DB pensions: 

Private assets and preparing
for an insurance buyout 

Continuing our spotlight series on risk transfer and insurance.

Defined benefit (DB) pension schemes’ asset allocations to private/illiquid assets have been prevalent in the news in 2024. Pension schemes have invested substantially in recent years in asset classes such as private equity, property and various forms of private debt such as real estate debt, infrastructure debt and direct corporate lending. Numbers in the Pension Protection Fund’s (PPF) Purple Book imply the aggregate holdings in these asset classes across the private sector pension scheme universe is around £250bn. 

The basic rationale for investing in these assets is that the pension scheme, as a long-term investor with largely illiquid liabilities, can monetise some of their asset liquidity by shifting some liquid assets into illiquid assets, thereby earning an illiquidity premium.  

The costs of liquidating illiquid assets can be high, but this is justified where the scheme expects to hold the assets for a long time. However, in the last couple of years some pension schemes have encountered situations where they need to liquidate their illiquid assets. For example, strong performance of the private asset classes relative to their liquid asset holdings can create a requirement to rebalance the portfolio back within target asset allocation ranges. More notably, the September 2022 gilt crisis highlighted that some pension schemes may need more asset liquidity than they had previously budgeted for.  

Perhaps the biggest prompt for pension schemes to consider liquidating private asset holdings is that the scheme is preparing for an insurance buyout – and buyout insurers have quite limited appetite to receive these types of assets as part of their insurance premium. So, schemes that have seen their timeline for funding a buyout accelerate forward by a number of years due to rises in long-term interest rate may seek investors in the secondary market who are interested in their private assets. 

Buyout insurers
and private assets 

When we work with schemes contemplating buyout who have illiquid holdings, we first look for solutions outside of the insurance contract – working with the sponsoring employer to trade the asset onto their balance sheet, structuring a loan against the asset, or approaching secondary market buyers. 

Before liquidating their private assets, however, schemes should appreciate that whilst buyout insurers’ appetite to receive private assets as part of a buyout insurance premium is limited, it isn’t necessarily zero. And in the highly competitive bulk annuity market, insurers may be increasingly flexible, especially in the larger transactions where private assets may be more prominent in schemes’ asset strategies.  

Bulk annuity insurance firms can digest private assets in various ways: 

  • Insurers already have significant allocations to private assets in their asset portfolios. In ideal circumstances, the private assets of the scheme could simply be incorporated into the existing private asset portfolio of the insurer. However, this may not be as easy as it sounds. The assets that are held to back buyout insurers’ liabilities are subject to a lot of regulatory constraints (the Matching Adjustment (MA)) and supervisory scrutiny by the PRA. Whilst these constraints are being loosened somewhat by incoming insurance regulatory reforms (Solvency UK), private assets will still need to meet some demanding eligibility criteria to be held in the asset portfolios backing insurance reserves. 
  • However, insurers hold capital well in excess of those required to meet current policyholder reserves. The insurer could opt to hold the private assets in those shareholder funds, which are not subject to the MA asset eligibility rules. They will have limited appetite for this though, as the assets will still generate regulatory capital requirements and won’t generate the regulatory MA benefit that is obtained when they are held in the asset portfolio backing policyholder reserves. 
  • There is also a hybrid approach to allocating private assets between policyholder and shareholder funds – the assets can be re-structured by the insurer to create a less risky piece that can meet MA eligibility rules and hence can go in the assets backing reserves and generate MA benefit; and a riskier piece that can go in the shareholder fund. This approach creates some complexity and cost but it is an increasingly well-trodden path for insurers.  
  • Insurers may accept private assets as part of the buyout premium when it has no intention of retaining the assets – in a highly competitive bulk annuity bidding process, the insurer may accept the role of liquidating the assets as part of the cost of doing business. However, pension scheme trustees should be aware that insurers are likely to apply a significant discount to the net-asset-value in this circumstance.  

Some of these options may also interact with the insurer’s reinsurance strategy. If the insurer is using a funded reinsurance strategy in the transaction, this could create some additional flexibility if the reinsurer is willing to accept some forms of private assets as part of their reinsurance premium.  

Additionally, even in cases where the insurer is not willing to accept the private assets as part of their insurance premium, they may offer some other forms of flexibility. In particular, the bulk annuity transaction could be structured such that a part of the premium is deferred for a period (say, two or three years). This would allow the pension scheme to execute the buyout transaction today, whilst providing time for the scheme to liquidate the private assets in an orderly and cost-effective fashion. As ever, there is a catch - the insurer’s appetite for the use of deferred premium is likely to be quite limited, as a deferred premium also defers the recognition of the regulatory MA benefit. This will have a negative impact on the capital efficiency of the deal that will probably need to be recognised in the buyout pricing terms. 

Finally, it is also possible for insurers to offer a mixture of the approaches outlined above. A deferred premium with an agreed ‘backstop’ price for the asset gives trustees the flexibility to sell the asset over the deferred premium period with the knowledge that if an attractive price cannot be found, the insurer has agreed to take the asset at a pre-agreed minimum price. Again, this approach brings some risks and costs for insurers that will very likely be reflected in the pricing terms.  

Further potential investment
flexibility could arrive in a ‘sandbox’ 

Insurers appetite for the above approaches to private assets has changed significantly over the last couple of years or so. This leads to a natural question - should we expect this private asset flexibility to increase even further in the future?  

We think this is certainly plausible. We briefly noted above that a Solvency UK regulatory reform program is currently underway - these reforms include an objective of providing greater investment flexibility in insurer’s Matching Adjustment (MA) portfolios. New rules will come into force in this area on 30 June. However, there is a general expectation that these reforms will have quite a marginal impact on insurers’ asset allocations.  

A more substantive impact may arise from another reform idea that is currently gaining some traction - the ‘sandbox’. In recent months, insurers have argued that the sandbox idea – where, say, 10% of the asset portfolio would be exempt from most of the usual MA eligibility rules – could better allow them to meet the government’s policy objective for these portfolios to have higher allocations to UK productive assets, such as infrastructure.  

The PRA has recently announced that it has established a Subject Expert Group (SEG) to investigate the sandbox policy idea. This signals that the PRA is taking the sandbox idea seriously. If the MA sandbox were to become policy, this could potentially allow a much wider spectrum of pension schemes’ private asset portfolios to be accepted by insurers as part of the buyout premium (though of course the insurer and pension scheme would still need to agree on valuations following due diligence, etc.) 

asset strategies 

The above discussion highlights that insurers may increasingly offer various forms of flexibility when working with pension schemes that hold significant private asset portfolios. This should be borne in mind by pension schemes when they consider just what a buyout-ready asset strategy looks like.  

It is also important to understand that different insurers may have markedly different appetites for different types of private assets. For example, new entrants to the bulk annuity market may not yet have the MA approvals that are important to holding potentially MA-eligible private assets in their asset portfolios. On the other hand, some new entrants to the bulk annuity insurance market may emerge that are backed by asset management firms whom have significant private asset capabilities. In such cases, the insurer may be able to offer a joined-up approach where other parts of their group stand ready to acquire the private assets from the pension scheme. 

The key point that emerges from the above discussion is that the evolution of a pension scheme’s asset strategy in preparation for buyout should be done with an understanding of what flexibility insurers may be able to offer and at what cost it is likely to be available. This is a complex and continually-evolving aspect of the buyout market that, in our experience, can have an increasingly significant impact on buyout transactions and their terms. We have extensive experience of working with schemes to dispose of their illiquid assets before a buyout transaction and of working with insurers on transactions involving illiquid assets.

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