First, the nature of the business for which it is primarily used: pensions provided by insurance companies. When an individual puts their life savings into an insurance company in return for a promise that the company will pay their pension right up until their death (potentially decades later), we need to be very confident that the company is going to be able to make good on that promise. The same is true when companies of all sorts pass their pension liabilities over to an insurance company, which is happening in very high volumes – for those pensioners too we need take care that the foundations of that insurer are robust. We estimate that over 8 million policyholders are served by this sector. [3] And second, the MA is a vital part of those foundations simply because it is so large – on the most recent figures, the total assets in MA portfolios amount to around £ billion, and the MA confers a capital benefit on insurers of around £ billion – up from around £ billion when the regime was introduced. To put that £ billion figure in context, the entire capital base of the life insurance industry is around £ billion, and for a number of insurers the MA by itself makes up the bulk of their capital. In short, millions of pensioners rely on their insurer for their livelihood, and in turn those insurers rely very heavily on the MA.
The word “expect” is doing more work in this sentence than you might have appreciated. In working out what returns firms should expect to receive from their assets, it is necessary to make assumptions about how many of those assets will go bad – for instance, how likely is it that a company in whose bonds an insurer has invested will go bust and stop paying interest? Or how likely is it that an insurer will get into trouble, be forced to sell its asset for less than it originally paid and recognise a loss? Due to these possibilities it would obviously be wrong to recognise all the returns on assets upfront, because some of them will not materialise – at the very least these need to be deducted. Under the MA this is done in a mechanical way, based on returns and losses experienced in the past. The problem with this approach is simply that expected losses based on averaging the past may or may not be a good guide to the future. [4] There are plenty of examples in finance and elsewhere where the past has not proved a good guide to the future – recent moves in some commodity markets is a topical example, and the performance of subprime US mortgages in the financial crisis is another which illustrates the serious costs that can be incurred when we get this wrong.