Guy: Why would UK Defined Benefits pension funds want to enter into a Bulk Purchase Annuity arrangement with an insurance company?

Esther: Recently because of the market turmoil, it has become more burdensome for the companies to manage their pension fund liabilities. Improved funding levels due to rising interest rates, combined with innovative solutions by insurers have improved the economics of an insurance buy-out. In addition, anticipated Solvency II reforms should provide an even greater catalyst.

Guy: Esther, my sense is that there is excitement around the magnitude of the growth opportunity that is unfolding.

Why now? Tell us about the opportunity set, and put the numbers into perspective for us?

Esther: Many UK Defined Benefit schemes are underfunded and are closed to new pension accruals. This creates a heavy financial burden on the company, as they need to fund the scheme, which results in huge amounts of debt on corporate balance sheets as well as accounting volatility. In a nutshell, it is expensive and technically complex for companies to run their pension schemes, which is why some companies choose to transfer their pension liabilities to an insurer as a way to de-risk.

The turmoil in November 2022 following the mini- budget has really highlighted the risks inherent in managing pensions, making companies even more eager to offload their schemes. It has taught pension funds an important lesson: they cannot rely on LDI as a fail-safe option.

The insurance industry expects that the recent rise in bond yields would encourage schemes to consider buyouts from insurers. With the recent macroeconomic environment of sharply higher bond yields, pension funds’ funded position have improved despite the liquidity issue they faced, bringing them closer to a status where they have the option to de-risk. Therefore, it is expected that these recent changes would boost deals in the BPA space.

Will we see an immediate change?

At the moment, the pension schemes are assessing the situation and the fallout caused by the mini-budget, while also grappling with the implications of high inflation and an uneasy economic outlook. However, the underlying drivers of the change in the BPA market remain the same, so the trend of offloading the retirement schemes to insurers is likely to continue.

Today, there are over £2 trillion of pension liabilities sitting on companies’ balance sheets. We have already observed quite a strong de-risking trend over the last decade and yet it is set to grow even more over the next decade. According to one estimate, the growth of the BPA market over the next 10 years is projected to be over two times the historical growth levels, with ~£600 billion of risk being transferred to UK life insurers. This would constitute a 40% increase relative to the current UK life insurance AUM.

Guy: Since the market for BPA transactions is growing, do you still see many BPA players entering the market?

Esther: There are extremely high barriers to entry for new BPA players. BPA de-risking solutions require significant technical know-how and expertise. Reputation also matters, as does the expectation that the insurer will be around in, say, 50 years’ time or longer, to pay pension liabilities. In addition, the insurer must have a well-established asset management platform that includes expertise in sourcing illiquid investments and managing them on an on-going basis.

Although BPA players have in-house origination teams to source private assets, the increasing need for those assets means that some insurers choose to go to external private deal originators. MIM complements the in-house origination teams very well, having experience in sourcing private assets across various geographies and deal types.

Jihui: As mentioned, there are significant barriers to entry. There is only a handful of large well-established players which are well-known to trustees, and so it is not surprising that only few insurers are active in the BPA market even though competition has increased. In fact, there have been no new major players who have joined the BPA market in the last five years.

The ability to source illiquid assets is a key differentiator in this market. UK insurers typically apply for SII’s ‘matching adjustment’ (MA) provisions for BPA liabilities. Once approved, insurers are able to discount their long-term liabilities at a more favourable discount rate (risk free rate plus a spread called the ‘matching adjustment’ spread). The higher the spread, the lower liability valuation, the better the solvency position. Only assets meeting a certain set of criteria are eligible to be included in the MA portfolios. Illiquid assets tend to have higher spread to compensate for the lack of liquidity. As a result, adding eligible illiquid assets bring significant benefit to the MA portfolios.

Esther: We are excited because MIM is well positioned to partner with BPA players given our strong origination platform which supplies private assets that are higher yielding (relative to public fixed income), diversifying, and that can help satisfy the duration profile of the liabilities being transferred. MIM has developed a unique origination platform that can help BPA insurers access private assets across infrastructure debts, corporate private placements and commercial mortgage loans. The scale of our platform and our ability to execute reliably helps our insurance clients price transactions competitively.

Guy: By including illiquid assets, is greater risk being introduced to BPA transactions?

What other factors drive the demand for illiquid assets?

Jihui: Compared to public fixed income with the same credit rating, private assets typically have a higher yield to compensate for the lack of liquidity. For matching adjustment portfolios, where liabilities are less liquid, having a larger allocation to private assets is not a big concern.

Investing in private assets is also a way to diversify across sectors, and to obtain access to issuers which are supporting growth and better infrastructure, or who are adopting greener solutions. Often, the deals have covenants which can provide protection during downturns, and our private assets’ historical loss profiles are a testament to that.

Guy: With the upcoming Solvency II reforms, could you describe how would they impact the Matching Adjustment portfolios of BPA players?

Esther: The industry consensus is that the reforms, driven by the UK Treasury post-Brexit, are likely to improve the economics of the BPA transactions, giving a further boost to the industry, and allowing insurers to benefit from greater investment flexibility, particularly in illiquid assets. The industry has for many years strained against some onerous requirements, particularly for Matching Adjustment portfolios, and the upcoming reforms with respect to risk margin reduction and increased investment flexibility will be welcomed by insurers. At the same time, we understand that the reforms will still be aimed at protecting policyholders, to ensure that the promises made to pension beneficiaries are adequately protected.

Jihui: Just to add on what Esther mentioned, the proposed reforms include a risk margin reduction which is expected to reduce capital burdens for insurers. The volume of BPA transactions would accelerate, with more players wanting to write more new business due to reduced capital requirements, and the cost of executing BPA deals would also improve.

The matching adjustment eligibility changes which are part of the proposed reforms would allow insurers to include assets they would normally not include in their matching adjustment portfolios, for instance assets which don’t have fixed cashflows but instead are highly predictable, assets with prepayment risk or under construction phases, and below investment grade assets given the severe treatment would be revised. These added flexibilities will not only increase the asset universe for those transacting in BPA deals but reduce the cost of restructuring assets to make them MA eligible.

Disclaimer

This material is intended solely for Institutional Investors, Qualified Investors and Professional Investors. This analysis is not intended for distribution with Retail Investors.

This document has been prepared by MetLife Investment Management (“MIM”)¹ solely for informational purposes and does not constitute a recommendation regarding any investments or the provision of any investment advice, or constitute or form part of any advertisement of, offer for sale or subscription of, solicitation or invitation of any offer or recommendation to purchase or subscribe for any securities or investment advisory services. The views expressed herein are solely those of MIM and do not necessarily reflect, nor are they necessarily consistent with, the views held by, or the forecasts utilized by, the entities within the MetLife enterprise that provide insurance products, annuities and employee benefit programs. The information and opinions presented or contained in this document are provided as of the date it was written. It should be understood that subsequent developments may materially affect the information contained in this document, which none of MIM, its affiliates, advisors or representatives are under an obligation to update, revise or affirm. It is not MIM’s intention to provide, and you may not rely on this document as providing, a recommendation with respect to any particular investment strategy or investment. Affiliates of MIM may perform services for, solicit business from, hold long or short positions in, or otherwise be interested in the investments (including derivatives) of any company mentioned herein. This document may contain forward-looking statements, as well as predictions, projections and forecasts of the economy or economic trends of the markets, which are not necessarily indicative of the future. Any or all forward-looking statements, as well as those included in any other material discussed at the presentation, may turn out to be wrong.

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¹ MetLife Investment Management (“MIM”) is MetLife, Inc.’s institutional management business and the marketing name for subsidiaries of MetLife that provide investment management services to MetLife’s general account, separate accounts and/ or unaffiliated/third party investors, including: Metropolitan Life Insurance Company, MetLife Investment Management, LLC, MetLife Investment Management Limited, MetLife Investments Limited, MetLife Investments Asia Limited, MetLife Latin America Asesorias e Inversiones Limitada, MetLife Asset Management Corp. (Japan), and MIM I LLC and MetLife Investment Management Europe Limited.