Life insurers selling higher-risk products like annuities are moving to reinsure or hedge this business outside Europe to soften the impact of new capital rules which could add hundreds of millions of pounds to their costs. The new European rules, known as Solvency II, which come into force in January, will require European insurers to set aside more capital against annuities, which give pensioners a fixed income for life and are considered higher risk because they are long-term products and people are living longer.
But insurers can cut the amount of capital they are required to hold against annuities by reinsuring or hedging the risk. Some companies, such as Legal & General, have already done such reinsurance deals and more are expected. This is expected to benefit insurers in the United States and other countries outside Europe that sell the reinsurance. But it is likely to hit European insurers, given the cost of the reinsurance and, also, when life insurers offload risk via reinsurance this can dent their share of any profits.
"The capital charges are high and that's driven by the credit risk that comes with annuity transactions, as well as by the longevity risk," Michel Abbink, partner in the actuarial services practice at PwC, said. "That has led some insurers to say 'if we want to be competitive in this market, we need to transfer that risk'." Annuities are a major source of income for British insurers such as Legal & General and Prudential, with margins for individual annuities as much as 10 times higher than for more flexible drawdown pensions. Other European countries offering annuities include Germany and the Netherlands.
The threat to profits from Solvency II's higher capital requirements has spurred companies to hedge via reinsurance in the United States or Bermuda, which are not subject to the new European rules. Legal & General has already moved to what it calls a "capital-lite" model using reinsurance deals. Analysts say Prudential and others are doing the same, with several more reinsurance deals expected in the next few months. L&G said in its half-year results it had reinsured 5.4 billion pounds of longevity risk and "selectively used asset reinsurance" in bulk annuity deals it completed in the last 18 months. Insurers do bulk annuities deals to take on the risk of defined benefit, or final salary, pension schemes.
The winners from this are non-European insurers such as US firm Prudential Financial, which recently reinsured the longevity of retirees insured by L&G's bulk annuity business in a $3 billion deal. Around half the $260 billion in bulk annuity and longevity swap deals completed since 2007 in Britain, the US and Canada was reinsured, Amy Kessler, head of longevity reinsurance in the retirement division of Prudential Financial, said.
"We expect to see this trend continue to grow because this is sensible profitable business for life companies to write." The new strategy has also been a boon for the banking and legal firms which advise insurers. "We are working on several very high value transactions involving EU life insurers reinsuring annuity business to reinsurers outside Europe," Martin Membery, partner at law firm Sidley Austin, said.
Europe's new capital rules have even pushed Prudential to consider moving its headquarters from Britain, according to a Sunday Times report this week. Prudential said it regularly looked at the structure of its business, when contacted by Reuters. Britain's largest insurer said in its annual report that a 10 percent increase in capital requirements for its UK annuity business would cut its capital surplus by 600 million pounds($916.20 million). Barrie Cornes, analyst at Panmure Gordon, said a 23 percent drop in UK life insurance shares since March was partly a result of uncertainty about the impact of Solvency II. The exact increase in costs from the new rules is still unclear as big insurers await approval of "internal models" of financial strength. Britain is one of the world's most sophisticated markets for bulk annuities. Sales of individual and bulk annuities in Britain alone came to around 20 billion pounds last year, including a record 13 billion in bulk annuity deals.
But this market is becoming more competitive, which means insurers have to bear any extra costs themselves, rather than passing it on to pensioners. Another way to cope with the Solvency II capital costs is to do bulk annuity deals outside the European Union. The US market is attractive as it is less mature and still only around one-third of the size of the British market.
"The US bulk annuity market is potentially similar in size to the UK market, has little inflation linkage, and is likely to be outside the scope of Solvency II," BoAML analysts said in a client note. L&G America last week completed its first US bulk annuity deal, for part of the pension scheme of the US subsidiary of Royal Philips. Chief executive Nigel Wilson said L&G planned to be a "major participant" in this market.
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