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It is only a matter of time before a more simplified approach to longevity swaps becomes more prevalent, Robus Insurance (Guernsey) directors Kate Storey, Frank Oldham and David Riley, explain.
As more and more Defined Benefit (‘DB’) Pension schemes steadily reduce the various forms of investment risk, moving away from return-seeking assets and increasing exposure to liability-matching forms of asset, along with the hedging of interest and inflation risks, mortality rapidly moves up the agenda as a material and, in most cases, the only completely unhedged risk. While the rate of mortality improvement may appear to have slowed, according to CMI data (as published by the Institute and Faculty of Actuaries), it is still arguably an unrewarded risk and certainly a skewed risk for pension schemes. Furthermore, the often-hidden component of longevity risk is concentration. It is common for no more than 20% of the pensioners represented by the largest pensions to account for more than 50% of the liabilities. In some sectors this can be as low as 10% of pensioners. Naturally this portion of the population tends to be more able to look after itself, with higher standards of living, and so will be likely to live the longest, adding to the inherent longevity risk for a scheme. As a consequence and combined with the level of capacity and attractive pricing, this continues to make the longevity swap market active.
Guernsey is seeing marked interest and growth in the use of incorporated cells (ICs) as an efficient structure to facilitate longevity swaps. In particular, two major transactions have been executed, for £3.4 billion in liabilities (Marsh & McLennan Companies) and for a further £1.6 billion in liabilities (British Airways Pension Scheme). There was a further recent transaction in Guernsey however the details have not been made public. Pension scheme trustees see benefits in the flexibility afforded through a more direct relationship with the re-insurer that an “owned” captive cell affords, along with more visibility over management of the operational risks, as shareholder of the captive cell. There is also the possibility of sitting on the board of directors and the potential for valuable fee savings for a material transaction from the elimination of the fronting insurers’ fees.
Moreover, Guernsey continues to be the domicile of choice for IC-based swaps, with a range of key stakeholders already being experienced in the relevant issues, added to which the Guernsey Financial Services Commission (GFSC) have demonstrated their support by endorsing practical guidance issued by the Guernsey International Insurance Association (GIIA).
There is a widely held view that, with increasing competition between potential longevity reinsurers and some new participants entering the market place, pricing remains attractive – not least since the reinsurers now appear to have embraced the latest trends in mortality statistics. That all said, there is also increasing demand, both from insurers looking to manage their own longevity risks and capital requirements under Solvency II and of course from pension schemes themselves as the flow of buy-ins, but-outs and longevity swaps continues. All of this is currently combining to generate a strong desire to execute within an active market.
However, it has been argued by some that longevity swaps remain in a similar situation to insurance-linked securities (ILS) some five years ago. Every deal is largely bespoke with the consequential increase in complexity and execution costs. There is strong demand from interested parties for simplification and standardisation which have the potential to reduce deal liability sizes from billions to hundreds of millions and significantly enhance the deal flow. It will be interesting to see over time whether ILS commoditisation is achieved.
Increased funding levels over the last 12 months, driven largely by increasing yields and discount rates, are undoubtedly leading to increased activity in the risk transfer market with expected growth in bulk annuity purchases by pension funds. However, the full asset transfer that a bulk annuity purchase entails is not for all. Many are still unable to fund a buy-in without a material impact on their residual risks and/or potential funding implications. By comparison a longevity swap allows the scheme to retain control over the portfolio of investments, investing for higher returns if necessary, or to fit with broader sponsor or trustee beliefs. Some may even prefer to rely on the corporate rather than an insurer covenant, adopting a “self-managed” approach to investment and longevity risk.
The Guernsey IC structure continues to flourish, primarily due to its flexibility. Ownership of an IC can be changed via a simple share purchase agreement, in the event of changes to the swap structure (eg subsequent novation to a third-party insurer). Further, ICs can be moved relatively easily between Incorporated Cell Companies (ICCs), the umbrella structure within which an IC sits, or hived off from its ICC to form a standalone company. Each IC is also a separate legal entity, financially ring fenced, which provides stronger protection than that afforded by Protected Cell structures.
There has been one practical concern, sometimes raised by trustees, in relation to Guernsey-based ICs, namely that the directors of the individual ICs must be the same for every IC within an ICC. The GFSC has recognised this and there are now proposals in hand to change the ICC law to require only one director to be common across all the ICs of an ICC. This is a strong signal by Guernsey of the desire to be flexible and supportive of the pensions industry and would allow trustees more direct oversight of their own IC.
Overall, the evident proportionate regulation adopted by the GFSC is supporting the continued growth of and interest in the market. There is effectively a simplified application process for an ICC in this market as the regulatory risks are well understood by all parties. By way of example it is now the case that ICs can be licensed for longevity swaps without the need for an appointed actuary. This is in recognition of the fact that the more recent transactions require insured (pension scheme) and reinsurer actuaries to agree on any changes to actuarial assumptions or models. On this basis there is no benefit in the IC appointing their own actuary, not least since the IC itself retains no mortality risk.
So, in conclusion, the reduction of other investment risks over time combined with the 20:50 rule in relation to the concentration of pensioner liabilities is likely to continue to feed demand to transfer longevity risk, whether through bulk annuity transactions or longevity swaps. Surely then it is only a matter of time before a more simplified approach to longevity swaps becomes more prevalent – not least to feed the demand for such solutions amongst smaller and mid-sized schemes.
Whatever the outcome, it seems likely that we will see continued interest and activity in Guernsey-based ICCs as one of the key and most practical implementation options, involving buy-ins, buy-outs and longevity swaps, to provide a flexible and sustainable way to deal with this concentration of risk.
All three authors are directors of Robus Insurance (Guernsey).
Kate Storey is a Guernsey lawyer with Walkers and over 17 years industry experience. She can be contacted at: firstname.lastname@example.org
Frank Oldham is a pension trustee and formerly global head of defined benefit pension scheme de risking at Mercer. He can be contacted at: Ftoldham@btinternet.com
David Riley is a risk consultant with Robus Group and project managed one of the recent longevity swaps. He can be contacted at: email@example.com
Pension risk transfer, Incorporated Cells, Robus Insurance, Guernsey