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Speaker
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Transcript
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Helen Norman, Associate, Burges Salmon
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[Music] Hi everyone, welcome to episode 6 of season 4 of the Burges Salmon pensions pod, I'm Helen and I'm joined today with Chris. Hi Chris.
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Chris Brown, Director, Burges Salmon
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Hi Helen, hi everyone.
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Helen
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And today we're going to be having a discussion about insurer due diligence with Richard Hall, a partner, Argyll Covenant Advisory. Richard thanks for joining us today.
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Richard Hall, Partner, Argyll Covenant
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Oh pleased to be here thank you.
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Helen
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[Music] Richard if I could start by asking you what is an insurer due diligence assessment and if you can explain that in a high level to our listeners?
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Richard
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Yeah sure, I mean you'll be aware that the pensions Insurance markets have exploded over the last 12 - 24 months boosted in particular by the yields over 2022, so many schemes are in a position of being able to buy out what they weren't sort of planning to do just yet, so I think what's happening is you're seeing a lot of trustees and employers suddenly think well you know, what is the strength of the financial, or strength of the insurer behind these transactions? So they're just doing a bit of due diligence around the financial strength of those insurers, to sort of help if you like with the governance of the transaction.
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Chris
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Yeah fantastic, Richard, I've been really looking forward to this episode, because it's so topical as you say because the market has absolutely exploded and sort of you know those considerations that trustees having to take into account, I think this is going to be a really interesting episode for our listeners. So I suppose the question, maybe perhaps the million dollar question, is insurers are regulated aren't they, so you know, I suppose someone might ask, why do trustees need an independent assessment?
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Richard
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Yeah, we do get asked that quite a bit and you're absolutely right insurers are regulated of course, but I wonder how many trustee boards and how many employers actually understand sort of the nature of that regulation, or in particular the the protections that it offers and the limitations of those protections. So, I mean just as a sort of a high level view, the way it works is you treat the sort of the insurer a bit like a pension scheme, it's got assets and liability as much as a pension scheme has and you hold a margin on top just to reflect sort of the contingencies that it might face and the margin is supposed to be sufficient to cover 99.5% of eventualities. So only sort of the one in 200 extreme events are the ones not covered by that margin. That all said, all the insurers in the marketplace at the moment, and there are nine currently and we can see sort of a couple more on the horizon, but all those nine they use different models to sort of get to that solvency margin and they've invested differently so you're not necessarily comparing apples with apples. So what we do, is we go back to Grassroots, we go back to First principles, and we say well look what are the risks facing this insurer? And we look underneath you know the Investments, and the use of reinsurance, and so forth and then we just we just sort of put a overall measure of financial strength and give trustees the comfort that the insurer is uh is good for the transaction, if you like.
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Chris
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And the reinsurance is interesting isn't it, because you know different schemes, different trustee Boards of different schemes will have different approaches to assessing risk, but I've certainly been in trustee meetings where some trustees have sort of put a lot of stall by whether the insurer is a household name for example. But of course, that you know is ignoring the fact that there's a lot of reinsurance behind the scenes and you know you might think you're dealing with a household name and you are, but then actually are you understanding the risks reinsurance behind that?
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Richard
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No, I think that's absolutely right and you're right it has made the Press quite a bit. So reinsurance should be a good thing I think for insurers, because it allows them to diversify the risk. So if you think over 2023 there were a couple of very big transactions we had sort of RSA 6.5 billion at the start of the year, and a big boots five billion at the end of the year, so it's better for insurers if they can spread that risk around, so that should be a good thing, but you're right. It does make trustees wonder whether they, you know, they're really dealing with the insurer in hand, or whether they're dealing with the reinsurer. Particularly if that insurer is sort of seeding a large amount of premiums. So, you know, the reinsurer might be invested in a different territory, or might be based in a different territory, it might be under a different system of regulation, have a different financial strength. So, again, it is crucial to understand exactly the additional risk if you like, the the financial standing of the reinsurers behind the insurers proposition. And that sort of forms a fundamental part of the analysis and enables trustees to get comfortable.
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Chris
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Yeah absolutely
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Helen
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Richard, I guess
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Chris
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Go on, Helen
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Helen
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this is all to further trustees understanding it might be worth us just being upfront about what the legal duties of Trustees are, when considering whether to enter into a 'buy in' or 'buy out' with an insurer, so at its core the decision to buy in is an investment decision for the trustees, and some, definitely most of my clients, would engage with the employer but actually it's more of a trustee decision. So they really do need to look at their rules and see if it's permitted, check that the investments in accordance with the statement of investment principles for their scheme, and make sure that they're really taking proper advice in relation to this. Both legal advice and investment advice, and I guess your due diligence advice can definitely come into that.
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Richard
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No absolutely, I think that's very sensible, a very sensible approach. I mean to us it just seems like it's just it's like no other, like any other sort of appointment that trusties might make, so as you say they might appoint legal advisors, investment advisors, covenant advisors, in the ordinary course of things for which you go through a due diligence process. You know, it would form part of the trustees governance processes. It shouldn't be any different really for selecting an insurer, because the difference with an insurer and selecting the other advisor is, if things go wrong with the other advisor you can just appoint another advisor and that's it you just carry on as normal, but, you really have one opportunity to assess an insurer so it does make sense to sort of kick the tires a bit.
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Helen
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And it's a very high duty of care, I was going to say, with investment decisions by trustees, so the classic case is re Whiteley, where the care is that an ordinary prudent man would take if he were indeed to make an investment for the benefit of other people, for whom he felt morally bound to provide. So, it's such a significant decision, it does make sense to try and get all the information you can about who to choose.
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Richard
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No it really does and of course we're talking trustees but actually the same concern should apply to employers, and I think in our experience this sort of transaction does tend to be done very closely between trustees and employers, rather than one or the other. Partly because often there's a cheque to be written at the end of the day by the employer, so you know to fill that, perhaps small, funding gap now to get to full buy out may need a bit of funding from the employer, but it tends to be done between trustees and employers. But their concern should be the same, they don't want to find that their transaction and their decision-making process is picked over at the end of the day and they want to be able to demonstrate that they've done enough due diligence.
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Chris
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Yeah absolutely, so forms a very key part of trustees and trustees duties and as you say same concern for employers. What about sort of, you know, if trustees are lucky enough to get more than the one quote? Does sort of thinking about due diligence on the insurer help with sort of other situations as well?
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Richard
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Absolutely, so particularly in those situations when trustees are lucky enough to have more than one quotation -
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Chris
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Yeah.
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Richard
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and those do tend to be some lucky situations, often some of the situations we see that there's only one insurance that's prepared to quote. But let's say you have got more than one quotation -
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Chris
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Yes, yeah.
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Richard
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then a financial strength assessment might help trustees steer between one insurer or the other, particularly pricing and everything else, exactly, as everything else might be the same. So it can certainly help then, and I think also when you've got a situation where trustees are interested in the change in covenant, so they've got a covenant now which might be perfectly reasonable from their corporate sponsor. What is the covenant going to move to if they move to an insurer? And again, those sort of situations we're increasingly seeing.
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Chris
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And that's not always a straightforward decision if you are sponsored by an employer with, you know, which for different reasons might have a very very strong covenant, perhaps on par with insurers, you know, and actually that level of analysis there can be really helpful.
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Richard
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I think that's exactly right and we try and bring out sort of the salient points, if you like, that the trustees should consider in that transaction. I mean, particularly with any corporate versus an insurer, you have got the sort of, if you like, ongoing comfort with an insurer that they're going to be regulated on an ongoing basis, whereas often with the sponsor there's no there's no ongoing regulation, or sort of constraints in terms of how they operate, so you know, it can be, it can sort of help in those situations also.
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Helen
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And Richard, definitely when we're producing kind of, the final advice to trustees about whether they should do the no go decision on an insurer, we always cover about the financial services compensation scheme. Could you provide just a bit more background to that and how that supports these kind of transactions?
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Richard
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Yes, well all bulk purchase annuities, all sort of buy-in and buy-out transactions, the benefits are covered by the FSCS I suppose there has been a little bit of concern in the insurance industry, whether the FSCS would pay out in the event of collapse of one of these large BPA insurers, so there is that sort of concern. I think also to use a covenant analogy within sort of the TPR's risk framework for sort of schemes, or trustees assessing the sort of, the risk management of their schemes, the guidance is that you probably shouldn't rely on the safety net of the PPF when you're sort of looking at risk in schemes, you should manage those risks -
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Chris
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ITS hope
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Richard
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Exactly, in the sort of, with the sort of premise, that that safety net isn't there, so again it perhaps steers more into a case of the trustees ought to do their own due diligence rather than rely on the comfort of the safety net, assuming it's going to be available.
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Chris
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Yeah okay, so that's really interesting. So, Richard we had another question for you which is, can you tell tell us about some of the key differences between the insurers please?
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Richard
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One of the things you notice most frequently is actually there only sort of a few of them are the famous names, less than half are names that you might have your car insurance with, or house, or life insurance, whatever it happens to be. So while we'd absolutely stress, to covering off your point earlier Chris, that probably familiarity isn't the only thing you want to be looking at in terms of financial due diligence, it does nonetheless create a bit of uncertainty on the part of trustees and employers, you know. How good is this insurer for the money, if we if we haven't even heard of them? So again it sort of steers perhaps towards some independent expert help there.
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Chris
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They're all invested differently I suppose as well aren't they and different exposure to different types of assets perhaps?
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Richard
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They are indeed, they're all invested differently in addition as well so you'll find that a bit like a pension scheme, they're invested, you won't be surprised, in variety of fixed interest, so bonds and so forth, but all those all those portfolios of fixed interest Securities can have different, and do have different, credit strengths. So that can vary quite a lot between insurers and also insurers tend to get invested in more, sort of, interesting things than sort of plain vanilla equity and equities and bonds, so they're invested in infrastructure and in particular lifetime mortgages and all that can vary between insurer, as can the use of reinsurance as we as we touched on earlier. So again, these are all things that trustees need to understand.
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Helen
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Is there a problem with lifetime mortgages? You do see a lot about it in the press and perhaps some uncertainty for trustees when they acknowledge that those are part of the portfolio?
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Richard
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There's not a problem per se, I mean they just an investment category that all the nine insurers are exposed to, so a lifetime mortgage or an equity release mortgage is just where a policy holder effectively releases the equity in their home through a loan, so they get the proceeds of the loan against their property and they use it to spend on cruises or whatever else they happen to do in retirement, and then when the policy holder dies the property value is used to repay the loan to the insurer. Now that's fine, but as long as the property value is sufficient to cover the loan plus interest at the point of death and obviously at the moment in the UK property Market things are sort of heading south a bit, property market, property values are falling, it becomes crucial to understand what the exposure of the insurer is to the sort of falling property values and understanding what the sort of LTM portfolio is all about. So again, a crucial part of the analysis, but as I say they are all exposed to it so it's just a category of investment that is quite common among these insurers. The other thing to bear in mind, is they get they get a sort of what's called a matching adjustment credit for the for the LTMs, so what they do is they pass all these mortgages up into securitizations and they get additional credit for it when they're valuing their liabilities, so it keeps, it puts a lower value on the liabilities and a lower value on the capital requirement at the end of the day. Now we know as part of the proposed changes to solvency 2, this is an area, the matching adjustment is something that will be looked at, so again if the insurer is very exposed to the matching adjustment and has a big reliance on it, it could mean that they have, that things could change if there's changes made to the the matching adjustment. So again, it's something that we pay close attention to.
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Chris
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Yeah absolutely, and I think what certainly I'm getting from this conversation is that, I think we're probably only really scratching the surface of descriptions there of assets that different insurers hold and the sorts of things that covenant due diligence would look at and, you know, it's a it's a fair question, do trustees fully understand all of this when they're signing over, you know, all or the large, you know, a large proportion of their schemes assets to insurers in a in a one-time decision? So yeah really interesting. What sort of things, you know, would you expect an assessment to contain? Sort of, you know, could you summarize the sort of like different sort of topics or what what an assessment might look like?
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Richard
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Sure absolutely, I mean the main thing to understand really with the financial strength of an assessment of an insurer is its balance sheet, so it's a bit of a change from a covenant assessment that you might be used to in the ordinary running of your scheme where you're looking at profit and cash flow. We do look at that a bit, but actually to be honest the thing that's most of importance is the balance sheet, so we'd look at sort of solvency capital requirements, you'd look at what they're invested in, you look at use of reinsurance and so forth, we'd also want to understand the legal structure, just understanding which entity you're dealing with, particularly if you're part of a larger corporate group, so that's very important as well. And also a peer analysis just looking at what the other insurers look like in the group and so you can understand where the chosen insurer actually fits in within their peer group.
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Chris
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And would that be something you envisage for clients who only have one quote or only dealing with one insurer as well? Because even if you haven't got a choice to select from, I suppose that really helps you with your decision that yes this is the only insurer and I'm on a exclusive basis to get the quote from them, but actually you know to give me comfort that this is still an appropriate move, you know, vis-a-vis the others in the market that I could have been speaking with.
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Richard
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Yeah exactly that, so it just I think it just provides the next level of comfort because people, you know, it's human nature to want to know where you sort of peg against the other insurers so I think it just helps knowing where you sit on that spectrum.
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Helen
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And I guess trustees, this is such a significant part of it for trustees to consider, but they will depending on the size of the scheme, have other considerations, for example ESG, how the members are going to experience the new insurer and things like that, but this is the financial analysis that's really significant as well that sometimes falls by the wayside.
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Richard
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That’s right.
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Helen
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Richard, I guess I I was wondering, how much buy-in do you get with the insurers that you're approaching are they very happy to help you with the reports and is it the same across the board, or?
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Richard
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Yeah, I mean I think you know as a group they are very they're all very cooperative and they're all keen to help, because actually it's in their interest at the end of the day that trustees concerns are allayed -
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Helen
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Definitely
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Richard
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and that they want to make sure that their insurance business is portrayed in the correct light and in a strong light if you like, so they are quite keen to engage. They have constraints in terms of information they can provide, they all have December year ends, and they all have sorts of sensitivities around that and there's commercial sensitivities, some of them are listed so they have listing requirements, but by all you know, pretty much all of them they are all very cooperative and helpful and just have regular calls with us, so yeah, I think there's an acceptance of this type of analysis in the industry now.
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Helen
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Oh that's really good to know.
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Chris
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And trustees, if they are contemplating a buying transaction and thinking about, you know, exactly this, how, you know, how should they select Argyll, or another provider, or you know how should trustees go about selecting a provider for this type of advice, this type of work?
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Richard
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Yeah I mean, we would suggest that independence is quite important, because I mean, you know, there are a number of providers out there offering this sort of service but we stand outside the broking transaction, we don't have any role in the selection of the insurer, beyond -
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Chris
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In the broking, yeah -
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Richard
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yeah exactly, so I think that's quite important if you try to offer this as part of a broking package you might find there's a perceived conflict of interest there. Also in terms of expertise, I think there's an awful lot of public information on insurers so I think trustees and employers should expect a little more than just a summary of what's in the public domain, I think there should be additional expertise on top and certainly ourselves, you know, we have our own in-house insurance expertise to be able to deliver our assessments. I think finally cost, it doesn't have to be expensive, so you know, again just shop around make sure you're getting reasonable value for money because this sort of thing, this sort of analysis does not need to be expensive in the context of a transaction.
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Chris
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Yes
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Helen
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Yeah
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Chris
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So sorry go on Helen, go on.
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Helen
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No, I was just going to say that's really helpful and I think, as we said at the start, it's so topical because even the recently published general code has a lot of guidance about investment and what trustees should be thinking about and this can be something that really backs up that the trustees have had given proper consideration to the decision that they're making.
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Richard
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It's a very busy market and a lot of trustees will be thinking over 2024 and beyond, you know, the opportunities for buying out.
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Helen
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Definitely.
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Richard
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Possibly only constrained by the capacity of the insurance, so it's going to be an interesting year I think.
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Chris
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Yeah absolutely. So Richard, on that note if you could leave our listeners with one or perhaps two key messages please what what would they be?
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Richard
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I think the I think the main thing I would suggest would be to just do some financial due diligence on the on the insurer, I mean I think that's crucial, it's a governance, it's a governance process and you know it's a one off opportunity you've got to assess the insurer, so my one piece of advice would just do some financial due diligence on the insurer.
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Chris
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Yeah absolutely, thank you. Well, that's been an absolutely fascinating discussion and I think that it would be really useful to trustee clients, but as you say, corporates as well, considering their strategy and solution for their DB schemes as and you know risk transfer as part of that. So Richard, thanks ever so much for coming on our podcast.
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Richard
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Thank you.
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Helen
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[Music] Thank you for listening to the Burges Salmon pensions pod. This is our last and final episode in season 4.
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Chris
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Helen, I can't believe it, I've really enjoyed doing this season and it's flown by so fast, but we've covered some great topics haven't we?
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Helen
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Well, luckily Chris all of the previous episodes will still be on the Burges Salmon website, wherever you listen to your podcasts.
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Chris
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Yeah that's right, and to all our listeners thanks so much for listening and keep your eyes and ears peeled for season five later this year.
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