Solvency II took a decisive step forward in April with the
European Parliament’s approval of the Solvency II framework
directive.
However, in its proposed form Solvency II due to take effect in
October 2012 would have a potentially serious impact on retirement
schemes in the UK.
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At issue is what consultancy Mercer stresses is the UK’s “unique
reliance” on annuity providers for retirement income and pension
scheme security.
In this context Mercer has urged the Financial Services Authority
to ensure special characteristics of annuity business and pension
provision in the UK are respected by the Committee of European
Insurance and Occupational Pensions Supervisors during the current
framework directive consultation process.
“Solvency II should be introduced in a way that is sympathetic to
the different risks being underwritten and that avoids damaging the
UK’s pensions industry,” said Deborah Cooper, head of Mercer’s
regulatory group.
Of key significance is the Solvency II regulatory regime’s Pillar I
which considers an insurer’s primary quantitative requirements
including own funds, technical provisions and calculation of
Solvency II capital requirements.
The problem, explained Cooper, is that some proposed Pillar I
capital requirement tests seem ill-suited to annuity portfolios
which have stable long-term cash flows and will only be gradually
impacted by increases in longevity.
For example, the proposed Pillar I stress test for longevity risk
would require insurers to demonstrate they can bear a 25 percent
decrease in mortality rates.
However, noted Mercer, over the past 100 years, mortality rates
have decreased by 1 percent per annum on average, and insurers
already reserve assuming that experience is likely to continue at a
more rapid pace than this in future.
Since there is currently no evidence for such a material,
additional, shock, such an extreme test, which could increase
annuity prices by about 10 percent, seems disproportionate.
Also of concern is that under Solvency II insurers will be required
to hold sufficient assets to ensure that their risk of failure
within a 12 month time horizon is no greater than 0.5
percent.
Mercer expressed concern that failure will be measured as a
shortfall against an insurer’s technical provisions, which under
the Solvency II requirements contained in consultation documents
released in July should be measured using a risk-free rate of
interest.
Mercer explained that in order to meet their annuity liabilities,
most UK-based insurers currently invest in corporate bonds with a
range of default ratings, often centred on AA or single A.
However, if annuity liabilities are valued with a risk-free rate of
interest then insurers will have to choose between investing in
AAA-rated government bonds which are likely to provide lower yields
than corporate bonds, or hold higher reserves than they do
currently.
If insurers are forced to value liabilities using the risk-free
rate, it could increase retirement schemes’ technical provisions on
average by at least 20 percent, estimates Mercer.
The overall result of the proposals, warns Mercer, is that annuity
prices for those yet to retire and for those schemes looking to
undertake a buy-out or buy-in may rise, potentially sharply.
Indicative of the impact of the Solvency II requirements under the
framework, directive independent pension specialist Ros Altman
estimates that defined contribution scheme members face a 20
percent fall in retirement income.
Her estimate is consistent with those made by a number of other
industry experts, among them Legal & General’s CEO Tim Breedon,
who was quoted by the Financial Times as commenting that
introduction of Solvency II requirements as they now stand would
represent a “betrayal of savers.” Breedon estimates that the
decline in retirement income would range from 10 percent to 20
percent.
Mercer noted that insurers active in the UK bulk annuity business
claim costs will rise substantially as a result of Solvency
II.
However, Alan Baker, a Mercer pension fund de-risking specialist,
warned trustees not to be pressured into a “knee-jerk reaction” and
rush into buyout or buy-in arrangements before Solvency II comes
into force.
“While buyout strategies are valid for many schemes, there are
alternative options open to trustees and companies looking to
manage longevity, inflation and investment risk,” stressed
Baker.
