The UK life insurance industry has taken on a collective hundreds of billions of pounds of pension liabilities via the bulk purchase annuity market in the past decade or so, making their survival critical to the millions of Brits who now depend on these companies to pay their defined benefit pension.
This is partly why the Prudential Regulation Authority (PRA) ran its LIST (life insurance stress test) initiative this year – to see which insurers, if any, were standing too close to the risk precipice.
Good news: None of them are. At least, none of the 11 subjected to the test, which together account for 90% of annuity liabilities in the UK, according to the PRA.
Under the PRA’s one in 100 severity scenario, a three-stage process that begins with an interest rate decline of 150 basis points, widening credit spreads of +270bps and a fall in equities of -30%, followed by a deepening phase including reductions in property assets, notably residential, and a consolidation phase with credit and inflation spreads easing and the allowance of easing of management actions.
The overall effect was to cut the aggregate solvency capital requirement (SCR) coverage ratio from 185% and to a still healthy 154%, which “remains well above regulatory requirements”.
Under stage 1, the test’s initial shock, the SCR declined by just five percentage points to 180%, a win for those that defend the industry’s resolve.
“That’s barely a blip,” said Roger Lawrence, Managing Director at W L Consulting. “For the 11 insurers tested to see only a five-percentage point decline in the SCR given the criteria laid out by the PRA for the test – from an already very strong start – speaks to the quality of the asset and liability matching of these companies.”
Stage 2 is where the action happens, as the SCR falls to 154%, “reflecting exposure to credit rating downgrades and defaults on bonds and falls in residential property values – key asset classes used to generate cash flows for annuity payments to policyholders.”
Relevance here, then, to the equity release market. Insurers in the UK are prolific funders of these mortgages, as they are one of a limited group of long-term assets that they can buy for long-term liability matching. UK life insurers internally securitise equity-release portfolios to retain them on their balance sheets, allocating senior notes to the matching adjustment and junior tranches to shareholder funds to optimise capital and solvency.
The LIST scenario notably calls for a -28% reduction in residential property values – something which has not happened in the last 50 years, with a reduction of 18% between September 2007 (when the average house price in the UK was £175.052) and March 2009 (when it fell to £142,278) being the largest fall observed in that period.
On top of these core stresses, however, LIST looks at the addition of two specific stresses. The first is a further specific credit downgrade to the asset class making up the biggest share of the matching adjustment (MA) portfolio – the aforementioned equity release mortgages (ERMs).
The PRA said that ERMs account for 16% of the MA portfolio asset value on average. Under the scenario specification, this results in around 3% of their MA portfolio assets being subject to downgrade.
“Whilst the additional stress is only being applied to a small part of a company’s whole balance sheet. The PRA have expressed concern before over growing concentrations of ERMs in MAs. The fact that it only results in a drop of 1% on the SCR coverage ratio to 153% is positive news,” said Lawrence.
While UK life insurance exposure to ERMs may be notable, it’s the use of funded reinsurance by insurers that is a current PRA bugbear. A letter to CEOs back in July 2024 explained that “the PRA is concerned that the current growth in FundedRe transactions by UK life insurers could, if not properly controlled, lead to a rapid build-up of risks in the sector and in January this year it made clear that this topic remained a focus.
Under the second exploratory test, which was to see what happened if there was a total failure of an insurer’s biggest reinsurance counterparty (resulting in a large recapture of liabilities), the results show a collective recapture of liabilities of £12.3bn, approximately 50% of the aggregate Funded Re exposure of the test’s participating firms (as at 31 December 2024, the date at which the composition of life insurer balance sheets was tested).
The recapture increases their MA portfolio net liabilities by approximately 6%; with a corresponding fall in the average SCR coverage ratio of 10% to 144%.
While it doesn’t appear that the PRA will let this one go – “The exercise also identified some gaps in how firms consider and allow for the costs of recapture, which will become increasingly important in the event of continued growth in the use of Funded Re and potential changes to the underlying collateral. These findings will inform future policy work in this area,” said the PRA’s report – for now, it’s a good news story for UK DB scheme trustees and their members.
“The results of the PRA’s LIST demonstrate the resilience and capital strength of the UK’s life insurance market in the face of a severe macroeconomic shock,” said Chris Rice, Head of Trustee Services at Broadstone.
“It should give trustees confidence in the security of their members’ pensions should they opt for a pension risk transfer transaction for their endgame objective.”