Longevity risk — the risk associated with increasing life expectancy of a scheme’s membership — is one of the most significant risks that defined benefit pension schemes face. It is therefore no surprise that insurance longevity swaps have become a key method of risk reduction for a number of schemes.
Put simply, a longevity swap involves a pension scheme making a series of fixed payments to an insurer, based on a best estimate of the payments that will become due to members. In return, the insurer makes a series of variable payments based on the actual payments that become due to members.
Longevity swaps are not a new concept, and previous years have seen a significant volume of longevity risk insured, so why are they becoming increasingly attractive?
Well, it would be difficult to consider the longevity swap market without considering it in the context of the booming wider pension risk transfer market.
In 2018, we saw £28.9 billion of de-risking deals completed. The record breaking £24.2 billion in respect of bulk annuities, that is, buy-ins and buy-outs, was 80% up from the previous record set in 2014. The value of risk transferred is only set to increase this year, with many experts predicting that bulk annuity deals will exceed the £30 billion mark for the first time. Longevity swaps accounted for the other £4.7 billion in 2018 — this was actually down on the previous year, but is not indicative of a lack of appetite from pension schemes or insurers/reinsurers.
Clearly buy-ins and buy-outs are, and will continue to be, a favoured option for many schemes, but there is no one-size-fits-all method of de-risking, and longevity swaps continue to prove an attractive option for many schemes. For some schemes it is the best option they can afford, and for others it is their preferred option irrespective of funding position.
So, what are some of the key factors that are increasing the appetite for longevity swaps?
It has been well-publicised that improvements in life expectancy in the UK have been slowing down. In 2016 and 2017, Aon publicly questioned reinsurers for failing to reflect this slowdown in their pricing. Since mid-2017 this “pricing dislocation” has been addressed, and the markets are now back in sync.
Indeed, it has been reported that by delaying until 2018, National Grid, who we acted for, in their £2 billion longevity swap transaction with Zurich (insurer) and Canada Life (reinsurer), saved some £40 million in cost. It appears to be an attractive time for pension schemes to be actively considering longevity swaps in order to lock into more favourable pricing.
Another positive financial aspect of longevity swaps is that, unlike buy-ins or buy-outs, there is no need to pay an up-front premium i.e. there is no day one balance sheet or profit and loss impact. Instead, the cost is satisfied by way of a series of net monthly or quarterly payments — all the while the swap provides certainty as to long term pension costs.
The regulatory regime for insurers has created a healthy appetite for longevity risk. Much of the longevity risk taken on by insurers is reinsured, and there is a global re-insurance market interested in this risk, particularly as a hedge for mortality risk on their books. At least ten re-insurers in the UK market are actively seeking deals over the £500 million mark, with many having an appetite for deals in the billions of pounds. There is also a market for sub-£500 million transactions, opening the doors to the longevity swap market for schemes of all sizes.
One risk on the horizon is the impact of demand from overseas pension schemes. LCP recently conducted a survey of reinsurers and concluded that a growth in demand for longevity re-insurance overseas, particularly in the US, could have ramifications on the pricing of longevity risk in the UK. The re-insurance capacity currently available may be diverted to meet this new-found interest overseas. So whilst schemes should be alive to improved longevity pricing in the light of mortality trends, they should also consider the current availability for these deals against the risk of potentially reducing capacity in the future.
Another appealing feature of longevity swaps is that they can be structured in different ways, including fully-intermediated, pass-through and self-intermediated, allowing the trustees and sponsors of pension schemes to adopt an approach that best fits their needs.
A recent longevity swap involving the Scottish Hydro-Electric pension scheme was on a pass-through basis, meaning the scheme takes on the credit risk of the reinsurer. The British Airways pension scheme utilised a scheme-owned insurance cell based in Guernsey for its swap, meaning the scheme also took on the reinsurer’s credit risk. The National Grid transaction on the other hand was on a fully intermediated basis, meaning the scheme faces the insurer, and it is the insurer alone who bears the reinsurer credit risk.
Various factors impact which structure to pursue, including cost and related risk appetite; ease of implementation; ongoing management; and legal and regulatory risk. Whilst self-intermediated deals, such as the British Airways swap, are more cost effective than a fully-intermediated swap they require an increased commitment to ongoing management and increase the legal and regulatory risk.
For some schemes, their rules or investment strategies do not allow the use of buy-ins or buy-outs. In such cases, a longevity swap is a viable de-risking alternative.
In addition, many pension schemes have to date focused on hedging against inflation, interest rate and/or investment risk. Longevity swaps provide a mechanism by which to hedge solely against longevity risk whilst retaining the scheme’s existing de-risking strategies.
Provided the documentation is drafted with future-proofing in mind, pension schemes entering into a longevity swap can retain the ability to enter into a buy-in or buy-out, should their funding position or objectives (or rules) change in the future.
Looking only at the historic figures, it would be tempting to think that longevity swaps are losing their appeal. This is simply a result of the booming bulk annuity market last year picking up schemes that may otherwise have entered into a longevity swap. Through pricing, availability, structure and flexibility, longevity swaps are as attractive as they have ever been.