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The rising profile of longevity swaps

Will the swap deals market ever really mature?

Luckily for the sellers of longevity risk swaps, the number
of prospective clients for the product equal the number of companies that run a
pension scheme. Plus most of these are being weighed down by their pension
scheme obligations and want a way out ­ cue the blossoming of a large and liquid
market in these financial instruments. But while there has been a handful of
swap deals done in recent months that have raised their profile, some observers
think the fundamentals may not yet be strong enough to see it turn into a mature
market.

A longevity swap is a contract that allows a pension scheme to sell the risk
of its members living longer, but hold on to the underlying asset (the scheme
and its members). The buyer accepts the risk in return for a steady stream of
income by way of fixed payments from the scheme that are unaffected by the
longevity risk.

There are two key types of deals to choose from currently: capital
markets-based, which is a longevity swap backed by one or more investment banks
putting up the required capital and securities to undertake the hedge, or
insurance-based, in which the lead counterparty is an insurance company (but so
far, usually backed by investment bank capital).

The two types are essentially the same deal but the difference is the main
counterparty. Capital markets swaps are governed by the International Swaps and
Derivatives Association while insurance-based contracts are governed by the
insurance regulatory regime, though the latter has not been tested by the
market, given that all deals have had investment banking capital behind them
(and in the case of one of the first landmark swaps, insurance giant RSA’s swap
with counterparty Rothesay Life; Rothesay is a wholly-owned UK subsidiary of
Goldman Sachs).

First deals
The handful of deals done by UK companies so far have been restricted mostly to
pension funds of RSA’s scale ­ Babcock International’s swap for two of its
defined benefit (DB) schemes with Credit Suisse was the very first deal in the
UK, completed in May 2009 ­ but the numbers are widely anticipated to rise as
finance directors remain unsettled about their pension burdens and will need to
throw yet more cash at their schemes to adhere to new Solvency II capital
adequacy rules.

Providers see the UK as one of the most lucrative European markets for
longevity swaps given the size of its pensions industry, followed closely by the
Netherlands and Germany. As Financial Director went to press in
mid-February, rumours had surfaced that UK food producer Premier Foods and
Germany’s BMW were about to confirm they had signed longevity swap contracts,
though both remained tight-lipped.

However, the development of the market may be held back for some time by a
lack of understanding of the concept among trustees, finance directors and
others. Even those selling it cannot always explain clearly what it is. And the
pension fund manager at one UK company that has successfully undertaken a
longevity swap says simply organising the requisite data and contracts to
orchestrate the deal could be one reason why there has not been faster take up.

“It has taken so long for the market to take off because it has been a
lengthy process to negotiate and complete a deal,” says Nick Greenwood, pension
fund manager at the Royal Berkshire Pension Fund, which completed its longevity
swap contract with Swiss Re last December, covering 11,000 staff pensions and
liabilities worth £750m. Greenwood agrees that the time it takes to familiarise
all parties with the concept, explain how it works and then figure out a deal
everyone is happy with is both long and complex. There is a degree of education
at both FD and trustee level to be done.

Sellers of longevity swaps are investing in overcoming this particular
hurdle. In February, a consortium of investment banks and insurers including
Axa, Legal & General, Royal Bank of Scotland and Deutsche Bank set up a
dedicated organisation, the Life and Longevity Markets Association, aiming to
promote the idea of hedging longevity risk and build the skeleton of a
functioning longevity risk market, pushing the development of standardised
contracts, establishing a longevity trading index (similar to JP Morgan’s
LifeMetrics, which currently covers The Netherlands, Germany, England and Wales
and the United States) and a standardised longevity valuation model.

Questions remain, however, as to whether longevity swaps will become a common
thing or if they’ll remain restricted to larger companies with huge pension
liabilities. “The jury is still out on whether the risk transferred is material
enough to go to the trouble of buying a longevity swap,” says Richard Giles,
pensions director at PricewaterhouseCoopers. Giles adds that, at present,
longevity swap deals are very costly given that it is still a nascent market
requiring mostly tailored contracts. But he thinks this will change.

Time is right
John Lawson, Standard Life’s head of pensions policy, says the longevity risk
swap products that came out of the banking sector a few years ago did not really
appeal when they were first on offer as hefty pension schemes could be
shouldered by companies in good times. But he thinks they are now being picked
up as more companies close their DB schemes to existing or new members.
Additionally, many are unable to afford to pursue a full scheme buyout as
underlying asset values take a battering and intense interest in that exit route
pushes the cost out of reach for many ­ opening the door for longevity swaps.

Many are betting on these swaps as one way to manage various burdens holding
back the UK economy from exiting the recession of the real economy. But some
think that the creation of a sustainable longevity swap market could also help
the industry to improve its image and to offer something that can help bu
sinesses through what is expected to be a long road to recovery. It is also an
alternative to simply closing schemes: in 2008, according to The Pensions
Regulator, 18% of defined benefit schemes were shut to future accruals, while in
2009 a glut of big companies including Vodafone and Barclays followed suit
taking advantage while employees are less likely to complain ­ because at least
they still have their jobs.

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