Insurer annuity pricing & solvency – the impact of COVID-19
Plan Sponsors embarking on an annuity purchase face additional uncertainty and risks due to the impact of COVID-19. Transactions will continue, but awareness of market conditions and performing due diligence of insurance providers takes on additional importance.
Over the last decade, de-risking a pension plan through the use of an annuity buyout has become prevalent. In 2014, total buyout sales were under $10B; in 2019 they had skyrocketed to $28B. Plan sponsors that have offloaded liabilities to insurers through this strategy have saved on administrative costs and lowered funded status risk. In addition to buyouts as a de-risking strategy, there has also been an uptick in the number of plan terminations which ultimately end in a buyout contract. It’s clear that annuity buyouts have served as a valuable strategy for pension plan sponsors.
But in the current COVID-19 world, are annuity buyouts still a good idea? The short answer is yes! However, given the market conditions we’re facing today and the strains that are felt throughout the economy and especially the financial services market, it’s imperative that plan sponsors approach a potential buyout (for de-risking or plan termination) with extra diligence. The diligence revolves primarily around two facets: pricing and insurer solvency. We’ve tackled both of those topics in depth in the sections that follow. The two key points are:
- Pricing: Interest rates are currently quite volatile. Typically, sponsors compare accounting liabilities to buy out prices to determine the cost/benefit trade off of purchasing a group annuity. The daily change in the various elements of rates (duration, yield, credit spreads etc.) need to be closely monitored to assure the analysis is accurate.
- The insurers that provide group annuities are all high quality. However, how they invest their capital and their exposure to the markets vary. Up to date analysis on quality is imperative.
Plan sponsors need to work with an annuity placement specialist that can help make sense of the day-to-day changes in the markets to ensure that they receive optimal pricing for their buyout along with the peace of mind that their fiduciary obligations under DOL 95-1 (the standard by which plan sponsors need to evaluate insurers) have been met.
Impact on Insurer Pricing
Liability Values and Annuity Purchase Prices are Very Volatile
The amount insurers charge to take on pension liabilities is determined by the yield on bonds that they can purchase in the market place. The price will move, just like pension accounting liabilities, as these yields oscillate. The onset of the COVID-19 pandemic has seen record volatility in bond markets, with the Federal Reserve cutting rates to near zero, long US Treasury yields falling dramatically and credit spreads widening. The overall yield, and thus the premiums insurers quote in absolute terms, are changing day-by-day with weekly 1% moves the new norm. Such yield changes have given rise to annuity price or accounting liability changes of 10-15% in a week.
How do annuity purchase costs now compare to accounting liabilities?
The past few years have seen typical annuity purchase costs for retirees come in at around 100% of accounting liabilities for plans that use up-to-date mortality tables and discount rates based on realistic bond yields. Many plans have also used LDI investments as a way to hedge the accounting liability or termination cost. It’s this relative price between annuity purchase costs and accounting costs or the value of LDI assets that is of more relevance to plan sponsors.
Current market conditions make this relative cost more uncertain. The factors described below could make annuity pricing relatively more or less attractive. However, on balance in the near term, we expect slightly higher annuity purchase prices compared to accounting values.
- Downgrade risk (increases prices). Credit spreads (the yield difference between corporate bonds and US Treasuries) are at elevated levels which pushes accounting liabilities down. High spreads reflect fears that the coming recession will cause investment grade companies to be downgraded, or even default. However, if the insurers choose not to buy some of these bonds due to these very reasonable fears, the price they are able to quote at will likely be higher than the value of liabilities on an accounting basis. Additionally, the constructed yield curve used to measure pension liabilities would exclude those bonds that are downgraded but those bonds may still be in the LDI funds used in a plan’s portfolio. Also, this mismatch will lend itself to differences in the relative price of the annuity purchase to the accounting liability and the LDI assets.
- Illiquid markets (increases prices). It has been challenging to actually buy or sell traded corporate bonds in the current environment. Transaction costs have increased. Many private debt transactions about to close will be on hold (e.g. consider a loan to a shopping mall, hotel or office!). Recent interventions by the Federal Reserve have helped, but insurance companies will be demanding a greater margin of error in pricing in these conditions.
- Potential for change in insurer appetite (increases/decreases prices). Current conditions may cause some insurers to be less aggressive, or step away from the market entirely. We are yet to see any evidence of this and it is very early days but it is a possibility over the rest of the year. However, if there are fewer transactions brought to market in the first nine months of 2020, it could increase the insurers’ appetites in an effort to reach year-end sales targets.
- Cheap assets (decreases prices). With financial market distress comes opportunity. As was the case coming out of the 2008 financial crisis, there will be high quality assets that look cheap and it is quite possible insurers will choose to buy these and offer better pricing than expected at certain times over the rest of the year. With this we expect that there will be a greater dispersion of bids between insurers.
Will COVID-19 affect insurer mortality rate assumptions?
The short answer is that we do not expect insurers to change their underlying mortality assumptions to account for the COVID-19 related deaths.
Should I defer my annuity purchase transaction in these conditions?
There are many considerations that could cause a sponsor to re-think an annuity purchase in the current climate. However, focusing on pricing alone relative to accounting liabilities, it is not clear that pricing will improve over the year, or even beyond that. If we do see downgrades and defaults in corporate bonds, as is highly likely and is already happening, accounting liabilities will increase and come into line with insurer pricing. Essentially, accounting liabilities do not yet reflect the ‘hit’ due to deteriorating economic conditions that insurers should already be allowing for.
Timing will be everything in deciding whether to execute an annuity purchase transaction. If a company is considering an annuity purchase for de-risking purposes or a plan termination, having some flexibility with when to implement will be key to optimizing the outcome.
Will Insurers Remain Solvent?
Insurers participating the pension risk transfer (“PRT”) market start from a strong position. They are heavily regulated companies that maintain a significant buffer of assets to weather the economic storm that is coming. They are not leveraged in the same extent as the banking sector.
Impact of death claims not material
Most PRT providers offer life insurance policies which will experience higher payouts due to deaths associated with COVID-19. The good news here is that the number of deaths in the insured population, which is typically 35-65 year olds, is expected to be manageable provided the virus is not left to propagate completely uncontrolled (a much more severe impact is expected on providers of Health Insurance). The virus has a higher mortality rate in old age so there may be, sadly, some benefit to insurers with large annuity books who no longer have to pay out annuities to these individuals.
“Pandemic risk” is a scenario that all insurers offering life insurance policies plan for, typically with a death rate higher than COVID-19. In addition, insurers generally re-insure this risk away meaning that they will not experience the full force of any claims on their balance sheets beyond a certain level.
For completeness, it should be noted that the insurance industry as a whole writes business interruption cover that could suffer larger losses as a result of the shutdown. Such policies are not written directly in the life and annuity companies that offer annuities, so should not impact their solvency, but some insurers will have affiliates with this exposure. Pandemic events are generally excluded from such policy terms, but state legislators have, in late March, passed laws to oblige insurers to pay out COVID19 related policy claims retroactively. The losses here for the insurance industry are potentially vast if this principle is extended to larger companies and it is likely the Federal Government would provide some kind of support if such losses are essentially mandated by a change to law.
The primary risk to life and annuity providers is the economic impact of the pandemic….
The high likelihood of a deep recession
Despite global fiscal and monetary intervention, a deep recession is likely already underway. It remains highly uncertain how quickly economic activity will resume to normal.
The majority of insurance company failures have arisen due to losses incurred on investment portfolios. Although the quality of insurers’ portfolios is high with relatively few equities, insurers are exposed to higher quality investment grade bonds being downgraded to sub-investment grade or ‘junk’ status. A recent example was Ford Motor Company, which was downgraded by S&P on March 25th. This represents one of the largest downgrades from investment grade, by value of debt, in history. Although Ford may not necessarily default on its debt, an insurer holding bonds issued by Ford may be effectively forced to sell them due to policy constraints or other covenants, realizing losses, or have to hold more capital against them worsening solvency.
Concerns around the impact of a recession on the insurers’ portfolios, and the impact on profits of a persistently low interest rate environment, have driven the share prices of listed insurers drastically down in March:
Any insurer can fail, but it is reassuring that all companies active in the PRT market have books of business that have been in force for many years with a degree of ‘seasoning’. A hypothetical insurer that started from scratch in the past few years, would be much more vulnerable to a recession as the bond portfolio would entirely consist of assets bought at low yields which are now not sufficient compensation for risks ahead.
What action should plan sponsors take?
Sponsors undertaking an annuity transaction can take heart in that all insurers active in the PRT market, at the time of writing, are still very likely to remain solvent and meet their obligations to make payments. The security of participant benefits is still likely to remain higher in an insurance company, with associated guarantees, than it is in any pension plan. In addition, if there is a higher relative cost of placing an annuity with an insurer this may not be ‘real’ in that holding the liability, with matching bonds, in the plan may eventually lead to losses that match this higher perceived cost.
In a recessionary environment it is critical that plan fiduciaries are aware of the risks and undertake due diligence on insurance companies. Fiduciaries are encouraged by Department of Labor Bulletin 95-1 to select the “safest annuity available” and to “conduct an objective, thorough, and analytical search“.
The majority of data available on insurers is only availably annually, i.e. before the impact of COVID-19, so it is essential for your provider to have a deep understanding of how the insurers will be affected. Going beyond standard credit due diligence, for example, assessing insurers’ ability to service participants off site in a disaster environment, also takes on particular importance in these times.
Given the current market environment, plan sponsors need to have an annuity placement specialist that can help them make sense of the current market pricing for annuity buyouts as well as provide fiduciary cover under DOL 95-1. Because pricing and insurer solvency concerns are in a constant state of flux, the right specialist will have a rigorous process for looking at how the markets are affecting the insurers and their ability to provide the safest available annuity.
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