Author: Mathias Rasmussen
With pension buy-in and buy-out transactions reaching record levels in recent years, many schemes are taking decisive steps to secure their members' futures. As funding levels continue to improve relative to insurer pricing, a growing number of schemes are considering buy-ins or buy-outs.
Strong funding alone, however, is not sufficient to achieve a successful deal — a scheme needs to get its "ducks in a row" across a number of areas, with for example data cleansing and benefit specification being front of mind for many.
One area that can sometimes be more of an afterthought is investment strategy, which involves ensuring that the assets held are both acceptable to the insurer (either in-specie or readily convertible to cash) and structured to hedge against movements in annuity pricing. Aligning on investment strategy helps avoid last-minute surprises or funding setbacks just as a transaction nears execution, delivering the best possible outcomes for all stakeholders.
Investment Grade (IG) credit has historically played a key role in this. Its stable risk-return profile, favourable capital treatment under the Solvency II insurance regime, beneficial cash flow characteristics and ability to match annuity liabilities has long made it a fundamental component of insurer portfolios.
However, market dynamics (including historically low credit spreads) and evolving regulation are reshaping how insurers source yield, prompting a shift in their asset preferences. As a result, Trustees of DB schemes must reassess what it means to be 'buy-out ready,' ensuring their portfolios are aligned not just with legacy expectations, but with the types of assets insurers are now seeking and are permitted to accept.
To meet regulatory requirements, insurers must hold sufficient capital to cover the risks embedded within their investment and liability portfolios, with capital charges varying depending on the nature and risk profile of the assets held.
They can reduce this capital requirement by cashflow matching their liabilities with high-quality assets whose cashflows are highly predictable and secure through a mechanism known as "Matching Adjustment."
The "so what?" is that insurers don't look to optimise investment risk/return in the traditional sense (i.e. excess return relative to volatility), but rather return on capital — the attractiveness of an asset in this context is therefore not just a matter of its credit spread but also whether it's Matching Adjustment eligible.
Two key market dynamics are reshaping the investment landscape for insurers — wide gilt/swap spreads and tight credit spreads.
Swaps are generally considered the risk-free rate for insurers, however they can hold gilts without a capital charge. When gilt yields are very high relative to swap rates, as is the case today, insurers can pick up incremental yield without much additional risk. This, all else equal, makes gilts more attractive and other investments less so.
Gilt-swap spreads have widened in recent years.
At the same time, investment grade credit spreads have tightened and remain at levels well below the historical median. This makes credit relatively less attractive compared to gilts.
IG credit spreads are at their tightest point in decades, materially below the 15-year average.
The combined effect of wide gilt/swap spreads and tight credit spreads is that for insurers — once you adjust for capital requirements — the 'traditional' approach of holding longer-dated IG credit alongside a program of interest rate swaps has become less attractive.
Recent regulatory changes have also influenced insurers' investment strategies. Traditionally, insurers were limited in the types of credit assets they could invest in due to very specific Matching Adjustment requirements — for example, assets needed to have strictly fixed cashflows which made it more difficult to work with floating rate investments, IG bonds with embedded options and other high-quality investments (e.g. certain types of infrastructure).
In 2024, the Prudential Regulatory Authority (PRA) — which regulates insurance companies — relaxed some of the requirements for Matching Adjustment, allowing investments with "highly predictable" cashflows to constitute up to 10% of total Matching Adjustment benefit. Based on our ongoing dialogue with insurers in the market, we expect Investment Grade ABS allocations to increase in the coming years. However, as ABS tends to be shorter-term in nature, we wouldn't expect this on its own to meaningfully increase the sensitivity of insurer pricing to the level of credit spreads.
As a result of current market conditions and changing regulations, insurers are increasingly favouring government bonds, reducing exposure to corporate credit.
The chart below illustrates the shift from traditional insurer strategies to the strategies observed over the past two years:
We can make two key observations about general insurer investment strategy changes from this (although noting a couple of the buck the trend):
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Gallagher Benefit Services is a trading name in the UK for Gallagher Risk & Reward Limited (Company Number: 3265272), Gallagher Communication Ltd (Company Number: 3688114), Gallagher Actuarial Consultants Limited (Company Number: 1615055), Gallagher (Administration & Investment) Limited (Company Number: 1034719), Gallagher Consultants (Healthcare) Limited (Company Number: 172919) and Redington Limited (Company Number: 6660006) which all have their registered offices at The Walbrook Building, 25 Walbrook, London EC4N 8AW. All the companies listed are private limited liability companies registered in England and Wales. Gallagher Risk & Reward Limited, Gallagher (Administration & Investment) Limited, Gallagher Consultants (Healthcare) Limited and Redington Limited are authorised and regulated by the Financial Conduct Authority.
