Insurers still budgeting for infra

Michael Wilkins and Oliver Herbert of Standard & Poor’s explain why demand for high-yielding assets in the UK will remain following the Chancellor’s move on annuities.

The pension reforms set out in the Chancellor’s spring statement are predicted to result in a falling demand for annuities. However, a smaller and subsequently more competitive annuity market is likely to sustain the demand for high-yielding assets such as infrastructure projects.

Chancellor of the Exchequer George Osborne’s radical reform of UK pension provision has removed the obligation for pension policy holders to buy an annuity. Yet such a liberalisation raises concerns regarding the £20 billion (€24.2 billion; $33.6 billion) a year UK annuity market. The assumption is that the number of people opting for annuities will shrink, which has implications for infrastructure investment.

Infrastructure projects are attractive investment options to annuity providers such as insurers due to the returns on offer and the potential for matching long-term liabilities. In December 2013 the UK government agreed with a number of insurance companies, including Legal & General, Prudential, Aviva, Friends Life, Scottish Widows, and Standard Life, on investing £25 billion in UK infrastructure over the next five years. However, with the forecast slowdown in annuity sales, there is a concern that this will impact insurers’ demand for infrastructure assets.

At Standard and Poor’s, however, we believe the concern may be overdone. Despite the forecast decline in demand for individual annuities, we believe the volume of bulk annuities will remain potent. Furthermore, we believe a smaller annuity market will heighten competition between insurers, forcing them to innovate and introduce more attractively priced annuity products. And, in an attempt to offset this cost, we also believe that insurers may look to greater investment in higher-yielding assets, subsequently boosting the demand for infrastructure assets.

Annuities relevant and attractive for savers

In our view, the clearest impact of the reforms will be felt in individual annuity sales as policyholders digest the implications of the recent legislation. Yet individual annuity sales were already beginning to decline due to a combination of low interest rates and previous regulatory change – specifically gender-neutral pricing – leading to policyholders deferring from purchasing an annuity.

Nonetheless, we expect annuities to remain a relevant and attractive product to savers even without an obligation to purchase. Annuities provide policyholders with the financial protection against uncertain life expectancy, and eliminate the issue of having to actively manage savings to generate a consistent income. In addition, a material proportion of existing pension savings benefit from a valuable guaranteed annuity option which entitles holders to a beneficial guaranteed annuity rate.

Furthermore, recent legislation has meant that UK employee pension schemes are progressively moving towards an opt-out, rather than opt-in, model. This increased participation should result in an increase in pension savings of around £11 billion a year to over £30 billion a year by 2018. Alongside the insurance sector’s current holding stock of about £600 billion in defined contribution pension assets, a considerable potential market for individual annuities remains.

Corporate bulk annuities continue to hold potential

Bulk annuities – bought by companies intending to transfer the risks and responsibilities of their own employee pension schemes to insurers – make up 45 percent of the annuity market. And considering UK corporate balance sheets currently hold more than £1 trillion in pension scheme liabilities, there is considerable potential for the bulk annuity market to grow. However, although these volumes are inherently large, they remain unpredictable, and we have yet to see if there will be any impact to bulk annuities from the Chancellor’s reforms.

Of course, we may see some increased margin pressure as insurers intensify their focus on this sector. But such pressure should be offset by natural growth, barriers to entry, and the higher risk profile associated with managing bulk annuity business.

Demand for higher yield is crucial

Certainly the annuity market will become increasingly competitive as the segment shrinks. Insurers will need to become more innovative – with new products or alternative investment strategies – to secure income. While UK interest rates and 10-year gilt yields remain at record lows, there will be greater incentive to invest in higher-yielding, illiquid assets – such as infrastructure.

In our view, investment in infrastructure works well to offset insurers’ liabilities, which can closely match revenue flows from the index-linked concession agreements common to many public-private partnership transactions, for instance.

Ultimately, insurers will continue to invest in illiquid assets, such as infrastructure projects, where they provide higher returns at limited extra credit risk. Although the decline in annuity sales could diminish insurers’ long-term capacity for investing, the need to be competitive and the need for yield will become ever more pressing – meaning that insurers will continue to find infrastructure assets attractive for the foreseeable future.

*Michael Wilkins is managing director of infrastructure ratings, and Oliver Herbert is an insurance analyst, at Standard & Poor’s Ratings Services.