Next ‘black swan’ event may be an insurance crisis, SPP warns

Insurers bear potential for significant systemic risks, which would have knock-on effects for the pensions sector, the Society of Pension Professionals (SPP) has warned in its latest research.

According to the SPP’s Vision 2023 report, changes to Solvency II regulation in the UK may lead to a 20 per cent increase in the annual probability of life insurer failure, if a firm met just the minimum regulatory standard.

Therefore, “assuming an insurance covenant will always be stronger than that of a strong corporate might be imprudent. It is not beyond the realms of possibility that the next black swan event is an insurance crisis”, the paper stated.

The paper explained that, under current rules, insurers can hold a range of assets – including investment-grade corporate bonds (as well as private debt and illiquid assets) – against their liabilities, with the additional spread on those assets (relative to government bonds) effectively meaning an insurer can hold fewer assets against those liabilities.

Most pension funds measure their liabilities with reference to the gilt market, whereas there is no such ‘mark-to-market’ mechanism within insurance regulation.

“If corporate bond default rates rise by more than expected and reserved for, this could have a significant impact on insurers’ ability to fund their liabilities," the report stated.

"As credit spreads increase within a pension scheme portfolio, the reported funding level would decline, triggering deficit repair contributions at a valuation if this decline is material enough."

Meanwhile, current proposals to adjust the Solvency II regulation in the UK are likely to further reduce the capital insurers are required to hold against their liabilities, the paper added.

The report highlighted how the potential for systemic risk in the insurance sector has been raised by Bank of England governor, Andrew Bailey, who said: “If a future [insurer] failure occurs, it would be difficult to predict the quantum of losses, nor is it certain that it would be limited to a single firm.

"For example, as corporate pension schemes continue to transfer their pension liabilities into the life insurance industry, the insurance sector might in future have larger and more concentrated exposures to similar types of risks. This could impact the capacity of surviving insurers to take on significant additional liabilities of a failed annuity writer.”

Insurer failure would lead to Financial Services Compensation Scheme (FSCS) support for pensioners, the paper added, but “FSCS protection is contingent on future policy and political appetite”.

“Coverage could fall back from 100 per cent if circumstances change; if insurers fail, the FSCS may not be able to charge sufficient levies on the sector to cover the funding required," it explained.

"Depending on the wider political and socioeconomic context, considering intergenerational inequality, it could be very difficult for a future government to bail out pensioners through financial support to the FSCS."

Much of the risk facing insurers, such as longevity and liquidity risk, can be passed onto reinsurers, “but the potential for systemic risk in the reinsurance sector, specifically as a result of taking on more risk from pension schemes as the buyout market booms, has itself become a source of concern," the paper added.

“For example, UK insurers often pass risk to reinsurers outside the UK, which are subject to different and potentially less stringent regulations; this could potentially increase underlying risk exposures.”

More broadly, the SPP's report raised concerns around the "systemic risks" with defined benefit (DB) pension schemes’ inflation hedging, warning that the inflation hedge of a DB scheme is imperfect because a Retail Prices Index (RPI) asset is used to hedge an inflation-linked liability, where the inflation linkage of the latter is limited by caps and floors.

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