One of the most widely noted changes as interest rates have risen is that many company defined benefit pension schemes are back in positive territory, after years of low rates gave way to relatively good returns on underlying assets. The net result of this is that pension scheme trustees are actively looking to offload schemes onto insurance company balance sheets, which then take on the risk of potential liabilities. This has left some regulators worried that this will result in the overconcentration of risk as insurance companies feast on high-margin bulk annuities business.
In a recent speech, the Bank of England’s Charlotte Gerken, head of pensions supervision, said she saw “strong incentives for insurers to stretch their supply capabilities in the short term, to capture as much of the new business while they can, before leaner years arrive”. The question for investors is how true this will be in practice and whether insurance companies' well-founded reputation for managing risk will mitigate any potential problems.
The growth in the DB pensions transfer market cannot be understated. According to pensions consultancy WTW, this year will be dominated by bulk annuity transactions, with up to £40bn of business due to complete, plus a further £20bn of longevity hedges put in place – with the distinct possibility that the year will see the highest number of deals ever. That compares with the £28bn of de-risking business that took place in 2022, along with £16bn of hedges. In other words, business for both pension schemes and life insurers is brisk.
Rising gilts yields
The key factor is that rising gilt yields have led to some of the cheapest pricing in a decade, providing an incentive for schemes that are moving into the black to offload their risk. The paradox is that rising yields also reduce the absolute size of pension schemes, which discourages partial deals in favour of a whole scheme buyout and gives the regulators’ fears over capital stretching some validity.
Some prominent schemes in the past few months have negotiated buy-ins with insurance companies. Private-equity-owned Morrisons this year traded a £762mn buy-in with pensions insurance specialist Rothesay to secure part of its 1967 saver scheme.
However, companies that specialise in pension scheme buyouts – Aviva (AV.), Phoenix (PHNX), M&G (MNG), Just (JUST) and Legal & General (LGEN) being the listed companies – have natural limitations on how much risk they can assume at any one time.
The first of these is how much capital can be committed and, secondly, how quickly the schemes themselves can complete the required paperwork and due diligence to be able to offload risk. According to a Just spokesperson, “it's possible demand may be higher than supply, rather than the other way around”.
“Capacity in the market to a large extent has been constrained by skilled human resources. Technology is helping to make ways of working more efficient, but there are limited numbers of lawyers, consultants, advisers and insurance professionals,” the spokesperson said.
Companies manage risk in different ways. For instance, Just said that transferring the liabilities of a DB pension scheme carries lots of different risks, such as the longevity of its members and the performance of its investments. Although the company has its own in-house methods to understand and manage longevity risk, “we also use reinsurance to pass some of that risk to counterparties”, the spokesperson said.
Indeed, whether the insurers are running large amounts of risk is a moot point as far as sector specialists are concerned. Analysts at RBC Capital point out that the insurers, unlike liability-driven investment (LDI) specialists, do not use leverage when it comes to taking on liabilities and that the overall quality of assets has been steadily improving compared with a decade ago.
“In this case, the regulators are just doing their job, which is to prevent the overconcentration of assets,” said Mandeep Jagpal, an analyst at RBC Capital Markets.
Commercial property questions
So, if transfer risk proves to be less than meets the eye, investors must look for another explanation as to why life insurer share prices have experienced significant attrition this year, despite record dividend payouts and share buybacks. It is likely that ongoing worries about the sector’s exposure to commercial property are behind the sum of investors’ fears.
Falling values have indeed afflicted the commercial property sector, with real-estate investment trusts (Reits) and developers all experiencing write-downs. However, RBC analysts add some useful context to this debate in relation to the life insurers. The broker reckons that around 54 per cent of the total of insurer shareholder equity is linked in some way to commercial real estate, although in total asset terms this is never greater than 3 per cent of the balance sheet.
RBC analysts point out that insurers hold commercial property loans, either through direct lending or repackaged, tradeable securities. The crucial point is that the main aim of this lending is not capital appreciation, which is tied to the ownership and valuation of physical assets, but the income that commercial property can generate through its repackaged mortgages and rents. The long duration of these loans makes them particularly attractive to insurers as they can be matched year for year with long-duration liabilities.
