Residual risk – whose risk is it anyway?

As more schemes become better funded and closer to their endgame objective of buying out benefits with an insurer and eventually winding up, trustees and sponsors thoughts are likely to become more focused on the residual risks left on the table post buyout, and how these can be minimised.

It is important to remember that a bulk annuity policy only covers the benefits recorded in the data and benefit specifications, which are part of the contract between the insurer and the trustees. There is a value to insurers if the benefits insured are complete and correct. However, this is linked to  reputational risk rather than to any real financial risk; also, insurers will want to minimise time spent dealing with benefit queries arising post buyout.

The risk for any benefits that have been left uninsured, or have not been insured correctly, remains with the scheme and claims can be made against the trustees even after a wind up has been completed.

Wind-up insurance

Wind-up insurance, covering “wrongful acts” and/or potential additional beneficiaries missed from the bulk annuity policy, can be secured from a number of providers and is something that most trustees will seek to put in place from the date of wind up. This insurance is often additional to a formal indemnity from the scheme’s sponsor, and is expected to take precedence over it.

Due to difficult financial conditions, and as a result of poor claims experience for some insurers, the market for “off the shelf” wind-up insurance products has hardened considerably, resulting in higher premiums and lower levels of maximum cover.

A hardening market also has practical implications on when cover is sought. Traditionally an indication of cover was obtained as early as 12 months prior to the expected date of wind up, but there is limited point in doing this if terms are likely to change over the period.

The scope of cover has also become less clear. For example, while cover for residual GMP Equalisation (GMPE) risk is understood to be included within the standard terms, in practice claims relating to past transfers out could be disputed if the chosen approach by the trustees is found to be overly pragmatic. The appropriate disclosures and discussions need to take place at the time a quotation is sought, so that both parties are clear on the terms being agreed (and trustees also need to be conversant with the requirements of the Insurance Act 2015, such as the duty of ‘fair presentation of risk’).

Residual risk cover

Larger schemes can secure additional cover, within a bulk annuity policy, for risks such as missing beneficiaries or residual GMPE risk. The minimum size of transaction this cover is available to has decreased over the last couple of years. However, it is unlikely to be on offer for transactions under £100 million due to the extra workload required from the bulk annuity provider to evaluate and price the additional risk.

Unlike off the shelf wind-up insurance policies, residual risk contracts usually set out the scope of the cover provided in detail, with exclusions also set out explicitly (for example, cover is rarely provided for risks relating to the proper execution of scheme documentation).  Trustees are also expected to repair some of the issues identified as part of the insurer’s due diligence process in advance of a buyout being completed, and this may in fact be a pre-condition to a buyout.

A decision on whether residual risk cover should be included in a bulk annuity policy should be made in advance of a market approach, as this element of the policy may impact insurer appetite and will definitely impact the broking process. Trustees should also have undertaken their own internal benefit and data due diligence in advance, so that there are no nasty surprises from the insurer’s review.

“Buyer reports” and “seller reports” (prepared respectively on behalf of the insurers or on behalf of the scheme) are becoming popular as a way to simplify and commoditise the process around obtaining cover for residual risks.

New products

A more positive market development is the entry of new providers offering specific “gap” cover for excluded items under residual risk, or for items which may be disputed under a more traditional policy. As the market develops further, and more schemes get to buyout, it will become more common to hold a portfolio of insurances and indemnities to best cover overall risks.

One note of caution needs to be made around the understanding of the conduct of claims clauses, and also how policies are meant to interact. This should be clearly documented, so that the information can easily be referred to if the need arises.

Conclusion

Ultimately, trustees and sponsors need to accept that the risks relating to a pension scheme can only be managed and mitigated rather than fully eliminated.

Understanding market developments, including processes and the impact of selecting one solution in preference to another, will result in risks being minimised for an acceptable cost, taking into account a scheme’s specific circumstances.