Bulk annuity contracts: Thinking about risks in risk transfer
A bulk annuity transaction is a transaction about risk. Funding and administering a DB pension scheme involves lots of risks. A bulk annuity transaction looks to transfer some of those risks from the scheme and its sponsor to an insurer. The key word here is “some”. A common assumption is that all risks must transfer. The insurer position is more nuanced. Just as the Lord of the Ring’s Gandalf is neither late nor early, but arrives precisely when he means to, an insurer’s goal in a buy-in or buy-out is to take on precisely those risks that they intend. As is often the case, the more nuanced position is the better description of what’s happening legally. A successful buy-out or buy-in shouldn’t be judged by whether all risks pass to an insurer. In practice, the most important and material risks will pass, but the transfer of all risks is never achieved and should not be the aspiration.
A bulk annuity contract (whether a buy-in or a buy-out) is intended to track very closely the benefits of the scheme being secured. It is tempting to get into the habit of talking about the insurer “securing the benefit”, but in practice the insurer will take on the liabilities as a body of administrative data, interpreted by a short benefit specification. The insurer does not adopt the scheme’s trust documentation, nor, in a typical transaction, will it accept responsibility for errors in scheme data.
There are several ways discrepancies might arise as between what is insured and the scheme benefit. The trustee may be forced to simplify or crystallise benefit features. For example, unusual increase rules may be impractical or very difficult for the insurer to price or administer, discretionary benefit rules can cause problems if the insurer is not willing to make the necessary decisions, or, if a long term buy-in is contemplated, the trustee may choose to simplify or take a view on a particular issue. These changes need careful consideration.
Then there is the possibility of error. It could emerge that the administrative record failed to include the details of a member entitled to a pension or that the data record reflected an incorrect final salary figure or there could also be errors in the scheme rules. In these cases, the insurer’s obligation would be to pay the benefit in accordance with the data and specification supplied to it. A member, unable to recover the correct benefit from the insurer, would naturally turn to the trustee and employer.
Careful preparation is the best mitigation to these sorts of risks. For a well-run scheme that has gone through a sensible process in preparing its data and specification, these risks should by their nature be low. In some cases, and for an additional premium, certain heads of residual risks can also be secured.
As residual risks cover involves the insurer taking on more risks, this typically means more due diligence and the approach to this needs careful thought. Importantly, bulk annuity providers are currently not writing general insurance policies aimed at covering risks particular to the trustees themselves (as opposed to the members), meaning that a claim brought against the trustee in relation to trustee conduct or decision-making would fall outside the scope of a bulk annuity policy. An important consideration in relation to this is costs and expenses. While a scheme is ongoing, the trustee’s expenses in defending a claim brought against them would usually be indemnified from scheme assets. After the scheme is wound-up, that layer of protection falls away. Not only should the trustee be considering how to put members right in relation to residual categories of risk, but they must also consider their own practical position were any claim brought.
Those wanting to hear more on this subject may wish to attend our next seminar “Buy-ins and Buy-outs – how to transfer risk successfully” on 21 September 2021, in which we will reflect on some knottier aspects of buy-in and buy-out transactions, including deal preparation, benefit specification due diligence, residual risks and trustee protections. For details and to sign-up, visit the events page of our website.
We will return to residual risks further in our December finance & investment briefing.