Swaps back in fashion

THE SECOND half of 2011 saw something of a boom in longevity swaps after the lengthy pause which followed the biggest swap on record, namely the £3bn swap with Deutsche Bank by BMW’s UK pension fund in February 2010. A longevity swap is a derivative contract that offsets the risk of pension scheme members living longer than expected.

The next major swap was not until July 2011, when ITV did a £1.7bn swap with Credit Suisse. This was followed by a flurry of deals, which included another £3bn deal, this time by Rolls Royce, while Pilkington Glass concluded a £1bn swap and British Airways did a further £1.3bn swap.

Lane Clark & Peacock partner Charlie Finch says that in total, the market for insurance-based solutions to pension fund risk, including longevity swaps, was worth between £11bn and £12bn in 2011, up from a steady figure of around £8bn for the two previous years. Longevity swaps accounted for some £7bn of that £11bn.

The rationale for companies doing longevity swaps is fairly clear, though there are complex calculations to be made for each scheme to see if a longevity swap makes sense for their particular circumstances. The whole idea is to cap off a potentially volatile source of risk.

“There is no doubt that the vast majority of finance directors would like to be able to get rid of their entire legacy final salary scheme through a buy in, but for most there are other demands on company cash, or there is simply insufficient funding available to go for a scheme buyout,” Finch says. “So taking out chunks of risk, including longevity makes sense.”

Life expectancy, Finch points out, is increasing by about two hours per day. Each additional year added to a scheme’s mortality calculations adds about 3.5% to the scheme’s liabilities. This figure has proved pretty stable over the last 10 years.

“There are huge uncertainties surrounding mortality and the assumptions that are made. The actuarial profession is working hard on this and we have seen mortality creep predictions becoming much more stable,” he says.

Andrew Ward, a principal with Mercer, points out that while the actuarial profession has excellent historical data, there are many imponderables concerning how things might progress in future. On the one hand, medical science might dramatically increase life expectancy over the next few years, leaving schemes well behind the curve. On the other hand competition for scarce resources, or runaway climate change could have dramatic effects on populations, sending mortality expectations sharply downwards. There are huge unknowns on every side.


One of the complexities with the big longevity swaps deals is that they are supported by both sides putting up collateral. This is seen as essential to mitigate counterparty risk. Longevity deals by their nature tend to be long-term contracts and you want to be certain that the person providing the insurance on the deal is going to be around to honour their side if mortality creep goes against them. This has been a major factor in excluding smaller schemes from participating in longevity swaps.

Another point is that each longevity swap is a heavily bespoke deal, and the costs can be offputting for smaller schemes. However, both Ward and Finch say there is considerable interest among reinsurers and banks to try to capture a slice of what looks like being a very lucrative insurance market.

“With about £1tn in scheme assets in the UK, and just £20bn or so of swaps done, the scale of the potential market is enormous,” Ward says. This interest is likely to open the way for smaller schemes to do non-collateralised deals, relying on the size of the big reinsurance companies and banks to provide them with the security that they need as far as counterparty risk is concerned.

Finch points out that while it might look odd, on the face of it, for any bank to want to take on longevity risk, when that risk is so painful for pension funds, there is actually a very sound rationale behind this developing market. The banks lay off the risk almost instantly to the big reinsurance companies. There are five of these who are the dominant longevity swap players, namely Munich Re, Hannover Re, Prudential Finance of America, Reinsurance Group of America (RGA) and Pacific Life.

“The attraction for them is that they have a massive exposure to the risk of people dying early. So hedging this risk with longevity risk, which is all about risk moving in the opposite direction, makes a lot of sense for them,” Finch says.

Andrew Gaches is longevity consultant with Club Vita, an organisation set up by actuaries Hymans Robertson. The club was set as a group of 150 participating pension schemes, all of which pool their pension scheme data anonymously with Hymans Robertson so that the firm can provide members of the scheme with very detailed longevity analysis across a large pool of data.

“What is emerging is that there is a huge variation in life span across schemes,” says Gaches. “There is no such thing as one type of scheme with one type of member and a very clear lifespan profile. You have to understand the range of lifespan possibilities inherent in the scheme and this helps you to make better decisions, and to see if a longevity swap would make sense for your scheme.” ?


Related reading