No such thing as a safety net

The booming buyout market has been one of the most visible effects of increased risk awareness among pension schemes and their sponsors. Nowhere has this been more prevalent than the UK, where the market was expected to quadruple to over £10bn in 2008.

Longevity and inflation issues affect pensions globally, however, and have been responsible for schemes offloading their liabilities to insurance companies in an ever-increasing number of countries.

But September's news of large-scale, previously unthinkable, financial blow-ups has forced counterparty risk further up the agenda.

Faced with an increased threat of insurer insolvency, questions are being asked about exactly what risks buyouts themselves entail and whether schemes can ever truly finalise their liability.

"Just because a scheme is insured, doesn't mean it is fully guaranteed," Andrew Ward, consultant in Mercer's financial strategy group, warned. "As we've seen, many large names in the financial industry that were considered to be secure have run into trouble. Trustees need to be aware that buyouts are not a completely risk-free route."

Counterparty risk has become a catch-word in financial markets, which Christopher Clayton, managing director at Close Brothers, said was equally true of insurers. "The events of the last few months have made a big difference," he said. "Until recently, there was a sense that schemes could get several quotes and select the cheapest, but the process has become much more complicated."

Dan DeKeizer, CEO of MetLife, agreed, saying: "Schemes' understanding of insurance companies' capital position is fundamental. If they are transferring risk for 50 years they need to work with a company with demonstrated solvency." No guarantees

A year ago, however, few would have predicted the problems of AIG. So how can trustees be sure an insurance company will exist in the long term? "The short answer is they can't," Clayton said.

"Some of the certainties that people felt they had in the financial markets are going to be severely questioned over the next year to 18 months. The trick is to understand not only the history of an insurer, but also what other risks they are taking, their capital structure and the regulatory environment," he said.

Schemes also need to be aware of insurers' underlying counterparty exposure. Insurance companies derisk their own liabilities using longevity swaps, for example, which spread risk across the broader insurance market. "When schemes pass their liabilities to an insurer, they are passing the risk to other insurance names at the same time," Clayton warned. "The banking crisis has already revealed the dangers of compound counterparty risk."

But, as the wider economy weakened and a prolonged, deep recession became more likely, schemes were left pondering the relative merits of their own sponsor covenant versus that of an insurance company.

Hugo James, sales development director for Legal & General's bulk annuity business, believed insurance companies were relatively safe, requiring an extreme change, such as a very large overnight jump in life expectancy, to come under threat.

"Insurers are better placed to survive market shocks than many sponsor companies. Very few corporates have AA+ ratings, so trustees are usually trading up the credit covenant ladder by going to buyout," he argued.

Because insurance companies are legally required to hold more capital, DeKeizer believed the impact of the credit crisis was predominantly emotional. "By going to buyout, schemes are benefiting from higher capital reserves and other fail-safes, such as the UK's Financial Services Compensation Scheme (FSCS), and are therefore gaining protections."

Questions have been raised, however, over the validity of some regulatory failsafes. In the UK, for example, the Financial Services Authority (FSA) was facing increasing pressure to clarify whether the FSCS would apply to all schemes that had undergone a buyout.

Ward believed this was crucial to weighing up the relative benefits of sponsor versus insurer.

"In the pensions arena, we are fairly comfortable with how the Pension Protection Fund works and its funding status. However, the FSCS is not funded and the FSA would be looking to other insurers to bail out any failures at a time when balance sheets are weaker generally. This system is also untested and there is less certainty about how it would operate in the event of insurer insolvency."

In theory, if a company remains solvent, but has sold out to an insurer that then goes bust, the liabilities should transfer to the FSCS.

"It is not certain if the FSA will honour this, which is potentially a big risk," Matthew Furniss, senior consultant at Punter Southall, said. "This was a concern before September, but the events of that month have exaggerated its importance as people realised any type of company can go bust."

Pricing

The decision process has been further complicated by an increase in the price of buyouts in recent months.

"Buyouts have already become more expensive," Clayton said. "The peak time from a trustee's perspective would have been early 2008. Costs have gone up partly because some providers were pricing their products to go."

Faced with a tougher capital-raising environment, buyout providers would likely have to improve returns for their backers. "A year ago, there was more capital than good investment opportunities," Clayton argued. "That has now changed and while buyout returns are still above cash, they may not be as good as elsewhere."

Ward argued: "Some buyout business has been written using marketing budgets, but I personally don't believe that prices are likely to increase massively as enough capital still exists to write more business. There may be marginal upward pressure, but not the significant leaps that are being talked about."

Some experts argued widening credit spreads already improved the rate of return and could decrease the price of buyouts further.

Stephen White, head of pensions and investment at Buck Consultants in London, argued, however: "It is tempting to assume that widening spreads would lead to lower prices, but the default rates on the underlying corporate bonds are also higher, which has to be priced in."

Ward believed many providers were currently reviewing pricing models to account for higher default rates. For some, the effects of market uncertainty were more severe: "Due to the extreme events, some insurers are not giving guaranteed quotes, or are not providing quotes at all, until things have calmed down a little."

Although interest rate and spread fluctuation has led to some price moves, DeKeizer said this would be paralleled by changes in schemes' assets. "Prices are based on a long term view of risk and the cost of capital," he said. "The ratio of funding levels to cost of buyout should be fairly stable."

But not everyone agreed. Many schemes, particularly those with high exposure to equities, would find buyouts more expensive as asset values had fallen.

According to White: "Asset values are lower, so many schemes can no longer afford buyouts. The impact of the credit crunch on the general economic outlook is more serious than a few weeks ago and the probability of recession is higher. As a result, sponsor companies will be pressed to come up with the extra millions they would have needed to secure buyouts given weaker trading and tougher corporate banking conditions."

On the other hand, Ward argued, market shocks have hammered home the question of why companies are running such huge pension risks, which can damage profitability and, in extreme cases, threaten the solvency of otherwise viable and successful businesses.

Clayton said: "Although things will be more challenging over the next year, the buyout market will continue to grow. Most companies are looking for finality to pension scheme risk and the value of this has been underestimated." The extent to which buyouts actually represent finality has come increasingly under debate, however.

"Schemes need to consider that if something went wrong and the decision to go to buyout ended up costing members money, they could potentially face litigation. Trustee liabilities could, therefore, still remain long after the transaction completed," DeKeizer warned.

"Trustees need to be sure they have done good due diligence, sought good advice and the process is well documented to protect themselves from that eventuality," he said. Ward believed reputational risk and an increasing litigation threat was already becoming more prominent, as evidenced by the growing popularity of indemnity insurance.

"These issues are arguably more important for the sponsor though," Ward said. "The company will most likely continue trading after a buyout. Its brand name will be one of its most important assets, which it will be keen to protect. They may also still have active members, which creates a human resources angle."

Ward believed a situation could arise in which, even if a buyout transaction had been completed entirely honourably, but the insurer became insolvent, there may be sufficient pressure for a corporate to make additional contributions.

"The buyout decision has become much more complicated as a result of recent market turmoil," Clayton said. "As counterparty risk has increased, the need for more thorough due diligence and quality advice has grown significantly.

"Full buyout has been considered the gold standard, but not all gold is the same quality."