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Pensions special feature: Rush hour

The normally solid, uncontroversial insurance industry is currently caught up
in the dust cloud caused by a stampede towards defined benefit buyout schemes.

New entrants are rushing to get their game plan together while at the same
time ever larger numbers of companies with final salary schemes are demanding
instant quotes. There is a sense that billions are up for grabs now ­ yet
everyone involved is keenly aware this is an extremely long-term game. Any
provider that gets its sums wrong with a rushed-out quote to beat the
competition will have plenty of opportunity to repent at leisure in a later

The two companies doing the most business in this field at the moment are
Legal & General and the new kid on the block, Paternoster. Prudential, which
used to share this market with Legal & General, has lost a number of key
annuities market people, either to start new pension liability buyout operations
or to join them. (Mark Wood, CEO of Paternoster, is himself ex-Prudential).

However, Steven Haasz, Prudential’s managing director of corporate solutions,
resents any suggestion that the company has been sitting in the wings while the
buyout game has roared off.

In 2007, the company orchestrated a buyout with Equitable Life of 62,000
policy holders with around £1.7bn in assets.

Price is right
While Haasz says the Prudential is very much open for buyout business, he
emphasises that he has strong views about the kind of business it will write ­
namely, business that is priced correctly.

He has concerns over the kind of cut-price scramble for business that is
going on now as new players look to enter the market.

“Who really pays further down the line if the provider underquotes and things
go wrong? The ultimate impact will be on the pensioner. So it is very important
that providers get their pricing right and write sustainable business,” he says.

The two biggest risks for the provider are credit risk, since the name of the
game in the buyout arena is to hold as much of the assets in double-A corporate
bonds as possible, and mortality assumptions. “One in four deaths in the UK are
advised to the Prudential, so we understand the figures very well,” says Haasz.

Providers love getting schemes composed of cohorts of pensioners, or
near-pensioners, since they are much easier to price and carry lower levels of
risk (mortality is harder to predict for people in their twenties, and therefore
much riskier). However, one of the characteristics of the buyout market at
present is that there are a lot more complex schemes coming to the market.

Schemes with a greater cross section of deferred members at various ages make
for difficult quotations.

The market has responded to this by developing what is increasingly called a
“buy-in” option, rather than a buyout. With a buy-in, the provider takes an
agreed segment of the members and a matching chunk of the assets. It then pays
the benefits of those members. This leaves the sponsoring corporate and the
scheme trustees with the security of knowing that a provider with a strong
covenant (since insurance companies are more tightly regulated than plcs and
have to hold decent amounts of cash in reserve) now stands behind at least some
of the scheme.

A recent study of the buyout market by actuary Punter Southall caused a bit
of a stir by suggesting that the scale of the buyout market was massively
over-estimated by many of the players. The report pointed out that the cost of a
buyout, even with the discounts currently available from the newer players, was
still exorbitant for companies, and most of them would discover that they were
better off either continuing to manage the scheme themselves, or opting for
another alternative such as insuring against the risk of the employer’s covenant
failing. Products are starting to come to market to cover this.

Favourable conditions
However, Haasz believes this view is incorrect and flies in the face of the
facts. Not only is the buyout business picking up sharply, with a 400% increase
so far this year in volumes written, but the cost dynamic is changing too,
becoming much more favourable.

“There is an interesting piece of analysis which shows a graph of the buyout
price versus the reserve price you would hold as a corporate on a fully-funded
scheme,” Haasz says. “A year or so ago, there was a significant gap and the
finance director would have to put his hand in his pocket to achieve a buyout.

Today, there are signs that the two graphs might have crossed over, with some
providers doing you a deal for less than you are holding as a fully-funded

Hugo James, sales development director at Legal & General, agrees. He
points out that corporate advisors are struggling to deal with the pressure from
corporates for buyout quotations. It is also tough on the insurers.

“You have to remember that, in the ordinary course of things, scheme
actuaries can correct their figures every three years. We get one chance to get
a quotation right, and if we price it too high we lose the business. If we price
it too low we lose money for a very long time.”

The insurers are being rushed off their feet and one of the crosses they
have to bear is the fact that, when an adviser asks for a quote, they have no
way of knowing if the adviser’s client is serious about a buyout or merely

“The quotes right now cover everything from: ‘This is something I should find
out a bit more about’, to: ‘I need to do a buyout in the next three weeks to get
the sale of this business concluded’,” James says.

Kevin McLaughlin, a principal with Mercer Financial Strategy Group, points
out that, in many instances, the buyout players will take over a scheme with the
assets ‘as is’ and will build in whatever cost is required to convert those
assets. “Corporate bonds are the favourite asset class for the insurers on this.
These are assets they are allowed to hold under FSA rules. They have to submit a
business plan to the FSA, so that ensures they do not get too exotic in their
strategy,” he says.

Even if the bond market goes sour, individual pension holders are still
fairly safe, says McLaughlin. “The insurer has to hold technical reserves and
free reserves on top of that, plus anything extra the FSA requires.

A lot of defaults would have to happen before pensioners needed to panic,” he

McLaughlin challenges the Punter Southall maxim that an insurance company
buyout will be too costly for most schemes. “Clearly the insurance company has
to hold much greater reserves, but market competition has brought the cost of
buyout down by at least 10-15%,” he says.

Bulking up
In spite of the gloom in the Punter Southall report, with its emphatic
conclusion that the bulk buyout market is going to be a disappointment,
Paternoster’s Wood believes there is ample evidence that the scale of the buyout
market is ratcheting up at a very satisfying rate.

“We raised £500m of equity in our launch phase, to accumulate £6.5bn of
pension liabilities.

We have reached £2.5bn in liabilities after our first two years in the
market. We think that is pretty fast growth,” he says.

Paternoster’s market share in 2007 was 49% with L&G having 40% of the
market. Just to put that in perspective, Paternoster has so far written 40
deals, involving a total of 40,000 scheme members and £2.5bn of pension
liabilities. As other players, including the Prudential, have picked up their
activity levels, Paternoster’s market share has dropped by more than half to
20%. But Wood says this is still higher than he would expect to have, longer

“At some time during the next 12 months we will have got into the position
where we are seeking further capital and we have just put arrangements in place
to enable us to write liabilities well into 2009,” he says.

That will constitute the company’s second-phase growth and he is convinced
there will be a third and a fourth phase.

If you ask Wood what the things that worry him most in this business are, his
answer is that, in his more paranoid moments, a sharp spike in defaults in the
corporate bond market allied to a step-change in life expectancy would,
together, equate to very bad news. The prospect of GlaxoSmithKline, or some
other pharmaceuticals giant, announcing the ‘live forever’ pill, however, is not
one of the things that most concerns him.

“The human skeleton is designed for about 135 years before it falls apart
totally; the soft organs will last for substantially less. If you look around
the world there is an astonishing convergence of life expectancy above 90. We
are definitely enjoying a longer, healthier old age, but there is a strong
gravitational pull towards 102 or 104 as the end point,” he says.

Nevertheless, things could get tricky for providers if the assumptions
underlying life expectancy move out dramatically further than the provider has
allowed for in writing the buyout business.

There is an argument that says that the multiline insurers such as L&G
and the Pru will be a lot better placed to weather the storm than companies like
Paternoster and other mono-line businesses. Mono-line here means they are in
business to do one thing: bulk-buyout annuity deals. The multi-line businesses,
which write general insurance business and have life insurance and protection
products as well, have somewhere else to go if the annuities game turns sour.

Trustees will bear this in mind so the mono-line businesses will need to keep
their pricing sharp to compete.

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