Breaking into the BPA market: Challenges for new entrants

At a glance

The Bulk Purchase Annuity (BPA) market in the UK has rapidly grown over the years and is expected to continue its trajectory, owing to the drive for pension schemes to continue to seek de-risking opportunities and improved funding positions from recent increases in interest rates. It is expected that more than c.£600bn of pension liabilities and assets will be onboarded over the next 10 years¹, creating a sizeable opportunity for market players.

BPAs have the potential to generate large profits if managed efficiently, leveraging shareholder capital against the potential to achieve attractive risk-adjusted returns on the long-term, illiquid investments backing BPA liabilities. The size of the opportunity, coupled with the attractive market, is generating interest from an increasing number of potential new market entrants; indeed, we have already witnessed M&G re-entering the market in September 2023, bringing the total number of active BPA market players to nine.

However, there are significant challenges facing any new entrant to this market:

• Funding new business: BPA transactions are highly capital-intensive, so entrants will require access to initial capital and will need to consider the use of strategies such as reinsurance to minimise new business strain.
• Matching Adjustment and Internal Model approvals: Use of the Matching Adjustment (MA) and an Internal Model can help improve the technical provisions and capital requirements and allow for more competitive pricing, but it can be time-consuming and costly to obtain approvals and maintain compliance.
• Use of illiquid assets: High-spread illiquid assets have become well-established investments to back BPA liability cash flows and achieve competitive pricing. Acquiring these assets can be a slow and uncertain process, requiring specialist skills to source, restructure, model and manage the assets. Such assets are also often in short supply, making sourcing very competitive and requiring ongoing innovation by insurers as to how they invest.
• Reinsurance & hedging strategy: BPA providers have widely used longevity swaps to transfer the risks arising from BPA transactions and are increasingly considering funded reinsurance arrangements to further manage the resulting risk exposure. New entrants will need to navigate a busy reinsurance market to secure competitive risk management arrangements.
• Data quality & cleansing: Securing a BPA deal is sensitive to pricing, which in part depends on the ability of insurers to work with data of limited quality and create a commercially attractive proposition to handling data uncertainties. New entrants will need to consider challenges around setting up appropriate processes and systems to analyse large volumes of data and how they might mitigate data quality issues.
• Challenging and evolving regulatory landscape: Obtaining MA and Internal Model approvals depends on the regulator’s discretion, and Solvency UK introduces new requirements which could make compliance more onerous. The PRA is also increasing its scrutiny over funded reinsurance, which might make this method of transferring risk more difficult in the future.
• Competitive and finite market: New entrants will be competing against established brands with a history of transactions and will require differentiating factors such as competitive pricing. New entrants will also need to consider the appropriate timing of entry such that there is sufficient supply within the defined benefit market with which to transact and achieve scale.

Who this blog is for

Board members, senior executives and actuaries of UK insurers operating in or looking to enter the BPA market, and actuaries looking to specialise in bulk annuities.

Challenges in the BPA market

Entering a new market is accompanied with uncertainty, risks, and regulatory requirements, which need to be understood and navigated effectively. Below we consider the key challenges faced by potential new entrants in the BPA market.

A. Funding new business

BPA transactions are capital-intensive due to the underlying long-tail longevity and investment risks.

New entrants already operating in the wider insurance or asset management market may use existing free surplus to provide capital for BPA transactions, whereas those without an existing balance sheet may need to acquire funding through debt or equity from external providers of capital. Given the scale of capital required, access to the BPA market is only feasible to new entrants with access to significant amounts of initial capital. Those raising capital will also need to consider the increased cost of funding as interest rates increase or remain high.

Firms can seek to minimise the strain of writing new business through strategies such as funded reinsurance, whereby both asset and liability risk can be transferred to a third party to reduce the initial capital burden. However, there are challenges associated with employing such strategies, which are discussed in more detail below.

B. Matching Adjustment and Internal Model approvals

The Matching Adjustment (MA) allows the use of a higher discount rate in deriving the value of the annuity liabilities to reflect the spreads earned on assets backing the liabilities, thereby reducing the size of the best estimate liabilities and freeing up capital for the insurer. Obtaining MA approval is vital for a competitive BPA business.

All the major BPA players use an Internal Model to value some or all of their market risk Solvency Capital Requirement (SCR) components, as this more accurately reflects the risks - most notably for assets. Use of the Standard Formula is unlikely to be viable in the modern BPA market due to a potentially more penal SCR or pressures from the regulator for an Internal Model to be adopted. Where illiquid assets (including restructured assets) are part of an insurer’s investment strategy, use of an Internal Model is especially important to minimise capital requirements, compared with the less granular Standard Formula approach.

Obtaining MA and Internal Model approvals, as well as their ongoing maintenance, is a costly exercise given the standards required by the PRA and can be very lengthy. New entrants need to consider these costs and, to the extent that they are required to wait for approval to use the MA and an Internal Model, will find it more difficult to compete for business against incumbent firms which currently benefit from having these measures already in place.

C. Use of illiquid assets

To remain competitive, BPA providers will seek out long-term assets with attractive spreads to back the annuity liabilities. Illiquid assets such as equity release mortgages, commercial real estate loans, residential mortgages, and infrastructure assets are increasingly being used for this purpose.

However, these are complex assets that require substantial expertise in areas such as sourcing, structuring, valuation, internal rating, management, and capital modelling. New entrants will be unable to benefit fully from these assets and reflect that within their pricing until they have developed in-house capabilities or obtained third party support to fulfil such functions. Firms may indirectly access a wider range of investment opportunities through mechanisms such as exchange-traded funds or utilise funded reinsurance as a means of ensuring competitive pricing through leveraging the reinsurer’s access to illiquid assets. Further, access to some of these assets may only be achievable if bought at scale, making them inaccessible for new entrants with smaller balance sheets.

D. Reinsurance and hedging strategy

Owing to the high Risk Margin and SCR charges under Solvency II for longevity risk, there has been a strong appetite for longevity reinsurance from BPA providers. Longevity swaps have been widely used by BPA providers to transfer longevity risk since the introduction of Solvency II, leading to a mature and competitive reinsurance market. Another reinsurance strategy gaining popularity is the use of funded reinsurance, which transfers both longevity and asset risks, often to reinsurers in foreign jurisdictions such as Bermuda.

With high levels of demand from the BPA market and pension schemes, reinsurers may have a commercial need to focus on quoting for cases where execution is more likely and which are larger in size, posing a challenge for new entrants in terms of pricing and availability. New entrants could consider warehousing longevity and/or assets risk on their balance sheets, with a view to periodically undertaking large reinsurance deals to gain traction and improved pricing. However, a firm will need to consider the implications on capital requirements and capacity to write further new business until such deals take place. For small to medium-sized deals, new entrants could also consider using a ‘flow treaty’ structure, with pre-agreed terms and coverage, that would provide immediate reinsurance cover and price certainty.

E. Data quality and cleansing

Ensuring that scheme data is of the best possible quality is critical as it forms the basis for pricing assumptions and enables a BPA writer to reflect any risk elements inherent within a scheme within the pricing.

Existing BPA market players have established systems and processes set up to work through and clean large volumes of scheme data. Where schemes are aware of existing data limitations, the ability of an insurer to accommodate a range of potential remedies into a BPA transaction structure can be an attractive part of an insurer’s proposition. Existing BPA market players may therefore be better placed to deal with data issues and may be able to negotiate better terms for residual risk cover.

New entrants need to consider their ability to manage pricing, balance sheet and operational uncertainty arising from data limitations. Should systems and processes be required for these activities, new entrants should factor in the upfront capital expenditure required. Where this is not sufficient, new entrants might choose to explore outsourcing opportunities for specific administrative and data management roles.

F. Challenging and evolving regulatory landscape

As mentioned above, there has been an increase in the utilisation of funded reinsurance arrangements as a means of risk management. However, these arrangements typically sit outside the jurisdiction of the PRA, which has raised several concerns. The PRA considers that the probability of recapture is overstated and too highly correlated across reinsurers, credit cycle shocks are likely to affect both the reinsurer and the collateral portfolio at the same time, and certain management actions might be ineffective on recapture¹. This has resulted in increased scrutiny and PRA involvement, and so it might prove challenging for new entrants to utilise such structures in the future. The PRA has signalled that it expects firms to adhere to more stringent counterparty investment limits based on both idiosyncratic and concentration risks, develop robust recapture plans that demonstrate the ability of the business model to survive a recapture event, and develop formalised plans on collateral management. The exact bar to which firms need to work towards is undefined, but the additional stipulations from the PRA will reduce the extent to which new entrants can rely on funded reinsurance, and further investment may be required to enable its use.

On the asset side, insurers looking to source high-spread backing assets should be aware that modelling less conventional, long-term illiquid assets can be complex. Whilst the Solvency UK reforms are expected to reduce some of the burden on firms applying for the use of the MA and an Internal Model, there are still significant regulatory hurdles. Further, MA compliance is a key area of risk for BPA providers, with significant business consequences if MA requirements are breached. Investment is required by market players to ensure that breaches are minimised or rectified in a timely manner.

The PRA has recently published consultation papers^2,3 on the Solvency UK reforms, which are expected to come into effect over the course of the next year. The PRA is anticipating that the reforms will allow the inclusion of assets with highly predictable cash flows in MA portfolios, subject to certain conditions. The changes are expected to provide more investment flexibility for the industry, but more exotic assets will require more robust risk management and will be subject to greater scrutiny from the regulator. New entrants without an established infrastructure and expertise in sourcing and managing such assets may find opportunities to benefit from the changing regulations more limited.

The Solvency UK reforms introduce the need for firms to make an MA attestation which places the onus on firms to evidence that the calculated level of MA benefit is earned with a high level of confidence. This is expected to result in significant development work for BPA players with pre-existing frameworks and processes set up around the MA. New entrants without an established infrastructure might find it additionally challenging to have to factor in the build for such compliance requirements on top of seeking approval to use the MA.

G. Competitive and finite markets

Established players will have a track record of transactions which will have been executed by an experienced deals team. New entrants will have to work to establish a brand presence and may need to be more flexible with pricing to differentiate against the incumbent players.

Whilst there is a significant amount of defined benefit liabilities remaining within the UK market, with most defined benefit pension schemes now closed to future accruals, the supply of schemes to transact is finite. Therefore, new entrants will need to consider the need for timely and suitably strong entry to the market such that there is sufficient supply to achieve scale.

Conclusion

As BPA market opportunities continue to increase, there has been an increase in interest from third parties such as other insurers, private equity, and other investors in entering this market. There are barriers to this market that new entrants will need to overcome, but the prize for doing so represents a great opportunity for investors looking for long-term deployment of their capital resources.

Given the expanse of work required, potential new entrants should consider obtaining appropriate support to understand the financial and operational viability of entering the BPA market.

References

1. CP24/23 – Funded reinsurance | Bank of England
2. Solvency UK: Moving closer to reality | Deloitte UK
3. Solvency UK Matching Adjustment: Another piece of the puzzle falls into place | Deloitte UK