UK life insurer stocks are being pressured by moves in the gilt market, mainly by the speed of the market moves and the potential of short-term collateral calls required by derivatives, even though hedges and derivatives appear to be performing as expected.
According to a recent report by Goldman Sachs analysts, insurers and pension funds use a significant amount of derivatives and hedging to ensure they match their assets to their long-term liabilities. The liabilities are typically long duration and the sector will use interest rate swaps to match the duration of their assets to liabilities.
The LDI market (liability driven investment market) is a product specifically designed for pension companies where the assets managed by the fund manager, not by an insurer, are designed to perfectly match the liabilities of the pension fund and for the assets to move in exactly the same manner as the liabilities as macro impacts change, explain analysts.
Combinations of fixed income assets cannot exactly mirror a pension fund liability and hence derivatives are used.
Aon estimates that a £1bn pension scheme would require c.£200mn in additional collateral (c.£2mn for every 1bp move in Gilts). Given the total size of the UK pension liabilities (£1.8tn as of December 2021 according to the Pension Protection Fund), this would imply up to c.£360bn of collateral calls for a 100bp move in yields.
If the hedges were done via cleared swaps, it is our understanding that the collateral needs to be in cash and hence the pension funds would need to sell assets to fulfil these collateral calls. Furthermore, this applies to pooled LDI mandates (typically smaller pension funds).
Larger pension funds typically have segregated accounts, and segregated LDI mandates can use the actual securities as collateral and hence are not forced to sell assets.
This is similar to insurers who can also use the actual underlying debt instrument as collateral and are likewise not forced to sell. Moreover, in such an instance, as the liabilities would also fall by a similar amount, the pension funds would technically have the ability to sell the assets and meet the collateral calls, and indeed this has been happening gradually through the year; however, the near-term pressure appears to be coming from the speed of the market moves and the immediate collateral calls.
This is a liquidity issue, not a funding issue, analysts concluded. They believe that insurers with much higher capital standards (Solvency II) and buffers should find it easier to post collateral. Additionally, as companies test for these shocks and should have been fully prepared, they do not expect that listed insurers will face issues with meeting collateral requirements.
Regarding how this affects the bulk annuity market, the current market conditions are quite favourable for it.
They believe that the current market volatility may temporarily slow the market as neither insurance companies nor pension funds / pension trustees would want to execute in this environment.
Despite this, theta have also come to the conclusion that the current macro conditions (higher interest rates / wider credit spreads) combined with the recent volatility will drive the market to record levels in 2023.
The current experience of pension funds is likely to encourage them to fully de-risk and pass on the liabilities to an insurer. LDI is typically the first step to a buy-out (hedging the asset side of the pension fund) and hence the pension funds under most pressure from collateral calls at the moment are potentially the best placed to execute on a pension buy-out/buy-in (bulk annuity).
The analysis follows the Bank of England’s decision to purchase long-dated government bonds in order to calm the market, which was in response to the pound falling to an all-time low against the US dollar on the back of fiscal measures announced by the UK government.