Longevity swaps set to flourish in wake of BT deal

“MORTALITY CREEP”, as it is known, is wonderful looked at from the standpoint of the individual. After all, a long and happy life is universally thought to be a good thing. However, as far as defined benefit pension schemes are concerned, the continued upward path of longevity creates a whole new class of risk. 

As Andrew Ward, a principal at reward consultants Mercer, notes, longevity risk affects the vast majority of DB schemes in the UK. “There is an increasing awareness among trustee boards both that longevity is a risk to the funding level of the scheme, and that it is a risk that they have not yet covered,” he comments.

Many schemes have already addressed unwanted risks, such as inflation rate risk, interest rate risk and equity risk. They use hedging in various ways to cover the first two and liability-driven investment strategies to try to mitigate volatility in the price of the assets in the fund. Using longevity swaps to cover the risk that members of the scheme will live significantly longer than scheme actuaries and trustees originally assumed, thus putting pressure on scheme funding requirements, makes sense if trustees can get the risk shifted at a price they can accept.

According to Ward, Mercer is working on a number of transactions with UK and European DB pension schemes, which goes to show that there is now solid evidence of a trend for schemes to consider longevity risk as just another risk to be managed by transferring it to a third party at an appropriate price. What is likely to bring pricing down to the level where more schemes will find it acceptable, he says, is the interest now being shown in longevity swaps by the capital markets, via reinsurers. 

Record breaker 

Undoubtedly, the huge £16bn longevity swap  – the largest of its kind in the UK – entered into by BT which was accomplished via a reinsurance agreement with the Prudential Insurance Company of America (PICA) is likely to stimulate other reinsurers to get involved. 

A big feature of the BT scheme was the captive reinsurance vehicle set up by BT to facilitate the agreement with the reinsurer. By transacting directly with Prudential, the scheme saved the intermediary’s fee, which would usually be between 1% and 1.5% of the transaction value.

Ian Aley, senior consultant at Towers Watson, which advised on the deal, says the transaction was the result of a thorough review of the scheme’s risk exposure, followed by a competitive selection process.

“Until recently, it would not have been possible to hedge anything like this much longevity risk in one go,” he says.

“A strong appetite from reinsurers means that very large deals are now possible. A ground-breaking structure also meant that there was no intermediary wanting to limit how much risk passed through its balance sheet. We do not expect schemes establishing their own insurers to become the standard template for transferring longevity risk.”

The structure of the deal is similar to the £5bn longevity swap secured by Aviva earlier in the year, which used an insurance subsidiary to deal directly with reinsurers. BT is the first non-insurer to test the approach.

Affordable approach 

However, using a longevity swap is an expensive option to put in place, given all the bespoke documentation and legal and other professional advice required. Ward argues that more affordable approaches are available for smaller schemes.

“We have been doing a lot of work to address smaller schemes in the sub billion-pound fund category. Our goal was to get away from the large fixed costs associated with bespoke, heavily negotiated mega contracts, with their complex collateral requirements,” he comments.

“Where schemes have data on their members that is based not just on postcode but on a reasonably extensive history of the mortality numbers on pensioners who have passed through the scheme, it becomes possible to work with schemes to allow them to hedge risk – going down as low as £50m of liabilities.”  

The difference in scale between £50m of liabilities and the BT scheme’s transfer of £16bn is enormous and suggests that the UK could soon see even relatively modestly sized schemes looking to pass their longevity risk off to reinsurers. 

As things now stand in the market, Ward points out, you have the intermediated products in the mid-tier, with the likes of Legal & General and Deutsche Bank being prepared to look at longevity swaps. Meanwhile, there is the dis-intermediated market at the top end with schemes of the same size as that of BT setting up captive insurance companies domiciled offshore, which are then able to negotiate directly with the reinsurance market. This enables the super-large schemes to conclude a longevity swap without paying intermediate fees to Legal & General or Deutsche, both of which would then probably go direct to the reinsurance market for funding and to lay off part of the risk. Negotiating through their own captive insurance company potentially gives large schemes more flexibility in negotiating unique terms with the reinsurers. 

A big factor in favour of such negotiations is that the company has the benefit of not being caught up in the exposure that Legal & General or another intermediary will already have to the reinsurance market. At a stroke, they are no longer bound by the credit control limits that any particular reinsurer places on Legal & General or any other provider. On the downside, of course, the big scheme has to bear the administrative costs of running its captive insurance company over the medium term, until the scheme winds down. 

“One of the beauties of going through an intermediary like L&G or Abbey Life is that if the administration costs of the scheme go up, the insurance company – and not the scheme – bears the cost, but the dis-intermediated approach, with its direct relationship with the reinsurance market, is definitely worth exploring for the bigger scheme,” Ward says.

Tip of the iceberg

The smaller end of the market is now being actively considered by several parties. In June, Mercer and the global insurer Zurich announced what the pair called “the UK’s first competitively priced longevity hedge accessible to the majority of the UK’s DB schemes”. 

The scheme is backed by a panel of reinsurers, fronted by Zurich, and the complexities of running a longevity hedge, which involves collateral and cash moving between the parties depending on whether the hedge is in or out the money, will be handled on behalf of participating schemes by Mercer’s fiduciary management service. Mercer has basically pre-agreed hedging terms with the reinsurance panel, thus allowing clients access to very competitive pricing. 

“This is an innovative, practical step, opening up a cost-effective DB de-risking approach for schemes of all sizes,” explains Ward. 

He points out that while it is undoubtedly good that reinsurers are discovering an appetite for taking on longevity risk at sensible prices, the actual scale of the UK market is much greater than the available cash pool to date. 

“We have seen an increasing number of reinsurers coming to the market, but we have more than £1.5trn of private sector liability in the UK pensions industry. In 2013 we saw around £9bn in longevity swaps being written. This year, we are already at about £20bn and there is likely to be some £30bn in deals by the end of the year. However, in comparison with £1.5trn, that is just the tip of the iceberg,” he comments.

Matt Wilmington, a partner at Aon Hewitt, which was involved in the BT swap deal, says: “We have been talking for a number of months about the increasing capacity and appetite for the global reinsurance market to take on pension fund longevity risk. The BT transaction, and the total buy-in which was immediately reinsured, shows that there is plenty of capacity available.” 

Martin Bird, senior partner and head of risk settlement at Aon Hewitt, adds that the demand for large-scale deals will continue to grow and that he is confident that the provider market would respond. “We are seeing a rapid response from the provider market, with a number of new solutions available. This includes the use of captive structures which enable even the very large schemes to make risk settlement secure and affordable on such a scale,” he concludes. ?