Innovation in the bulk annuity market

This included the dependency on reinsurance for both backbooks and new business and the matching adjustment.

The market responded to these problems by innovating and identifying pragmatic solutions in relatively short timescales. So now that we have emerged from the shadow of Solvency II, how has this innovation manifested itself?

Reinsurance dependency

Solvency II generally penalises an annuity provider for holding naked longevity risk and reinsurance has therefore become an integral part of any reasonably sized annuity transaction.  

Innovation is rife and, notwithstanding Brexit, 2016-17 promises to be an exciting time for the market

However, the need for new business reinsurance presents potentially significant timetable challenges for the underlying annuity transaction, which is market sensitive and often has to be transacted in relatively short timescales.

This challenge has driven ever closer relationships between annuity providers and reinsurers as they look to streamline the new business reinsurance process.  

Many annuity providers have in place ‘agreed common terms’ with reinsurers, which allow new reinsurance deals to be concluded in a matter of weeks.  

Indeed, some annuity providers are going a step further and looking at arrangements whereby annuity transactions, once written, are automatically ceded to one or more reinsurers on pre-agreed terms.  

Such an arrangement is not, of itself, new (it is widely used in other insurance markets, such as term assurance). However, it should deliver real efficiency to transactions in the annuity market.

Separately, annuity providers are also currently considering ‘funded’ or ‘asset’ reinsurance solutions, which are attractive under Solvency II. These are typically written through reinsurers based in jurisdictions outside of the European Economic Area (eg US or Bermuda) and, whilst they pose a number of technical challenges, represent an exciting development in the market.

Gap policies

Solvency II – and more particularly Article 77b(1) of the directive relating to the matching adjustment – is allergic to optionality in annuity contracts. ‘Surrender options’ are a good example of this and are a common feature of large-scale bulk annuity transactions.  

If, for example, an insurer has agreed a surrender option exercisable by the trustee in an annuity contract and the agreed value to be returned to the trustee on termination exceeds technical provisions, then, under Solvency II the existence of this surrender option potentially invalidates the whole annuity contract from qualifying for the matching adjustment.  

The second half of 2015 saw many annuity providers engaging with the Prudential Regulatory Authority on this issue in the context of their matching adjustment applications, which led to the renegotiation of a number of existing backbook transactions.  

Solutions to the problem vary, but a growing theme in the annuity market is the use of ‘gap policies’ issued alongside the principal annuity contract.  

The term itself has no particular legal meaning (a gap policy could be a deed of indemnity or a policy of insurance, depending on the circumstances). However, in respect of a surrender value, the purpose of it is to remove from the principal annuity policy the excess value above technical provisions that falls foul of Article 77b(1).  

Accordingly, the principal annuity contract remains compliant with the matching adjustment rules and will therefore sit within the matching adjustment fund; the gap policy (covering only the excess) will not be matching adjustment-eligible and will therefore sit apart in the non-matching adjustment fund.  

Although it would be an exaggeration to say gap policies are commonplace in the market, they are likely to be a point of discussion in most large-scale bulk annuity transactions being undertaken currently.

These are two examples of innovation in the bulk annuity market. We could have covered many more. Innovation is rife and, notwithstanding Brexit, 2016-17 promises to be an exciting time for the market.

James Parker is a partner in the financial services team and co-head of the pensions, life and longevity team at CMS. Peter Coyne is a partner in the pensions team and Mark Jenkins is a senior associate in the pensions team