The mechanics: reinsurance
A longevity swap is a reinsurance structure where the client pays a fixed pre-agreed annual premium to the reinsurer plus an annual fee. The premium is equal to the expected annuity payment including a margin. The reinsurer pays the actual annuity payments for as long as each pensioner lives. Mortality and future improvement assumptions for annual premiums are agreed and documented in the reinsurance treaty.
In order to set up the mortality assumptions, Corporate Solutions looks at research into mortality by the UK actuarial profession, especially regarding self administered pension schemes. We also perform our own scheme-specific mortality investigation and closely monitor market developments covering future mortality improvements. In addition, we carry out stress tests to assess the impact of a lighter base mortality and higher mortality improvements. The fee represents the additional margin needed to meet our profit requirements and to pass the stress tests.
Premiums and claims only differ marginally in the first years, but later the gap widens. Initially, the major source of profit comes from the fee; in later years it comes from the difference between premiums and claims.
The demand for de-risking options is expected to remain high due to increasing longevity allowances in pension scheme valuations. Furthermore, the financial crisis has highlighted the level of risk run by UK defined benefit pension plans and their sponsoring companies.
The deterioration in the UK and global economy in late 2008 and early 2009 has caused dramatic changes to the “conventional’ pension buyout market, such as:
- insurance companies have adopted more cautious pricing and reserving assumptions and many have increased their assumed default rates on the corporate bonds backing their annuity portfolios
- many key investment markets became significantly less liquid, which impeded asset transfers from pension plans to insurance companies as market prices for certain assets were distorted, making accurate valuation difficult
- confidence in financial institutions was eroded, as evidenced by investors heavily marking down insurance company market prices. As a result, trustees increasingly sought additional collateral as part of any transaction.
Longevity swaps, however, can meet these challenges and are now perceived as an attractive de-risking option, especially for larger plans. This is because they:
- allow trustees to deal separately with longevity and investment risks
- eliminate upfront funding requirements, since cash flows are exchanged throughout the life of the transaction
- reduce counterparty risk compared to a buyout. More importantly, a longevity swap is symmetric, with both parties potentially exposed to counterparty risk depending on whether members live longer or shorter than expected.
The road ahead
The BMW deal is expected to pave the way for more longevity swap transactions in future. With continued focus on pension risk management, the longevity swap market is expected to grow, serving increasing numbers of companies wishing to take advantage of the benefits offered by this useful insurance tool.