Insurer of the year: Pension Insurance Corporation

Risk Awards 2020: Innovative regulatory capital bond gives PIC an edge

Rob Sewell

Regulators threw sand in the gears of the booming pensions insurance sector when they pronounced in February 2019 against a favoured type of bond issuance that several insurers had used to raise regulatory capital.

This year Pension Insurance Corporation found a way around that problem, boosting the firm’s capital position by 15 percentage points at a far lower effective cost than the alternative of issuing equity.

The improvement equates to the firm being able to write about £4 billion in new business, estimates PIC’s chief financial officer Rob Sewell: “The nature of our business is that we put money to work up front and get a return over the very long term. This really allows us to invest for the future.”

PIC is part of a fast-growing insurance sub-sector that takes on pension liabilities from corporates either in part, through so-called pension buy-ins, or in full though pension buyouts.

In July, PIC issued £450 million in convertible restricted tier-one (RT1) notes at 7 3/8% in a deal that was three times oversubscribed. The issuance lifted the insurer’s Solvency II regulatory capital ratio from roughly the mid- to upper range in its peer group. The firm’s ratio at mid-year had been 157%. The notes convert into equity in the event that PIC’s regulatory capital falls below required solvency levels.

Europe’s Solvency II regulation requires insurers to hold a buffer of ‘tier one’ capital through equity or equity-like debt to protect policyholders – in this case, pensioners – against market volatility or a big investment loss.

“We target new business based on a pre-tax mid-teens internal rate of return – that’s about 12% post tax,” Sewell says. “That for me is the cost of equity. That’s what the shareholders, current and prospective investors, want to earn over time.” The post-tax 5% or 6% cost of the bond, by comparison, represents “a good equation”, he says.

The bond issuance diversifies the firm’s funding and helps shareholders and bondholders by providing more options to adjust their exposure to PIC as they wish.

Previous regulatory capital bonds from Rothesay Life and Phoenix Life in 2018 qualified for tier one treatment by including a so-called perpetual writedown feature, whereby the bonds would be written down to zero if the company fell below a given solvency level.

But in February, the Prudential Regulation Authority limited the regulatory capital benefit from these bonds after tax authorities ruled the paper would incur a tax charge if written down. The PRA statement effectively killed the market for this type of capital raising by insurers.

We target new business based on a pre-tax mid-teens internal rate of return – that’s about 12% post tax. That for me is the cost of equity

Rob Sewell, PIC

An alternative path to securing restricted tier one treatment – used previously by banks and publicly listed insurers such as Aegon and Direct Line Insurance Group – had been to issue convertible RT1 debt.

But that option had generally been disregarded for private companies because of the complexities of setting a price in a debt-to-equity conversion. PIC chose to take on the conventional wisdom. 

“There were lots of ‘what-if’ scenarios that had to be considered, given these instruments are perpetual in nature,” Sewell says.

What would happen if PIC listed, if it was sold to a listed group or if the insurer listed and then went private again? PIC’s representatives corresponded with regulators about a dozen times over a month in the run-up to the issue date, and the two teams were in daily communication towards the end of that period.

Under the terms of the PIC bonds, if conversion to equity is triggered and the company remains in private ownership, then the bonds would convert to shares issued at a fixed price. If an IPO has taken place, then the debt converts at 70% of the IPO price.

A key part of the approval process was giving comfort to the regulator that the governance and risk framework around the decision to issue the RT1 bond was sound and that the company had fully tested its ability to repay the debt in multiple scenarios, Sewell explains.

PIC has now filled its quota for RT1 issuance, so repeat transactions are unlikely. The deal stands as an “intrinsic part of the capital stack”, though, Sewell says.

Longevity risk

Another way the firm unlocked capital last year, again setting a precedent for the wider industry, was in reinsuring deferred lives. This removes longevity risk from PIC’s regulatory balance sheet arising from pension scheme members that are yet to retire.

It is “much more tricky” than conventional longevity reinsurance, which is limited to existing retirees, Sewell says. The uncertainty about how many customers might die or switch out of a scheme before retiring is harder to model and reinsurers generally are much less willing to take it on. 

PIC addressed that by reinsuring the basis risk of longevity immediately but allowing for the reinsurance to take effect only as pensions come into force. The reinsurance premium adjusts at that time depending on the numbers of policyholders dying or leaving schemes, and any changes in life expectancy.

PIC had done small clips of deferred reinsurance as far back as 2008, but only for over-55s and “immaterial in size as a proportion of schemes”, Sewell says. The firm had never executed trades on the scale of the past year. It reinsured £500 million of this risk in the first half of 2019.

Without reinsurance, the cost of holding risk margin under Solvency II – an additional capital requirement to account for uncertainty around unhedgeable risks – would make some buyout deals prohibitively expensive, Sewell says. With reinsurance in place, the longevity risk adds zero to risk margin.

In investment, meanwhile, PIC invested £2.5 billion in 2018 alone in nearly 40 direct debt investments, including student housing and loans to charities such as the UK’s National Trust, making 18% of its overall investment portfolio.

Here, the firm is cautious. Ninety-eight percent of its fixed-income investments are rated investment grade.

One banker says of the firm’s matching adjustment operation that PIC has been able to “eke out extra basis points [of benefit] everywhere” by operating across multiple asset types as “number one or two in its peer group”.

There were lots of ‘what-if’ scenarios that had to be considered, given these instruments are perpetual in nature

Rob Sewell, PIC

Other insurers have invested more heavily in less run-of-the-mill assets, such as equity release mortgages and ground rents, which have long-term cashflow profiles well-matched to pension liabilities. An aim across the industry has been to source assets that qualify for Solvency II’s matching adjustment, a part of the rules that enables insurers to discount liabilities more favourably if they line up closely with designated asset cashflows.

Some of those efforts, though, have run into difficulty. The PRA recently imposed additional requirements on the inclusion of equity release mortgages in matching adjustment portfolios, for example.

At PIC, equity release mortgages make up less than 1% of the investment portfolio. The insurer does not buy ground rents due to concerns about the rental sector’s sometimes negative publicity.

Rob Groves

In a few cases, PIC has ventured into new areas, making initial investments in lending to local authorities, for example. The insurer has also started to invest in renewable energy projects outside the UK, says Rob Groves, chief investment officer.

Overall, in investment, though, “there’s no secret sauce”, Sewell says. “We’re not doing anything different from anybody else”.

PIC wrote £7.1 billion of new business premiums in 2018 – a record for the firm – and £6 billion in the first half of 2019.

The insurer reported adjusted operating profit for the year to the end of June 2019 of £629 million against £125 million at the same point a year earlier. Market consistent embedded value – a widely used insurance industry metric – climbed £250 million to £3.9 billion over the previous 12 months.

In an industry where volumes are growing but margins are thin, shrewd management of investment, capital and risk combined last year to give PIC a competitive edge.