The BPA Collateral Conundrum
Matt Price, Richard Hallt & Shaun Sheppard
“Does the drive to collateralise more bulk annuity transactions lead to suboptimal outcomes for customers, pension trustees and insurers?”
Bulk purchase annuity (“BPA”) business has grown significantly in the last 5 years, driven recently by pension reforms enacted in 2014 that had a significant impact on the individual annuity market. Recent market data shows that BPAs have averaged >£10bn each year from 2014 onwards. This trend is expected to continue as market commentators view BPAs as one of the few major growth sectors for the UK Life & Pensions market, especially given £10bn per annum is small when there is a potential c.£2tn of pension liabilities in the UK market.
The emergence of so-called “jumbo” BPA deals has been a key feature as the market has grown in size. Jumbo deals are those with a value greater than £500m and the most notable difference to smaller deals is the requirement from trustees for their BPA counterparts to post collateral. The intended purpose of the collateral is to mitigate the risk of an insurance company failure leading to an inability to meet the future payment requirements for the trustee’s pension members.
The requirement for collateral, which is often managed under bespoke bi-lateral (or tri-lateral) agreements, can be onerous for insurers, requiring them to develop a non-standard approach to their collateral management processes. The challenge is compounded given the starting point for many insurers is a collateral management process that is not fit for purpose, the result being that major costs are incurred in developing an appropriate collateral management infrastructure. Combined with the underlying complexity required to price and risk manage BPA deals, the barriers to entry for Insurers into the jumbo market are therefore significant. Given there is emerging pressure to reduce the size of deal where collateral is required to £250m, or possibly to even smaller deal sizes such as £50m, insurers considering entry to the market, or those already active but not in the jumbo space, face choices in deciding whether to try to compete effectively with the established players.
A further complexity is brought about because of the requirements for the collateral posted to consist mostly (and often entirely) of high-grade liquid assets. To price deals competitively a significant portion of the assets insurers use to back the future annuity liabilities (in their matching adjustment portfolios) are made up of alternative illiquid assets. Put simply, the greater yield generated by these alternative assets is required to meet the future annuity liabilities adequately. The result is a complete mismatch between the assets held by the insurer to back the future liabilities and the assets posted as collateral that the trustee can take control of in the event of the insurer defaulting. All of which means that in the event of an insurer default the trustee will have mitigated the insurer default risk but remains exposed to annuity risk that it intended to manage in the first place.
So why could all of this be detrimental to pension trustees seeking the best deals for their members? Three key consequences may arise from the above:
- The greater barriers to entry brought about by infrastructure costs (of both sourcing high yielding alternative assets or building a collateral management infrastructure) may have a limiting effect on the number of market participants and, if true, simple supply and demand economics would limit downward price pressure.
- The mismatch between liquid collateral requirements and alternative asset investments used to back the future pension liabilities may ultimately limit the pool of eligible collateral available to be posted. There are some interesting possibilities to consider as a consequence:
- One outcome could be to restrict the future size of the BPA market, although that assumes that insurers will run short of liquid collateral pools (which has yet to be tested). The net effect would be to restrict trustees’ access to future deal counterparties, again limiting downward price pressure.
- At some point, insurers will also start to price in the cost of providing liquid portfolios of collateral, which could lead to an increase in the cost of executing a BPA deal compared to current pricing levels. Whilst there is no sign of this happening at present it may be worth keeping a watching brief to ensure that a focus on risk mitigation doesn’t result in unintended consequences.
- The risk profile post-mitigation maintained by trustees might actually be greater than intended because in the event of an insurer default the returns from the pool of assets available to the trustee to back future liabilities is highly likely to be insufficient to meet the expected future liabilities. One way for trustees to react at that point would be to effectively start over and enter into a similar deal with another insurer, with the resultant exposure to prevailing market conditions, which is what they avoided by entering into BPA deals to begin with.
So in summary, if the expected growth in the BPA market is to continue, the industry will need to adapt and make better use of cash and alternative assets to meet the risk mitigation requirements of trustees and to maximise the commercial benefits for all stakeholders. Holley Holland will soon be conducting its 2018 Bulks Investment Services survey to provide further insight into the key challenges faced by market participants to enable future success.
In the meantime, Holley Holland has deep expertise that can help market participants to be successful in the BPA market. Our experience highlights are:
- Assisting trustees and their advisors in understanding whether prospective deal partners have the appropriate level of collateral expertise with the necessary controls in place;
- Developing and implementing necessary collateral capability within Insurers to meet current industry standards;
- Assisting insurers in developing alternative asset investment capability, including systems and controls for managing and controlling complex valuation processes and meeting current regulatory standards such as those on valuation uncertainty;
- Supporting transition activities, including the transfers of in-specie assets and embedding repeatable and scalable business-as-usual processes; and
- Providing thought leadership to help insurers and trustees to develop new industry standards for managing BPA deals.
For more information or to discuss any of the matters raised in this article, please contact Matt Price at email@example.com