Risk management and pension schemes
Pension schemes face a range of risks and trustees should understand and manage those risks. Risks for most schemes cover a range of challenges such as market risk, counterparty risk and longevity risk.
Estimating life expectancy is a key source of risk and uncertainty for trustees of defined benefit pension schemes. One option is to buy annuities which transfers all the longevity and market risk to an insurer. However, this can be seen as costly (as interest rates are low and many pension schemes are not funded to a level to meet the premium required). In practice purchasing annuities can be beyond the resources of many schemes as the longevity risk is packaged together with the market risk. Also, the trustees may be concerned about the level of counterparty risk of placing substantial benefits with a single insurer.
Therefore, some trustees have looked for solutions that can be implemented while the scheme is managing a deficit. The solution in a number of cases has been the longevity swap.
Structure of a Longevity Swap
The objective of a longevity swap is to allow the pension scheme to exchange a stream of uncertain future payments for the security of known future payments.
In a longevity swap, the pension scheme enters into an agreement to transfer its longevity risk using a swap with fixed and floating legs. The pension scheme exchanges a commitment to make future fixed payments (based on projected future pension payments) in return for another party's commitment to meet the uncertain actual future payments.
The ultimate counterparty in such a transaction is usually a reinsurer. However, as reinsurers are not permitted to transact directly with pension schemes, an intermediary insurance company is often used. It can be cost effective for the intermediary to be a captive of the pension scheme's sponsor (and the captive is often structured as an incorporated cell company (ICC)).
The pension scheme usually pays an additional premium as a contribution towards the costs and risks incurred by the counterparty committed to meeting the actual future payments. The transaction only covers the difference between the actual and projected pension payments. Therefore, the investment risk remains primarily with the pension scheme.
The pension scheme does then have a clear set of cash flows which it can plan to match without the uncertainty arising from potential changes in longevity.
The operation of the swap depends on monitoring the actual cash flows and comparing these with the agreed fixed payments. Both parties (i.e. the pension scheme and the reinsurer) will be concerned that any divergence in actual or projected experience could have a material impact on future expected net payments leading to a significant counterparty risk.
To address this concern over counterparty risk the captive (on behalf of the pension scheme) and the reinsurer are each required to post collateral depending on past experience and the projected net cash flow. The collateral is held by an independent custodian.
In order to determine the value of the collateral to be posted (and by which party) an independent calculation agent is appointed to calculate these figures. The calculation agent determines the value of collateral to be posted at the inception of the swap and revalues the position periodically throughout the life of the transaction.
This work is usually undertaken by an actuarial firm given their expertise and experience in projections involving the value of future pensions. The actuarial specialist appointed would generally be independent from the parties to the longevity transaction.
Guernsey has established itself as the predominant location for longevity swaps placed through captives. In 2014 the British Telecom pension scheme executed a £16 billion longevity swap with a US-based life insurer through a Guernsey captive. This was followed by a £1.5 billion transaction for the Merchant Navy Officers Pension Fund.
To date, all the major longevity swaps transacted in Guernsey have been completing using an ICC - a structure which is not available in the UK.
Two large longevity risk transfers were executed in Guernsey with details announced in September 2017. First, the pension scheme for Marsh & McLennan Companies completed a longevity swap using a Guernsey-domiciled ICC to hedge the longevity exposure in £3.4bn of its pension liabilities.
A week later, it was announced that one of British Airways' pension schemes had agreed a deal to hedge the longevity risk inherent in £1.6bn of its defined benefit pension liabilities.
The British Airways swap was subsequently absorbed as part of a wider buy in of annuities from Legal & General during 2018. This demonstrates the flexibility of the structures established in Guernsey which meant that the development to a buy in could absorb the benefits of the existing swap structure.
Relevance of substance
It is important that the captive demonstrates its substance in Guernsey, to avoid potential tax risks that can arise when dealing with a UK pension scheme. All parties will be keen to keen to demonstrate control and management is demonstrated in Guernsey.
The role of the calculation agent is also fundamental to the swap. In most cases this has been undertaken outside the UK to help minimise potential tax risks.
Over the last few years, longevity swaps have become a 'hot topic' among pension scheme trustees who may be concerned about their scheme's exposure to longevity risk. Some schemes have taken action to limit their exposure to such risks.
Guernsey has demonstrated a solid track record of experience and expertise that it is an effective domicile for a captive or ICC solution to longevity risk.
For more information about Guernsey's finance industry please visit www.weareguernsey.com.
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.