By DB and KD
Since we published our objections to the Matching Adjustment, and particularly since the FT article about the magic money tree, Eumaeus has been faced with a barrage of criticism. Are we being funded by right-wing think tanks such as the Adam Smith Institute? (No we aren’t) Shouldn’t the Guardian investigate Kevin’s links to pro-Brexit groups? (No point. ‘Unearthed’ already did and they didn’t, er, unearth anything that was not already in the public domain. Took them a year to find out less than they could have found had they asked politely.) Are we trying to bring about the zombie apocalypse of the insurance industry by mass insolvency? Give us a break. We are however trying to expose bad practice, and there seems to be a bit of that around.
There are three objections to consider.
Objection 1: Without matching adjustment, insurers would have to hold excessive amounts of money, which would result in the price of annuities rising to the detriment of consumers. Thus spake the president elect of the Institute of Actuaries.
We reply: why would the insurer have to hold ‘massive amounts of money’? If the excess returns are absolutely certain, as the proponents of MA claim, then asset prices are too volatile. Why then base your capital regime on the historical distribution of asset prices which are too volatile? Why dream up fictitious capital to meet a fictitious capital requirement? Why not just value everything at market, encouraging investors to take on risk at a low price, with a correspondingly low capital requirement? After all, the business will be highly profitable, on the assumption that the future excess returns are a racing certainty.
Objection 2: without matching adjustment, no one would invest in long term higher yielding assets, which would be a bad thing for the economy.
You have to question the premiss. Why would no one invest in long term projects, such as infrastructure, without an accounting trick like the matching adjustment? The history of the railways in nineteenth century UK and US suggests otherwise. Victorian Britain was carpeted with tens of thousands of miles of track by a burst of private investment, a legacy that has lasted until today. The growth of commercial aviation was also privately funded. Incredible to believe, but none of them required the matching adjustment. They made the investments because they believed them to be profitable.
So you have to ask why investors aren’t investing in these projects or, to state it more accurately, why they aren’t making the scale of investments that people say they should make. Apparently not even insurers are making these investments – examination of their balance sheets suggests that they primarily benefit from matching adjustment on shorter term corporate bonds, rather than infrastructure, so it is not clear that matching adjustment is helping to promote long-term infrastructure investments anyway.
Perhaps the problem is that infrastructure projects are famously risky? The ‘benefit’ of MA is the ability to realise risky profits up front, so that existing (or private equity) owners of insurance companies can take their profits straight upfront. You can see why they would want to invest. But the new shareholders are unlikely to receive a penny. If the infrastructure project is successful, the profit goes to pay off the creditors, i.e. the pensioners, and the shareholders are unlikely to get any more than they put in. If the project is not successful, they lose everything, and in all likelihood the pension fund is left with a deficit, in which case the compensation scheme kicks in, and insurance premia go up. How does that help the economy?
Other investments include equity release mortgages. But these are highly risky investments and patently unsuited to back pensions. Promoting equity release could be creating big problems down the road. Eumaeus also learned recently that some insurers are investing in leveraged ground rent loans, where the loan backs the ground rent stream paid by hapless leaseholders who failed to understand the significant cost of small amounts paid over a long period of time. These loans are far from riskless: political reform could (touch wood) wipe out their value entirely, and it’s unclear that the grubby business of excessive leasehold charges provides any benefit to the economy.
Objection 3: our market consistent fundamentalism will bring about the collapse of the UK life insurance industry, resulting in apocalypse, dead walking the streets etc.
Well, if the life insurance industry is really that dead, then there is no point in pretending it isn’t.
As we argued here, while we laugh at the befuddled thinking that confuses a system of measurement with the thing measured (‘give us our 11 days back’), some people really do believe that we can restore the subject to life by changing our accounting system to present a picture of rosy health. We can’t. Either the patient is desperately ill, or not. If the first, bring in the best doctors and make your best efforts, and so acknowledge the problem. If the second, then there isn’t a problem. If the risky returns are really going to happen, they will happen in time, and there is nothing to worry about. Or perhaps you are worried that they won’t happen? In which case, why massage the accounts to pretend that they will?