Making sense of longevity swaps

“For most pension schemes, we see the longevity swap debate as an interesting intellectual exercise, but one that currently has little real-world application.” That was the opinion of Norwich Union’s head of defined benefit risk management Nick Johnson last March, in a debate hosted by Professional Pensions magazine on the emerging topic.

“There are a number of practical complications for which we haven’t seen any workable solutions. These include cost effectiveness, difficulties of understanding and documenting exactly what you are getting.”

Johnson remains correct in the latter, at least. The risks of these products have not been examined as closely as the perceived benefits ­ but this is an important part of the process of understanding them, which some report trustees and FDs need to pay closer attention to.

The resounding entrance into the longevity swap market by some very large businesses has raised interest from many other UK businesses. But there are voices warning that FDs need to swot up on the potential for costly problems down the line. Finance directors should be taking note of the longevity risk swap market as a way to avoid closing schemes altogether and as a sophisticated way to manage pensions volatility that is hitting profit margins with alarming force.

Richard Giles, pensions director at PricewaterhouseCoopers says some attractive prices for longevity swaps are starting to come through, as some of the providers look to break into the market and some schemes’ own assessment of future life expectancy moves more in line with what counterparties price. “The gap between what providers want to charge and what schemes are willing to pay is beginning to close,” he explains.

But even before the first UK deal had been made in 2009, law firm Slaughter & May issued guidance around the possible ramifications from the emerging idea of insurers transferring pension risk out to the wider financial markets. While advising that those looking into these products will need to retain the advice of both swaps, insurance and financial regulatory experts ­ in itself, an expensive business ­ it outlines a series of concerns that FDs could use as an initial checklist when looking into longevity swaps. These include:

• Satisfying regulators as to the extent of risk transfer ­ which it thinks has a profound effect on termination rights, warranty protection and premium adjustment;
• Ensuring the swap is not at risk from counterparty default or other change in the credit environment;
• Establishing who is responsible and where the rights lie in respect to the administration of4 underlying insurance policies, asset management and custody arrangements;
• Outlining how the swap is affected if the business from which the pension scheme emanates changes hands, or if there is a merger. For example, outlining what happens if your business becomes insolvent
• Deciding if the swap arrangements themselves should be characterised as a contract of reinsurance, for legal and regulatory purposes, and what the consequences are;
• Establishing that rights under the swap amount to an admissible asset from the insurer’s perspective that can count towards the coverage the insurer has of its technical provisions ­ and do not lead to a capital deduction of the insurer; and
• Establishing provisions relating to the calculation and adjustment of any longevity index used and the swap payment flows.

Derivative or insurance
Touching on another angle, PwC’s Giles says there are two particularly fine points of which FDs should be aware. “One is to consider whether the cover you buy is written as a derivative, or as plain insurance,” he says. “The second is whether the cover is written against the longevity risk from the members of the scheme, or against the longevity risk from the population index used by the arranging counterparty.”

Giles adds that risks to all longevity swap contracts include the risk that the cover doesn’t match the schemes liabilities such as spousal benefits and the potential for the effect of inflation ­ something many are worried about in the future. There is, of course, the risk that the counterparty will go bust.

“Care must be taken to future-proof the contract,” says Giles, meaning that buyers must ensure either they insure against this eventuality or write into the swap a surrender clause that ensures the counterparty will surrender the swap to another party that can ensure continuity if it can’t, such as the Pensions Protection Fund.

Cost remains prohibitive for many companies who might otherwise undertake a longevity swap and counterparties are likely to charge extra for insurance cover as well as taking a rather juicy margin. If you can afford it and can weigh that against what you save in transferring the pension risk out, it is worth a look. “It’s a case of, is that peace of mind worth it,” says Giles. “For many pension schemes it proves to be a vital lifeline.”

Too difficult
Ensuring all relevant parties understand what’s on offer is not a simple undertaking. There are significant obstacles to pension fund managers from feeling confident in taking out a hedge on their longevity risk. According to Noel Hillmann, managing director at pensions research outfit Clear Path Analysis, more than 80% of pension schemes it contacted in a recent report on longevity hedging reported their greatest concern and challenge is simply understanding the details of the swap they were entering into. “Collateral, counterparty risk, impact on the sponsors financial reserves and education of trustees and corporate sponsors were all issues that they felt they needed to understand before progressing further,” he reveals.

Robert Gardner, founder of risk management advisory Redington, supports this view. He believes there has been a tendency to dismiss longevity as too difficult, with many schemes using prudent actuarial assumptions to provide the ‘illusion’ of risk management. “However, the emergence of longevity risk transfer concepts in the UK appears to provide the elusive final piece of the liability-driven investment risk management jigsaw puzzle,” Gardner says. And with the creation of the Life & Longevity Markets Association, which is aiming to increase understanding and, in doing so, bolster activity in the market, the idea that longevity risk swaps are simply too brain-zapping to consider may ebb away.