// . //  Insights //  Responding To The Run On Gilts

Point of view issued October 2022.

Navigating volatile market conditions

Life insurers and wealth managers have largely managed their way through the recent Gilt market crisis in good shape, with the Solvency of many companies actually improving. Improved liquidity management, developed in response to PRA requirements, has worked well for most, but attention now needs to turn to the commercial implications for customers and markets.

Key implications:

  • Maintaining a tight focus on managing liquid resources is key — this crisis emerged in the Defined Benefit (DB) pension market and there may be other potential sources of contagion that are not yet visible
  • More stringent market regulation of liquidity is needed to prevent this happening again — the industry needs to engage in the discussion so that this is focussed on DB schemes and does not undermine processes that have largely worked well in the Life sector
  • Customer needs and preferences will change fast — there are big uncertainties in the housing and mortgage markets, and in the role that investment guarantees and equity release will play in retirement. Insurers and wealth managers need to review their product portfolios to ensure they are not betting the firm on any one potential outcome

Liquidity management is key

This crisis is not over yet. The initial problem arose in DB pension funds that had significant interest rate swap positions for Asset Liability Management. Rapid increases in long bond yields following the “mini-budget” led to huge increases in collateral requirements for these swaps at the same time as the value of their Gilts collateral was falling fast. This led to a run on the Gilts market, with a spiral of sales pushing long yields higher and making the problem worse. This was mirrored by similar impacts in other swaps markets, such as FX and inflation. There has been a lot written about this with the benefit of hindsight, but it was not generally accepted as a systemic weakness before it happened.

We see three important consequences:

  • It could happen again. If markets jump rapidly, there could be other sources of contagion in the financial system and it is not clear how DB schemes can resolve their position if rates remain high
  • More regulation/government assistance is coming, particularly for DB schemes. The Life industry’s liquidity management processes have worked well so far, with most insurers having adequate resources and well thought-through plans. The industry needs to engage in the discussion to ensure that any changes do not undermine this and are additive
  • Enhanced stress testing for bigger changes in rates, higher volatility and a breakdown in historic correlations between interest rates, inflation and FX — what changes can be made to existing processes to improve resilience (including consideration of a broader range of scenarios and reverse stress tests)?

Helping customers

The cost-of-living crisis is likely to continue for several years, with a strong impact on the affordability of the industry’s products in the mass and mass affluent markets. Now there is also significant housing market uncertainty. Mortgage rate increases may deter first-timebuyers and movers, and prices could fall towards historic levels of income multiples.

Insurers can take action to help their customers:

  • In equity release, focus more on income drawdown structures to reduce the interest rate burden. In lump-sum products, help clients in decisions to defer taking the money until long-term interest rates are at a level they find acceptable. It may be prudent to halt sales of lump-sum products to younger retirees, managing the risk that they end up with poor value for money vs. other alternatives. This will also help to manage the cost of the No Negative Equity Guarantee (NNEG) 
  • In retirement savings and income, provide new forms of guarantee or underpins, taking advantage of the new opportunity to manufacture that rising rates have provided. The market may return for products such as individualised constant porportion portfolio insurance (iCPPI), or those which offer guaranteedminimum levels of income. Customers may understand and value guarantees more due to the combined effect of the interest rate spike and inflation
  • Reinvigorate individual annuity businesses as rates rise. More customers may now find these attractive for covering at least their first slice of retirement expenses
  • In Wealth, consider broadening out platform offers so that they can include the ability (under advice) to allocate funds to guaranteed funds and annuity products. This would be most effective if it is within the same wrapper, or at least the same operational platform. Higher interest rates will also increase the relative attractiveness of cash as an asset class, and wealth managers and platforms need to decide how best to offer cash savings, and where/when to seek to earn margins on cash
  • Increased availability of payment holidays, especially in Protection

The bulk annuity market is likely to offer attractive opportunities for insurers with the capacity and appetite to deploy capital. In the very short term, market volatility may reduce deal flow, but this has been another good lesson to plan sponsors (and regulators) as to why they should not be running a large financial business. Beyond this, we see strong tailwinds for deal-making as funding deficits reduce because of rising interest rates. Pricing should also improve due to these rate increases and widening credit spreads, although hedging costs and collateral requirements will partially offset this. Our long-term view is that half the DB market could eventually annuitise, providing the Life industry can provide the capacity.

Balance sheets and solvency

For most firms, balance sheets have survived this crisis well. The Matching Adjustment ruleshave been effective both in protecting against interest rate changes and in passing through the associated changes in asset spreads to the liability valuation. Many insurers will have likely also seen significant reductions in the Risk Margin as long-term rates have fallen, which has contributed to a general improvement in solvency. For example, L&G’s Trading Statement on 4th October estimated Q3 2022 Solvency Ratio to have increased by at least 23 percentage points from HY 2022 (212% to between 235-240%). The movement in Gilts has exceeded most Internal Model 1-in-200 standalone stresses, but the effect has been manageable.

The main lessons for insurers are:

  • Review the liquidity risk management framework to ensure it remains appropriate in light of market movements
  • Provide clarity through shareholder communication on impacts and responses
  • Perform additional stress testing and scenario analysis to capture magnitude of recent market movements
  • Revisit Internal Model calibrations to ensure they remain appropriate
  • Feed learnings into discussions with the PRA and HMT on Solvency II reform, particularly the potential combined impact on the Risk Margin and Fundamental Spread
  • Increase focus on liquid resources, ensuring their value is not overly correlated withother major risks. Look after your cash!
  • John Whitworth,
  • Sean McGuire,
  • David Clarkson, and
  • James Forbes-King