UK: Longevity Risk Sector Picks Up Momentum

Last Updated: 2 June 2010
Article by James Parker, Kirsty Maclean and Mike Munro

In February, Abbey Life, the wholly owned insurance company of Deutsche Bank, announced it had executed the largest-ever longevity insurance transaction, providing BMW (UK) Operations' pension scheme with a hedge for life expectancy risks associated with £3bn pension scheme liabilities relating to 60,000 pensioners.

The BMW transaction follows a year in which the pace of development of the UK longevity risk transfer market has strongly accelerated.

In early 2009, it was announced Abbey Life had concluded transactions with Pacific Life Re and another unnamed reinsurer for the transfer of longevity risks associated with a portfolio of in-payment annuities with underlying liabilities of £1.5bn ($2.25bn).

A number of further longevity only transactions followed through the year and, with further participants entering the market and predictions longevity hedges in respect of a further £10bn to £20bn of scheme liabilities are likely to be concluded in 2010, is longevity risk transfer on the verge of take-off?

Annuities and longevity risk

Longevity risk is a core feature of most classes of annuity business and therefore integral to the risk portfolios of many major life insurers.

Under a typical annuity contract, the insurer agrees to make regular payments to the insured annuitant, and sometimes to other beneficiaries or dependants, until death. If an annuitant lives longer than expected, then the payments made will be greater than expected. If there is a general increase in the life expectancy of a portfolio of annuitants, there will in turn be an overall increase in the insurer's liabilities.

Many life insurers also write protection (or term assurance) business and where that is so their portfolios will already incorporate an embedded, albeit imperfect, hedge against increased longevity.

Regardless of that, understanding and managing mortality, longevity and associated demographic risks is central to most classes of long-term risk and so is at the heart of the business of most life insurers.

Companies, pension schemes and de-risking

Any entity that sponsors or provides a defined benefit (DB) pension scheme is exposed to longevity risks (as well as investment and other risks integral to annuity business).

The liabilities associated with the DB market in the UK alone are vast. While estimates vary to some degree, the total DB exposures of UK pension schemes are generally accepted to be in excess of £1trn.

The associated risks and exposures, whether to asset values, improved longevity or otherwise are similarly significant, and recent years have seen ever greater focus by sponsors, trustees and advisers on the management and mitigation of those risks - and increasing demand for de-risking products and solutions.

Insured buy-outs and buy-ins

Insured "buy-outs", involving the provision of individual annuity policies directly to pensioners in place of their membership of the relevant pension scheme, have been available for many years.

Recently, "buy-in" policies have become more common (sometimes as a stepping stone to full buy-out). While economically similar to a buy-out, a buy-in policy does not alter the relationship between the scheme and trustees and its members, but rather is purchased by the trustees as an asset of the scheme. Common to both, however, is the transfer of scheme assets to the insurer in return for a promise to pay the relevant benefits.

The market began to open up from 2005 with a number of new players emerging. Driven to some degree by attractive pricing conditions, buy-out/buy-in volume peaked between the first and third quarters of 2008 -­ with liabilities of around £8bn transferred. However, the collapse of Lehman Brothers, and the associated effects on asset prices and volatility, adversely affected pricing and significantly suppressed transaction volumes.

Longevity hedges

The buy-out/buy-in market may now be showing signs of recovery (for example, Pension Corporation announcing a buy-in of approximately £500m of liabilities from the Cadbury pension scheme in November 2009).

In the meantime, the demand for cost-effective de-risking solutions remains strong, driving the rapid growth in longevity-only transactions described above. Transaction structures will vary. However, in its basic operation, a longevity hedge (or swap) will typically exhibit features similar to an interest rate swap. In broad terms:

  • The parties agree a schedule of "fixed" payments to be made by (in the case of a pension scheme) the trustee on each payment date during the term of the hedge. The fixed payments (or premium) will be broadly reflective of the parties' best estimate of the aggregate value of benefits payments expected to be made to relevant pensioners (or beneficiaries) on each payment date together with the hedge provider's profit/risk margin;
  • The hedge provider (or insurer) will in turn agree to pay to the trustee the actual amount of benefit payments made to relevant pensioners/beneficiaries on each payment date (floating payments); and
  • The floating and fixed payments at each payment date will be set off against each other, with the difference being payable by the relevant party to the other. So, if the floating payment exceeds the fixed payment, the net amount will be due from the hedge provider/insurer to the trustee.

At the outset, the fixed and floating payments are likely to be essentially identical, therefore a key attraction of a longevity hedge is that there is no initial requirement for any transfer of assets to the hedge provider.

Since each transaction will be tailored to the specific situation, the precise structure and terms of each will vary. Depending on the circumstances and solution (i.e., insurance, derivative, bond and so on) the range of issues the parties and their advisers will need to consider is likely to be extensive.

Some key issues may include:

  • The management and allocation of data risk (particularly in insurance solutions);
  • The management and mitigation of counterparty credit risk and, if appropriate, the development and structuring of collateral and associated security arrangements;
  • The extent to which flexibility can be built into the terms of the hedge to permit or cater for possible further de-risking by the trustees;
  • The obligations of the trustees/scheme in relation to administration and, in particular, as to continued existence checking during the life of the contract; and
  • The circumstances in which the hedge might be subject to early termination – and the consequences/financial implications of termination in differing circumstances.

Looking to the future

Reaction to the growth of longevity-only solutions has been positive. This, it seems, is acknowledged to be a socially useful financial innovation - and demand is likely to remain strong.

How far that demand can be met will ultimately be dependent on the extent to which secondary markets for longevity risk develop.

The BMW transaction was the first longevity hedge to be syndicated into the reinsurance market, with the announcements accompanying it making clear the availability and use of reinsurance capacity was integral to the overall deal.

However, while reinsurers plainly have a significant role to play, there is appreciation that reinsurance market capacity alone is unlikely to be sufficient to cater for anticipated volumes. Clearly, the capital markets will need to play a substantial role.

Reflecting that, the formation of a new trade body (the Life and Longevity Markets Association) was recently announced with the objective of promoting a liquid traded market in longevity and mortality related risk – the founder members being Axa, Deutsche Bank, Legal & General, Pension Corporation, Prudential, JP Morgan, Royal Bank of Scotland and Swiss Re.

The desire and commitment, it seems, is there. Longevity risk may, indeed, be the next big thing.

This article first appeared in Insurance Day on 12 March 2010.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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