PRT and BPA market in the UK

1. Private
and
Confidential
What Trustees
Should Understand
About Solvency
The Risks of Risk Transfer
from a Trustee’s Perspecive
Paul Brine

2. Private
and
Confidential
− Is insurance always better for Members than the status quo?
o What does an insurer look like?
o Where do the financial risks and behavioural risks reside?
o Which common place perceptions of insurance stand up to scrutiny?
o How much capital does an insurer have and where does it come from?
o How reliant on the PRA is a policyholder?
o Do the recent Solvency UK changes matter?
o What is the value of doing due diligence on an insurer?
o What are the questions I need to ask?
What Trustees should understand
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3. Private
and
Confidential
What does an insurer look like?
− It looks like a pension scheme!
o Trustees and insurers are looking to solve the same liabilities
o Trustees and insurers generally look to the same assets to solve for these
liabilities
− The central difference is that:
o Trustees have the “contingent capital” of the Covenant
o Insurers have a specific amount of capital reserved “inside the machine”.
What Trustees should understand
3

4. Private
and
Confidential
A Simplistic Insurer
4
Insurer
Assets
100%
Policies
85%
Capital
15%
Excess
Excess as Dividend

5. Private
and
Confidential
Unavoidable Consequence I: Embedded Leverage
5
Insurer
Assets
Add 100bp
of Yield
Policies
85%
Cost
unchanged
Capital
15%
100bp on
100%
667bp
on 15%
6.7x leverage on
asset yield

6. Private
and
Confidential
Unavoidable Consequence II
6
Assets
Add 100bp
of Yield
Policies
85%
Cost
unchanged
Capital
12%
100bp on
100%
833bp on
12%
Logical cause / effect:
o Increase asset yield
(leverage 6.67x)
o Decrease capital (leverage
increases > 8.33x)

7. Private
and
Confidential
− “Insurers invest very conservatively” (G+100bp)
− “Insurers have a lot of capital” (15%, 7x levered play on credit spreads)
− “No Insurer has ever defaulted” (But have been closed down… “RBS”)
− “Insurers invest in a very diversified portfolio” (Pensions do more)
− “Insurers cashflow match exactly between assets & liabilities” (…to reduce
capital required to back policies, Matching Adjustment)
− “If an Insurer fails, all the other Insurers have to rescue it” (Seriously?)
All that glitters is not riskless - I
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8. Private
and
Confidential
− “All Insurance is backed 100% by the FSCS”
o Fact I: The FSCS is not funded.
o Fact II: FSCS protection levels can be changed “overnight”.
o => It is mathematically impossible to assign much value to a
“guarantee” where the guarantor can unilaterally change the terms at
any time
o Observation I: FSCS protection is a form of private sector regulatory
arbitrage which is subsidised (unknowingly) by all UK Taxpayers.
o Observation II: The FSCS regime is up for review under the November 2022
UK Solvency plans.
All that glitters is not riskless - II
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9. Private
and
Confidential
− Who checks the numbers in an Insurer?
o Only the PRA has visibility into an Insurer’s risk management systems and
positions. This is non-trivial.
o For example:
o An Insurer’s capital requirements are reduced by investing in higher quality
rated assets (ie a single-A asset requires less capital than a BBB).
o For illiquid assets (~1/3 of the asset portfolio), the Insurer rates these
assets itself according to the Insurer’s own internal credit rating model.
o No one, apart from the PRA, audits/vets an Insurer’s credit rating model
AND
o No one, apart from the PRA, audits/vets an Insurer’s solvency capital model
o In Solvency parlance, the “Key-Person” risk on the PRA is immense
Reliance on the PRA - I
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10. Private
and
Confidential
− “The PRA is phenomenally strong and will always regulate the Insurers in
the interests of policyholders”
o The 2022 UK Solvency Review shows that this is an overly optimistic belief.
o There is a fundamental risk asymmetry in all regulatory constructs:
o The Regulator has to get it right 100% of the time; and
o The Regulated spends its time trying to optimise its bottom line;
o This is a natural conflict which is why you have to have a robust
regulator to control the risk capital provider’s behaviour.
o The PRA is indeed the strongest backstop in the insurance compact but:
o Financial history can list many regulatory failures.
o The PRA is manifestly subject to political demands of any
incumbent government.
Reliance on the PRA - II
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11. Private
and
Confidential
What it is
− Matching Adjustment is an increase in the discount rate which an insurer can apply to its
calculation of technical provisions.
− The higher the MA, the lower the total liabilities and lower liabilities represent less capital
required
− It is exactly analogous to the asset yield increment added by a scheme actuary to the yield
curve in a standard technical provisions calculation. The higher increment, the lower the
liabilities.
− The rules are (were) very strict as to what assets are admissible.
− The net result?
− The higher a rating an asset can be assigned by the Insurer’s own credit
ratings model, the more capital the Insurer has.
− The higher the yield on an asset, the more capital the Insurer has.
Matching Adjustment - I
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12. Private
and
Confidential
Matching Adjustment - II
12
What does a MA of 100bp mean quantitatively?
− Roughly it means the WEIGHTED AVERAGE total portfolio asset yield is about
+100 over Gilts.
− Taking an MA of 100bp into the liability calculation removes ~15% of the
liabilities.
− And, not uncoincidentally, equals the amount of capital held by the insurer.
How reliant on this calculation are insurers?
− Without MA the insurers have no virtually no capital: their assets equal their
liabilities.

13. Private
and
Confidential
UK Solvency Reforms - I
13
Allowing ~£18bn of capital out of a system can only increase risk of that system
and therefore it is an increase in risk to the pensioner.
Reducing standards of cashflow matching and thereby allowing incremental risk into
a system which previously excluded such, can only increase risk to the pensioner.
Since when did pensioners agree to take on more risk to support the incumbent
Government’s economic policy aspirations?

14. Private
and
Confidential
UK Solvency Reforms - II
14
Other items in the Review where pensioners are going to be taking more risk than
previously:
− Reducing the harsh capital impact of a credit downgrade from BBB to BB, making it
possible to hold onto BB assets and invest in weak BBB assets
− Intent to review the Financial Services Compensation Scheme (FSCS), including the levy
paid by insurers (today the risk levy is £0)
− Reforming fundamental spread
− Allowing more time to rectify any problems in the matching adjustment book?
− Removing reporting burdens
− Fast-tracking through the PRA:
o internal model changes
o matching adjustment book asset qualification

15. Private
and
Confidential
Asymmetry: Counterparty Risk
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Would an Insurer do the same trade as a Trustee?
− No insurer, bank or asset manager would countenance doing the same
trade that the trustee is encouraged to do.
− An insurer would never invest in the same “gold plated” policy that the
trustee is advised to buy.
− The relevance of the capital calculation as being a “true indicator” of risk
− If an insurer were to buy the “gold plated” policy like a trustee, it would have to
set aside vast amounts of capital which simply reflects the risk embedded in the
“gold plated” policy.
− The denial of collateral to the policyholder is a major flaw and one which rules
out any other financial entity countenancing such a transaction except for a
trustee.
− No other financial risk transaction is so asymmetric in that the insurer
can be the seller, but never the buyer, not at any price.
No market driven incentive to solve this failing

16. Private
and
Confidential
− Choosing an insurer is a somewhat academic exercise because the day after a trustee buys
a policy issued by its selected insurer:
o The insurer’s business can be sold at any time (including the next day) to a third party
(Part VII)
o e.g. Prudential selling to Rothesay: policyholders’ had no legal voice.
− The insurer can change its mind on any matter:
o Administration service
o ESG standards
− All DD is unenforceable.
Due Diligence
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17. Private
and
Confidential
Let’s be clear:
− Insurance can be better in some cases; and
− Insurance can be worse;
− Insurance carries meaningful, identifiable risks;
− The regulatory environment contains meaningful identifiable risks;
− You are reliant on your advisers to make a balanced case which is correct for your
circumstance.
o There is not an unquestionable default solution for everyone.
Deciding to insure is as complicated a risk decision as is whether to run off.
Summary
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18. Private
and
Confidential
− In what circumstances is a Member better off by being in the PRA regime and what
circumstances is the Member better off staying in tPR regime?
− What are the main risk factors a trustee should consider when looking at a buy-in or buy-
out?
− Why would no other financial entity buy a policy like a trustee is advised to? Why would
an insurer never buy the same policy on trustee terms from another insurer?
− The Insurer’s portfolio (including capital) yields as much as a regular pension fund? Why
is it less risky than the status quo?
− Insurers are incentivised to put as much yield / risk as possible into the portfolio as
shareholder return is driven by the leveraged play on credit spreads. What risk
mitigations are there to the insurer’s commercial incentives?
− Insurers’ capital can be described as an actuarial adjustment caused by the application of
Matching Adjustment. True or false?
Some questions to ask - I
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19. Private
and
Confidential
− How much capital does an insurer actually put into a transaction from its own resources?
− Is it correct that only the PRA sees the insurer’s risk capital model and its internal ratings
model operating?
− Did the November 2022 Solvency UK changes effectively add risk onto pensioners? Is the
regulatory regime subject to political machinations?
− FSCS protection as a concept does not stand up to scrutiny. Discuss.
− What other financial “lender” lends 85% to an entity worth 100% for 50 years, on a non-
transferrable, non-accelerable and unsecured basis whilst allowing the borrower to transfer its
obligations to a third party approved by the High Court (but not by the lender (policyholder))?
Why are Trustees willing to invest on terms on which no other financial entity would?
Some questions to ask - II
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20. Private
and
Confidential
Questions

21. Private
and
Confidential
Dalriada Trustees Limited is a company registered in Northern Ireland with registered number NI 38344 whose registered office is at Linen Loft, 27-37 Adelaide Street, Belfast, BT2 8FE.
VAT number 974 8252 79.
Belfast Birmingham Bristol Glasgow Leeds London Manchester
Linen Loft
27-37 Adelaide Street
Belfast
BT2 8FE
Edmund House
12-22 Newhall Street
Birmingham
B3 3AS
Castlemead
Lower Castle Street
Bristol
BS1 3AG
The Culzean Building
36 Renfield Street
Glasgow
G2 1LU
Princes Exchange
Princes Square
Leeds
LS1 4HY
46 New Broad Street
London
EC2M 1JH
St James Tower
7 Charlotte Street
Manchester
M1 4DZ
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