Brussels sprouts law to make insurance sick

Anthony Hilton
28 Jul 2009

Sherlock Holmes used to talk about a two-pipe problem. The insurance industry is currently grappling with its modern equivalent which occurs when Brussels lawmakers get involved with actuarial science, as has happened in the drafting the Solvency II directive for the insurance industry. This might usefully be described as a two-anorak problem; in other words a numbing mixture of the highly specialised and the mind-blowingly dull.

But the real message is that it is also very dangerous for UK savers. In particular one aspect of the proposal as drafted could easily result in a drop of up to 20% in the value of the annuities. This will affect some six million in the UK who are saving through defined contribution pension schemes — in other words most people in a pension scheme — and the millions more who in a few years time will be enrolled into the personal accounts pension. They are likely to find their potential pension has been reduced by one-fifth as a direct consequence of these new rules becoming law.

The reason this might happen is that the draft rules suggest either that annuities have to be invested in government securities — which are much more expensive than the corporate bonds British insurance companies presently use — or the insurance companies will have to set aside additional capital to cover the perceived additional risk of relying on corporate bonds. (I said it was highly specialised.)

But the point is that the cost of that extra “dead” capital will have to be passed on to the customer and it translates into a reduction of up to 20% in the weekly income his or her money will be able to buy. Currently about four-fifths of pension pots used for annuity purchase are £40,000 or less. Typically these buy a weekly income of about £60. Under the new proposals this would be whittled down to £48.

One would have thought a government which is rightly exercised about pensioner poverty and which is also keen to encourage employees to save for their old age would be alive to the damage this directive could do and would be lobbying vigorously to have it changed.

But while City Minister Lord Myners has been vigorous in his attempts to defend Mayfair hedge funds from draft EU laws, the Government has mobilised no one of his stature to join the insurance industry's fight in Brussels on behalf of tomorrow's pensioners. It is a curious reflection of what and who the Government thinks is important in the run up to an election — or perhaps it is just another example of its disarray and demoralisation.

In spite of that the industry is doing its best. Legal & General and the Prudential are both working hard at a technical level in Brussels by arguing that capital calculations should recognise the illiquidity of annuities and the liquidity of the bond markets, the combined effect of which would be to reduce the need for the extra capital. Unfortunately “save the liquidity premium” is hardly the most stirring call to arms. It is perhaps no surprise that without government backing it has so far failed to shift the opposition.

But the lack of government support is a surprise because this is bigger even than the loss of income to pensioners — and the further strain it will put on government finances as more have to apply for means tested benefits. The consequences for the corporate bond market would be severe if they are no longer deemed suitable for annuity investment. That in turn will cut off the flow of funds to companies, increase the demand for scarce bank loans, and further constrain our ability to climb out of recession. So even if it would like to keep its head in the sand this really is not something the Government should continue to ignore.

Put your mouth where your money is

If capitalism is to work properly shareholders have to take an interest in the companies in which they are invested. That at least is the theory. The practice is rather different.

Currently the combined Code of Corporate Governance is under review and a summary of evidence heard so far was published yesterday. In it FTSE 250 company chairmen claim that except in times of crisis most participants from smaller companies complained of:

a lack of interest in governance by fund managers, a lack of “weight” in most corporate governance departments, an over-reliance on voting services agencies who were also guilty of box-ticking, an unwillingness on the part of institutions to respond to invitations to meet the company chairman, and an unwillingness to engage on anything other than remuneration.

If shareholders did agree to meet anyone it was almost always the chief executive or finance director, never the non-executives or others in the management team.

Most institutions don't think it is worth their while to get involved. But then it is not their money.