The fall-out from coronavirus could leave the life insurance sector uniquely exposed due to life insurance firms’ reliance on matching adjustment which critics say creates “phantom capital”.
The matching adjustment allows life insurance companies to discount their pension liabilities by more than the risk-free rate, which in effect creates artificial capital, according to professor of economics Kevin Dowd from Durham University.
The risk-free rate is any interest rate on an asset that has little or no risk of default attached. It usually refers to gilts or sovereign bonds of high quality.
As the pandemic continues to hit markets, corporate collapses could see firms unable to pay their pension obligations – putting life insurance companies at risk, says Dean Buckner, formerly a technical specialist at the regulatory body, the Prudential Regulation Authority (PRA).
“If this crisis continues, there will be corporate collapses, he says. “We could see a lot more defaults,” says Buckner.
“So, this whole crisis is leading to challenge the basic assumption behind matching adjustment, which is that in the long run, it’s all perfectly safe,” he says.
Dowd believes there is now a “systemic solvency problem” amongst life insurance providers that could be exposed should corporate collapses ensue.
“It could lead to companies becoming insolvent or being revealed to be insolvent, leaving aside that many of them already are insolvent when you strip out the phantom capital,” Dowd says.
Steve Baker MP, who sat on the Treasury Select Committee during the previous parliament, believes the PRA must elaborate on the matching adjustment and explain to the Treasury Select Committee why the matching adjustment is permitted.
“As someone looking forward to returning to the Treasury Select Committee, I know we have much to do. I’m really looking forward to seeing the PRA and grilling them on this crucial issue of the matching adjustment. If Kevin Dowd is right, it could well be that this judgement-led facility to use matching adjustment is propping up firms which might be otherwise insolvent. We really need to get to the bottom of this alarming problem. If Dowd is right, we’ve got a serious issue on our hands,” Baker says.
What is the matching adjustment?
A safe method of backing pension liabilities is to invest in very low risk or risk-free assets such as government bonds. Then one can discount their liabilities by the risk-free rate because that shows the amount of assets needed to inoculate the pension portfolio from any losses.
The PRA allows life insurers to discount by more than the risk-free rate on the assumption that if they invest in higher yielding assets, such as corporate bonds, then those will grow faster than the risk-free rate because they’re high yielding. Then, they will be able to meet their pension obligations in that way.
Therefore, insurers can lower the amount of liability they have on the assumption that their high yielding assets are as risk free as a government bond.
That means life insurers can discount their liabilities at a greater rate meaning that liabilities fall in value, and that creates capital. Capital is the present value of assets minus the present value of liabilities. If a life insurer reduces the value of liabilities, all things being the same, they’ve increased the amount of capital.
This creates, as Dowd calls it, “phantom capital”.
“So, if your brain is hurting, that means you’ve understood it – it’s absolutely bonkers,” Prof Dowd says.
Life insurers could be insolvent
Dowd believes that a number of the 11 biggest life insurers could be insolvent due to their over-reliance on the matching adjustment. Life insurers must fulfil solvency capital requirements (SCR) to protect investors. For the 11 life insurers combined, that required figure is £66.6bn. The balance sheets show that the life insurers have £116.6bn in reported capital available, meaning that they appear to be in rude health. However, Dowd claims even this is superficial.
“Of that £116.6 billion in reported capital, the amount of matching adjustment (phantom capital) is almost £40bn,” Dowd says.
“Because it doesn’t exist, it has no loss-absorbing capacity,” he says. Dowd also argues there are further accounting tricks which create another £20bn of phantom capital, taking the overall total of phantom capital to 53 percent of reported capital.
“If 53 percent of reported capital doesn’t exist – that’s a huge problem,” he says. A problem that could soon be exacerbated if the economy begins to shrink.
PRA ‘speaking with forked tongue’
The PRA – which regulates the life insurance sector – permits the matching adjustment. But both Dowd and Buckner claim that while publicly the PRA say there is no problem with using matching adjustment, privately there is much debate.
“The PRA is in complete denial,” Dowd says. “You know the old expression ‘speak with forked tongue’? Publicly, they say that everything is fine, that the matching adjustment is allowed under the rules – that’s true.”
“That’s only because the PRA conceded to the lobbying pressure from the industry, the rules should not allow firms to make up non-existent capital. And the industry for its’ part says, ‘everything is rule compliant’ and never point out that they lobbied like hell to get those rules.”
Buckner, when asked if there were any worries at the PRA while he worked there over matching adjustment, says: “Yes, there were many. There were many internal emails.”
“There was considerable worry inside the PRA. And a range of views where you had people like me and pretty much all of the people outside insurance departments who were saying that this really is dangerous.”
“There was considerable concern in various quarters of the PRA,” he adds.