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Survey Report

Managing your scheme’s risks through to buyout

De-risking report 2024

By Sadie Scaife | January 24, 2024

A buyout with an insurance company remains the destination of choice for many trustees and sponsors of defined benefit pension schemes, and the appetite to complete full buy-ins continues to grow due to the improved funding position many schemes find themselves in. Sadie Scaife explores how trustees and companies can manage the risks which will remain following the buyout.
Retirement|Pension Board and Trustee Consulting|Pensions Corporate Consulting|Pensions Technology

If a scheme moves to wind-up, what protections can be put in place for the members, the former trustees and the sponsor?

Many trustees currently benefit from an indemnity from their sponsor under the Trust Deed and Rules, which trustees should seek to replicate in the wind-up deed, ensuring that the indemnity survives beyond the end of the pension scheme. Whether a given company is willing to offer an indemnity and the exact terms agreed can vary significantly from case to case, including any limitations on the term and amounts that can be claimed. If such an indemnity is provided it would typically indemnify the trustee against all claims and expenses, but clearly this can only be relied upon whilst the company remains solvent, and the company will likely expect that other forms of trustee protection (if these are purchased) are called upon before the indemnity.

Many schemes will also look to obtain trustee run off insurance, which is purchased from a specialist insurer at the point of wind-up. The typical cost is relatively modest in comparison to the size of a scheme’s liabilities, but there is a limited market for this insurance and usually cover is capped and time limited, with terms of up to 15 years typically possible. What this insurance will cover does vary, but a key protection it can provide is against the costs of investigating and, if appropriate, defending claims that may arise. Many trustee run off policies can also cover “overlooked beneficiaries” – members who aren’t on the trustees’ records and so aren’t covered by the buyout – for an additional premium.

Residual risks insurance is an “add-on” offered by bulk annuity insurers for larger transactions, with a relatively small number of cases written each year. Its main purpose is to provide additional benefits where a member successfully claims that the benefits secured by the trustee are too low – whether this is due to an error in the data or the benefits secured. It will also cover claims from overlooked beneficiaries. It is not limited in term or total amount of claims but comes at a typical additional cost of between 0.5% and 1% of the scheme’s liabilities. For these larger transactions this can easily run to multiple millions of pounds and can be particularly significant in the context of any surplus or deficit.

What are the pros and cons of residual risk cover?

The additional premium is not the only cost of residual risk insurance. The insurer will carry out detailed due diligence and will seek to ensure any issues found are resolved (at the scheme’s cost) or excluded from the cover. By opening up the scheme’s records and data to an insurer actively looking to find problems, there’s a real risk that the insurer finds issues in its due diligence that would otherwise likely never have arisen. For any issues that are found, there may be additional liabilities as well as the cost (and effort) of rectification exercises. In some cases trustees may need to go to King’s Counsel or even to court to untangle tricky legal issues – again meaning additional time and cost.

The scheme also needs to be prepared for the time and costs involved in undertaking the residual risks due diligence itself. For schemes who want to go into this process fully prepared, this will involve a detailed legal review of both current and historic Trust Deeds and Rules, administration practices, various other documents including member booklets, announcements and minutes and any special cases where members may have been promised enhanced benefits. Just gathering the data for this process is a material task to be undertaken and can take a significant period of time. In addition, the scheme’s administrators need to be prepared for the data due diligence and the material volumes of queries this may generate.

So why do schemes want to take out residual risks insurance?

In many cases this is due to the sponsoring company seeking a clean break from the pension scheme at a known cost, and particularly if they are working to a tight timescale to achieve this as residual risks insurance can speed up the time taken to move from buy-in to buyout. Trustees who wish to purchase the cover are generally comforted by knowing that member claims (where these are valid and not excluded by the policy) should all be met by the bulk annuity insurer rather than the member having to speak to multiple parties. They also take comfort from the fact that the cover is from a regulated insurer whose longer term financial strength is likely to be more secure than that of their sponsor.

However, there is a growing recognition that the cover may not provide value for money, particularly with the growing lists of exclusions and corrections required that arise from the due diligence process.

And what are the insurers’ views?

Insurers know that to compete in the large scheme market they need to offer this add-on alongside their core bulk annuity product, but the work involved for them is high – perhaps comparable to writing another similar sized bulk annuity, where the potential profit is significantly higher. For this reason, insurers are tending to be more selective on which cases they will offer residual risks, and it is one of the factors that will be taken into account when deciding whether or not to participate in any particular process in the current busy market.

Insurers are keen to stress that they are paying claims that have arisen under the residual risks policies they have written, but to date at least these have tended to be isolated or scheme specific issues and relatively low in value to rectify. Many of the claims are in relation to overlooked beneficiaries, who can be covered by trustee run off policies for a more commensurate premium.

And unsurprisingly, insurers are learning from the claims that are being made, making sure these issues are thoroughly investigated in their due diligence for new cases, making them less likely to arise again in future. However, there does still remain the risk of a really big claim under these policies, which could emerge many years after the transaction was written.

Top tips

Top tips for schemes considering seeking residual risks insurance for their bulk annuity:

  • Firstly, just because your scheme is large enough to demand residual risks insurance doesn’t mean it is right for your particular situation. Understand the whole package of protections that may be put in place and the views of both the trustee and company on how these risks are best allocated. In some situations, this will be through purchasing a very comprehensive package of insurance via a residual risks policy, but in other cases the money can be put to better use.
  • Secondly, make sure you understand the true cost of residual risks. As noted above, it comprises not only the extra premium, but also the additional costs of resolving any issues uncovered plus also perhaps paying a higher premium on the overall transaction if a competitive insurer chooses not to quote because residual risks is required.
  • Thirdly, if you do decide to seek residual risks insurance, be on the front foot in terms of identifying issues and resolving them before an insurer gets involved, to allow you to present your scheme in the best light when the time comes for an insurer to do its due diligence. And make sure you, and your advisers, are fully prepared for the work involved in due diligence and negotiation of the exclusions, to ensure that the cover does provide the protection you are looking for, rather than having to agree to exclude issues which cannot be resolved to the insurer’s satisfaction in the time available.

Senior Director, Transactions
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