrum between price, risk appetite and resources (primarily sponsor funding).
Although the entry price of consolidation looks set to be lower than that of an insurance route*, and resources will naturally be based on individual schemes’ and sponsors’ circumstances, we can also contrast a broad view of the risks of each option by comparing the operating models and regulatory regimes they operate within.
Insurance vs Consolidators
The basic principle behind insurance and consolidation is that the sponsor ceding the risk pays a price to do so. For that price, differing levels of capital support are provided to meet the potential costs of (extreme) risks, should these emerge. The Solvency II regime is highly prescriptive of how capital needs to be sized and structured to meet the different risks faced by an insurer. This is illustrated in the left-hand bar in the diagram below. On the other hand, the consolidator asset stack is made up of slightly different (conceptual) components.
This helps to illuminate three observations on the multi-year risk profiles being run under consolidation vs insurance.
1. Different initial capitalisation structures
Although the price to enter each arrangement differs, they are also backed by different levels of capital. The diagram above is only illustrative, but the relative sizes of the total bars are intended to be broadly representative**. So, based on this surface view, insurers are better capitalised than consolidators and consequently offer higher security of members’ benefits.
This is not to say that consolidators are offering low member security on an absolute basis. In a study of Clara-Pensions, our risk models suggest a very high chance of paying benefits (an estimated >99% chance of being able to transfer the risk from the consolidator to the insurance market in 10 years, as is Clara’s broad objective).
2. Accessibility of new capital
The structure of the insurer asset stack doesn’t have an entirely simple explanation, but let’s consider its broad objective. Consider the scenario where an insurer’s position was to weaken significantly, to the point the business was forced to close. This could arise, for example, from a severe shock to the assets held and the insurer no longer having access to enough new investor capital to meet ongoing regulatory requirements (e.g. the SCR – the sum of the bottom 3 blocks in the left-hand bar).
In this scenario, the insurer capital stack is sized to help ensure that, following such an event, another insurer is still very likely to see commercial value in taking on the liabilities and assets as a going concern (in all but the worst 0.5% of outcomes over the year ahead). Of course the sizing of capital based on this quantified criteria is highly subjective, but the statement of intent is clear: it is a strong protection for the underlying members in all but the most extreme circumstances. The Solvency II regime helps to ensure that insurance businesses maintain high capitalisation throughout a policy’s life.
It is as yet unclear whether consolidators will have the same continued access to new capital, to top up the levels of protection if a severe shock to the solvency position occurs. In the ‘severe shock’ scenario painted above, the initial capital held by the consolidator will certainly have performed a key role in absorbing the shock, but once depleted it may be hard to find suitors to recapitalise a consolidator. Considering the investment risk being run by a consolidator is therefore very important.
3. Benefit protection in the case of insolvency
Lastly, in the event that things really do go badly, and an insurer or consolidator were to fail entirely despite their well-capitalised positions, we need to consider the outcome for members. Under the insurance regime, the FSCS currently offers a guarantee that 100% of the benefits due to members will be met. In the UK, this has not occurred for a life insurer since inception of the FSCS (c2001), arguably due to the strength of the regulatory regime.
With consolidators operating under pensions regulations, the scheme would fall into the PPF. In this case, some of the members’ benefits would be reduced for the rest of their lives (e.g. 10% for deferred members, although other caps also apply). So, in a consolidator solution the recovery is potentially lower for many of a scheme’s members.
So what's the fuss about?
It is not a surprising conclusion that an insured outcome is safer than most forms of trust based provision; but it is also not available to most schemes.
If trustees are considering entering risk transfer transactions, needless to say they will be carrying out a deep dive around the detail of the costs vs benefits outlined above. As with any Trustee decision, it is a careful balancing act between doing the best job for the members with the resources at hand. We therefore expect different target markets for insurers and consolidators – those that can afford to press on to a near-term buy-out would naturally do so: the security is higher.
However, consolidators should offer a level of security that is a big improvement from today’s position for a tranche of the UK’s pension liabilities. Consolidators give the sponsors of schemes that are relatively distant from the prospect of buy-out an incentive to write one last cheque upfront, that they might not otherwise be motivated to do. That should enable a more stable and secure investment strategy to be adopted for a cohort of schemes in the near term. In the case of Clara-Pensions, this consolidation option will still offer the final destination of insurance in any case – and the promise of a better pension in getting there.
Consolidators and insurance clearly appeal to different markets. Providers should take the boxing gloves off and help trustees and sponsors form an informed view of how the solutions differ, and understand which end game will secure the best outcomes for their scheme and members.
**The rationale behind each component of capital does not lend itself to succinct explanation, but it goes without saying that more ringfenced capital equals additional security for members’ benefits. It is worth mentioning that “free assets” in the insurance capital stack are largely what they say on the tin – assets held beyond the regulatory minimum to help absorb shocks to the overall business and advantage from market opportunities, etc. This has an identical function to any other business’s capital. This capital is not ringfenced for a particular part of an insurers’ liability per se, but still help to weather shocks across an insurers’ business and are therefore a part of the security implicitly behind an insurance policy.