Do pension buy-outs carry needless credit risks? I think they do but Catherine Hopper, unconflicted partner at LCP, thinks not.
She writes:
Whilst the past is not necessarily an indicator of the future, it is of more than passing note that, to date, no life insurer has been unable to meet its obligations and, as a result, the Financial Services Compensation Scheme has never had to bail out a life insurer. It’s also worth noting that the life insurance industry held up well in both the 2008 banking crisis and, to date, through the Covid-19 crisis. Not least because of the strong focus on matching assets and liabilities under the insurance regulatory regime.
In contrast, the global banking system nearly collapsed in 2008 due to liquidity issues and the FSCS has paid over £20bn in compensation for banking failures.
The key clause is ‘past is not necessarily an indicator of the future’. She entirely skips over the Equitable Life disaster, which as David Blake (2001) notes, was mostly a problem of actuaries’ own making.
Once again the ELAS actuaries have been exposed for their poor understanding of financial market risk and the consequences of offering guarantees without investing in appropriate matching assets. Just as they failed to understand the risks underlying guaranteed annuity rate options, so they have failed to understand the risks underlying guaranteed minimum annual returns or GIRs. (Blake, 2001, p. 5)
As for the 2008 banking collapse, the parliamentary report on HBOS concluded that the HBOS failure was fundamentally one of solvency, not liquidity. “Subsequent results have shown that HBOS would have become insolvent without capital injections from the taxpayer and LBG.”
It is false that “the life insurance industry held up well in both the 2008 banking crisis and, to date, through the Covid-19 crisis.” During the 2008 crisis several insurers were approaching insolvency, indeed some of them have been technically insolvent ever since. Only the masking effect of weird insurance accounting obscures this fact. With their short term on-call funding, banks collapse immediately. With their very long term funding, life insurers can limp on for ages (but not for ever).
As for the covid crisis, that is entirely down to luck. Spreads ballooned out, then narrowed back again. The fact that they narrowed back has nothing to do with any management skill of any life firm.
Hopper continues:
Finally, the article also accuses insurers of “essentially manufactur[ing] equity” through the Matching Adjustment, which allows use of a higher discount rate when setting their best estimate liabilities. To exclude the Matching Adjustment and insist on a risk-free discount rate in best estimate calculations, would seem to be gold plating an already stringent regime. The insurers put up significant reserves (on top of their best estimate liabilities). Asking insurers to reserve even more cautiously would push up the price of buy-ins or buy-outs, putting further pressure on pension schemes and their sponsors.
But the reserves are created by Matching Adjustment! As we never tire of saying, the logical contradiction at the core of Matching Adjustment is that the capital required to support the risk of adverse asset outcomes can be created by assuming those same assets perform well. 1
The idea that the regulatory regime is stringent is of course a joke.