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21 August 2012 last updated
Solvency 2 will result in 8% lower
annuity rates for pensioners
Solvency 2 is an EU Directive designed to harmonise insurance regulation in the European Union and provide greater protection to the consumer.

As a result of Solvency 2 all pensioners retiring in the UK will be worse off in retirement and can expect a decrease in annuity rates by approximately 8% from the implementation date of 1 January 2014.

The directive is concerned with the capital adequacy and risk management standards of insurance companies to ensure these companies meet their obligations to customers and to avoid a crisis situation arising such as with Equitable Life.

By introducing these measures insurance companies will have to change the reserves they provide to cover their liabilities and as a result there will be less resources to provide income to pensioners and thereby a reduction in annuity rates.
 
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Directives impact on annuity pricing


Originally Solvency 2 was scheduled to start on 1 January 2013, however, this has been delayed to ensure each member state of the EU have made adequate provisions for it's implimentation.

When a pensioner buys an annuity the income is guaranteed for their lifetime and the insurance company will purchase UK government gilts and corporate bonds to secure the income. Gilts provide a lower income but are considered to carry no risk as they are guaranteed by the UK government. Corporate bonds offer a higher return but do have a risk of issuing company becoming insolvent and insurance companies retain a reserve in anticipation of corporate bond defaults.

The reserves are generated from the expected excess of the corporate bond yield compared to the yield from gilts and this is known as the credit spread. Insurance providers will typically reserve 25% to 50% of the credit spread to cover the expected default from corporate bonds. With Solvency 2 the rules originally required insurance providers to reserve 100% of the risk for corporate bonds and this would significantly reduce annuity rates, however, after lobbying this has been reduced.

The following table shows how the Solvency 2 rules may impact on annuity rates when introduced in December 2012.

Solvency 2 impact on annuity pricing
Before solvency 2 After solvency 2
  Gilt yields of 2.25%
  Gilt yields of 2.25%
  Corporate bond yields of 4.75%
  Corporate bond yields of 4.75%
  Credit spread of 2.50%
  Credit spread of 2.50%
  No illiquidity premium
  Illiquidity premium of 0.80%
  Default allowance of 1.00%
  Default allowance of 1.70%
  Yield net of defaults is 3.75%
  Yield net of defaults is 3.05%


In the above table the provider will generate more income from the corporate bonds, 4.75% compared to 2.25% from UK government gilts. The difference between the yields of gilts and bonds is 2.50% and called the credit spread, however, there is a risk of default from the yield generated from bonds.

This example assumes that before Solvency 2 the providers hold 40% of the credit spread for corporate bond defaults, or a 1.0% default allowance. After Solvency 2 the European regulations will require insurance providers to deduct an illiquidity premium of 0.8% from the credit spread with the residual representing the default allowance. In the above example this will increase the amount providers must hold for defaults from 1.0% to 1.70% or an increase of holding from 40% to 68% of the credit spread.

As a result the yield net of the default allowance reduces from 3.75% before Solvency 2 to 3.05% afterwards. As a general rule a change in yields will result in a 10 to 12 times change in annuity rates so the 0.7% or 70 basis point decrease in yields will mean a 7% to 8% reduction in annuity rates.

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