Here is something you won’t find explained in any finance textbooks. It’s a trick which allows insurance companies to conjure capital out of fresh air.
Let’s start hypothetically with a simple insurance company, which has assets and liabilities worth £100 each. The liabilities are long-dated annuity cash flows and the assets are tied up in UK government bonds, or gilts.
For the sake of argument, let’s assume the assets perfectly match the cash flows throughout the life of the entity. So despite having a net value of precisely zero, the annuitants’ incomes are perfectly safe.
Now let’s imagine that same company, except assume also that it has shifted its money in to some higher-yielding assets. In theory, this ought to change things: higher yields bring with them an elevated level of investment risk. So for the insurer to continue protecting its annuitants, the company is going to need rather more capital than its present zilch.
But here comes the magic in the shape of an actuarial trick known as the “matching adjustment”. Using this allows the entity to discount its liabilities at a higher rate, reflecting the additional return it hopes to make from those same higher-yielding assets.
When discounted at this new elevated rate, our company’s liabilities obediently fall to just £90. So without anyone contributing a penny, or the company retaining any earnings, hey presto, its equity buffer has risen from nothing to the more substantial level of £10.
It may seem bizarre, this idea of generating capital from nowhere. But it’s very far from uncommon. According to a study of 15 large UK insurance companies by the finance academic Kevin Dowd and a former employee of the UK industry watchdog the Prudential Regulation Authority, Dean Buckner, these entities had £37bn in artificial financial capital on their balance sheets in 2016 and a further £31bn in artificially reduced regulatory solvency requirements. That adds up to nearly £70bn of matching adjustment witchcraft.
Indeed, the regulator actively sanctions this actuarial sleight of hand. It does so because it lumps insurance companies into a special bucket; one marked “buy-and-hold” investors. The logic runs as follows: the annuitants cannot surrender their policies, so there is no risk of the insurers having to sell up to satisfy redemptions. It follows then that there’s no need for so much loss-absorbing capital to guard against short-term fluctuations in asset values. All that matters is that the assets mature and pay out in the end.
Now there are a number of questions you can raise about the logic of this approach. But the big concern is the way it allows the company to crystallise upfront a large chunk of the expected returns from its long-term assets. That may permit the payment of dividends and bonuses based on those “earnings” long before they are ever received (assuming, indeed, that they ever actually are). It may drive managers to invest not in the most appropriate assets for annuitants, but ones that attract the juiciest matching outcomes.
There are also concerns about the questionable signals that the matching adjustment may send out about the entity’s value.
Let’s go back to our theoretical company with its match adjusted capital of £10. An investor might not realise this number is entirely notional, based on nothing more than opaque regulatory assumptions about the future. They might then pay almost £10 to buy it, not knowing that the company’s current asset value is actually zero (and thinking themselves to be getting a good deal). The matching adjustment thus leads the investor to incur a loss that could have been avoided had the real picture been clear.
Nor are these risks entirely theoretical. Take the case of Just Group, an entrepreneurial UK insurance company that was formerly owned by the private equity firms Permira and Cinven. In 2016, Just’s capital of £2.1bn was entirely accounted for by matching adjustment, according to research by Mr Dowd and Mr Buckner.
Following the private equity firms’ final sale of their equity stakes in early 2018, the company was forced to raise £400m in additional capital, and suspend its dividend. Since Permira’s final sale in May last year, Just’s market capitalisation has fallen from £1.5bn to just £637m.
Martin Taylor, a member of the Bank of England’s Financial Policy Committee, has described “the actuarial convention” by which the composition of an insurer’s assets determines the size of its liabilities as “one of the weirdest emanations of the human mind”.
Not only does the practice make little logical sense, it’s also hard to reconcile with prudence. And it could lead to abuses that might harm annuitants’ interests.
Long-term savings are a serious business. Outcomes should not hinge on the flick of an actuary’s wand.
jonathan.ford@ft.com
