Pensions risk transfer: the risks of residual risk insurance

This can be an attractive option for trustees in some cases, but there are risks of seeking residual risks cover that should be considered before the insurance is purchased.

What is residual risk insurance?

As insurer pricing has continued to improve, more pension schemes are within touching distance of a full buy-out and wind-up. At this point, the priority for trustees and employers is to ensure a clean break – so that once the scheme is bought out, they are discharged of their duties and don’t need to worry about any future claims or disputes in relation to the benefits that have been secured. 

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• Pensions risk transfer: trustees’ rights to use scheme assets
• Pensions risk transfer: getting governance right
• Pensions risk transfer: the value of a clear vision for full scheme buy-outs
• Pensions risk transfer: reinsurer requirements
• Pensions risk transfer: company wind-up indemnities
• Pensions risk transfer: PPF+ deals
• Pensions risk transfer: discretionary pension increases
• Pensions risk transfer: GMP equalisation and bulk annuities
• Pensions risk transfer: data warranties
• Pensions risk transfer: material change
• Pensions risk transfer: insurer buy-out requirements
• Pensions risk transfer: the endgame strategy
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One increasingly popular way of doing this for larger schemes is to take out additional insurance cover from the buy-out insurer, known as “residual risks” cover. If residual risks insurance is taken out, the insurer will accept liability for certain residual risks, such as:

• claims from missing beneficiaries;
• a beneficiary proving he has a right to a higher level of benefits than those insured;
• a future change in law which reveals that higher benefits should have been secured;
• errors in the data file provided to the insurer; and
• the method used for guaranteed minimum pension (GMP) equalisation being found to be deficient.

The cost of this insurance is typically in the region of 1% of the bulk annuity premium.

What are the alternatives?

When a scheme winds up, there are usually various layers of protection for trustees. These include exoneration and indemnity provisions in the trust deed, statutory notices to protect against missing beneficiaries, and legal principles such as the corporate veil – which provides comfort for directors of trustee companies.

Beyond this, trustees often take out some form of insurance protection. This is typically in the form of either residual risks insurance form the buy-out insurer, and/or “run-off” insurance from a general/professional indemnity insurer.

Run-off insurance protects trustees against liability discovered during a run-off period which arises from their negligence or an “honest” breach of trust. It will usually cover their legal costs of defending claims brought against them. Premiums tend to be lower than for residual risks cover. 

So why consider residual risks cover?

Many trustees are comfortable relying on the protections described above, along with a run-off insurance policy. However, there are some limitations to typical run-off policies which trustees should be aware of. In particular, the cover tends to be limited. Typically, limitations include:

• a financial cap on the insurer’s total liability under the policy;
• a time limit for the run-off period, beyond which any claims (which are not time barred under usual legal principles) will be at the risk of the trustees rather than the insurer;
• the cover usually applies on an indemnity basis, which means that the insurer is only liable to pay out to a beneficiary who brings and wins a legal claim; and
• if a member's claim is successful, the insurer may be required to pay damages to compensate the member for the loss he has suffered, but if the member wants to convert this to a higher pension, he would need to arrange this himself.

Residual risks cover can address these limitations.

What are the risks with residual risks?

An important difference between residual risks and run-off insurance is the level of due diligence the insurer will undertake. Run off insurers typically undertake some basic due diligence, asking the trustees to complete a questionnaire designed to flag certain key risks.

Residual risks insurers follow a more rigorous process. They will require all scheme documents – current and historic rules, merger deeds, booklets, announcements, minutes of trustee meetings, etc. – to be uploaded to a data site. They will then arrange for a team of lawyers to review these in detail and flag any material risk areas or areas of uncertainty.

If material risk issues are discovered which the insurer cannot price with confidence, these are likely to be excluded from the cover and the risk will remain with the trustees or the sponsor. Usual suspects are issues arising from Barber equalisation, changes to pension increases and scheme closure/severance of the final salary link, but this is not an exhaustive list.

If there are significant exclusions, then the residual risks premium may begin to look expensive relative to the scope of the cover. If material issues emerge, this could also impact on project plans and timelines for completing a buy-out, whilst these points are being resolved. 

Also, once these issues have been identified, trustees wishing to purchase additional or separate cover from a run-off insurer may need to disclose those issues to that insurer too, which may give rise to exclusions under a run-off policy that would not otherwise have been required.

In summary

Residual risks insurance can be an attractive option for trustees as it addresses a number of limitations often encountered in the run-off insurance market. However, if material issues are identified in the due diligence phase, they may be excluded from the cover and will ultimately remain with the trustees and corporate sponsor after winding-up.

Different solutions will suit different schemes, depending on several factors including the risk appetite of the trustees and sponsor, the scheme's financial position and the trustee's confidence in the reputation, standing and capabilities of the insurer.

Trustees and sponsors should carefully consider the risks and benefits of the main insurance options with an authorised insurance broker and take legal advice on the other layers of protection on buy-out. They should do this at an early stage of the process, as a decision to purchase residual risks cover will affect the timescales and professional advice costs for the transaction.