To insure or self insure
The normal practice in the UK is that death-in-service lump sum benefits will be provided on a fully insured basis. This is the case even for schemes which are sufficiently large to have moved away from insurance contracts as the basis for providing pension benefits. Yet there are circumstances when the trustees of the scheme can profitably consider providing the lump sum life cover benefit on a self-insured basis.
John Cowell senior consultant and actuary at employee benefit consultants William M Mercer explains that there are four main factors that come into play when considering whether the death-in-service lump sum should be insured or self-insured:
Claims variability: The greater the number of active members, the smaller the likely variability in the scheme’s claims experience over time. The smaller the variability, the greater the predictability of the cost. The greater the predictability of the cost, the easier it is to fund the cost of lump sum death benefits from the pension fund. Variability is also affected by unusual differences in the profile of the active members - for example it will be harder to predict confidently a scheme’s future claims experience if it has many young, lower paid, employees and just a few older very high paid members. In such a case, the use of ‘stop loss’ insurance might be advisable so that the larger number of younger employees would be self-insured and the older members would be insured. Alternatively all could be self-insured up to a stated amount, and in the case of the death of a higher paid member, the excess over of the stated amount would be insured. An actuarial analysis of the expected claims outcome and associated variability is often undertaken so that a conclusion can be reached.
Strength of scheme funding: If a scheme is strongly funded, the trustees are more likely to be happier to self-insure. If the funding level is weak, the trustees are more likely to prefer to insure the death-in-service benefit.
Attitude to risk: Catastrophic events do occur. A large number of employees could be killed at the same time. Even in a large scheme the cash flow implications could be severe, perhaps requiring the liquidation of pension assets at a bad time in the market. Trustees who have a high aversion to risk are more likely to prefer to keep death benefits fully insured or to buy in some form of supplementary stop loss cover.
Availability of good life rates: a comparison of a scheme’s probable future claims experience compared to the cost of the premiums payable on the market might well indicate that it is likely to be cheaper to insure.
Taking into account these four factors, in particular assuming a scheme which has a uniform distribution risk profile among its active members, is there a minimum number of active members that a scheme must have before self-insurance is a practicable option? ‘ Yes’ answers Cowell, ‘ with the option of stop loss cover, I would say that a scheme must have at least around 1,000 lives’.
Cowell points out there is two-way traffic between the insured and fully self-insured bases with stop loss cover acting as a half-way house. He gives an example: ‘the combined effects of lower interest rates, the minimum funding requirement (MFR) and the loss of the tax credit on UK company dividends are likely to persuade the trustees of some schemes to move back from self-insurance to an insured basis.’ Company acquisitions and disposals with resulting bulk transfers of active members can also radically change the risk profile of a scheme leading to a reassessment of the best way to provide death-in-service benefits. As regards the current availability of good life rates, Cowell remarks: ‘there are at the moment some extremely low rates on offer from insurers - particularly for large schemes’
The trustees or employer should therefore seek help to research the market to ensure they get the best deal. Mike Mills, who is responsible for the risk broking teams at Mercer, urges trustees or employers who have insured schemes not simply to assume that the insurer providing the pension benefit should also automatically be selected to provide the life cover element. ‘In many cases a better rate can be obtained by going to another insurer who specialises in death-in-service cover’ says Mills and adds ‘there is usually no penalty imposed by the main benefit insurer if the scheme trustees go to another for the group term assurance cover’.
In general for any scheme which insures lump sum death benefits Mills recommends a comprehensive broking exercise to identify the most competitive provider from among the 15 or so players in the UK group life field. ‘Group term assurance rates are very competitive’ , says Mills, ‘and the insurer quoting the best rates today won’t necessarily remain the most competitive’. He adds: ‘Most insurers will guarantee their rates for a two year period so re-broking exercises usually take place on a two year cycle’.
The rates offered to any trustees or employer will depend mainly on previous claims experience and the profile of the employees to be covered. Mills explains: ‘Insurers are careful about their claims experience and mortality rates differ markedly between different groups of employees. Insurers are competitive but they are still very careful about the nature of the liability they might be taking on’. He explains that broking exercise start by the consultant preparing a specification of the scheme, setting out the benefits structure, eligibility criteria as well as the scheme’s claims experience. Mills comments: ‘It is a free and easy market for scheme trustees to move from insurer to insurer. An insurer will normally take over the risk on the same general terms as the previous insurer other than premium levels.’