When Pension Schemes Need Us, We Are There
Reinsurers have a significant role to play in novating/restructuring longevity swaps
The 2019 pension de-risking market in the United Kingdom was a record breaker, with several landmark buy-in and buy-out transactions by Rolls-Royce, Telent, Marks and Spencer, and British American Tobacco. In addition, there was an uptick in demand for scheme direct longevity risk transfer to help sophisticated defined benefit (DB) schemes appropriately hibernate their pension plans. The most notable example is The HSBC Bank (UK) Pension Scheme, which executed the second-largest captive longevity reinsurance transaction ever, totaling £7 billion ($8.7 billion) and covering over half their retiree liabilities.
For most of 2019, market conditions were ideal for de-risking:
- high funded status of DB pension schemes
- ample insurer and reinsurer capacity
- attractive pricing for transferring longevity and pension risk
Pension schemes focused on longevity hedging have long wanted to know that their longevity swaps could be restructured in support of a future buy-in or buy-out. The Rolls-Royce transaction has proven that this is not only possible, but reasonable and efficient.
As U.K. pension schemes took advantage of these favorable market conditions and executed transactions that satisfied their de-risking goals, the Rolls-Royce transaction was noteworthy. Several years after its 2011 longevity swap, Rolls-Royce completed one of the largest bulk annuity deals to date with Legal & General (L&G), which included annuitization of new retirees, as well as older retirees that had been covered by the earlier longevity reinsurance contracts. The preexisting longevity reinsurance contracts were swept into the buy-out and transferred from previous reinsurers to L&G. This transfer of insurance and reinsurance contracts is known as a “novation.” We believe the success of the Rolls-Royce transaction has set a precedent for future novations and will fuel the growth in the longevity risk transfer market, because it provides clarity that longevity swaps can be used as a stepping stone to a future buy-in or buy-out.
Transferring Pension Risk
With increased growth and sophistication in the pension risk transfer market, schemes can now transfer risk through a variety of methods. However, transactions executed through a buy-in or buy-out, or a longevity risk transfer (often referred to as a longevity “swap”) remain the most prominent. Under a buy-in and buy-out, schemes transfer both asset and longevity risk to an insurer. In a pension buy-out, the pension liability is settled, and the insurer issues annuity certificates to the plan participants and promises to pay their benefits for as long as they live. Conversely, a buy-in contract is held as a liability matching asset by the pension scheme, so the risk stays on the sponsor’s balance sheet, while the insurer pays the pension fund the exact amount needed to cover the benefits owed to the plan participants for their lifetimes.
By executing a longevity risk transfer, schemes transfer only longevity risk to a reinsurer, often by first establishing a trustee-owned captive insurer. Under the longevity reinsurance contract, trustees of the pension scheme agree to pay a fixed series of payments, representing the expected benefits payable under the pension scheme, plus a fee, in return for the reinsurer paying the benefits based on actual scheme mortality, as illustrated in Figure 1 below. The trustees therefore have certainty over the payments that they are expected to make. This certainty of payments reduces overall scheme funding risk and enables the scheme to focus on funding and investing to the fixed series of payments owed under the longevity contract.
Figure 1. Illustration of a Longevity Risk Transfer Contract
We believe sponsors that deploy longevity risk transfer fall into two broad categories. They are either large and sophisticated enough to pursue a “Do-it-Yourself” de-risking approach, or they are unable to afford a buy-in or buy-out at the desired time of de-risking due to funding constraints. The overall motivation for each category remains the same—schemes want to manage their pension risk and reduce funded status volatility, as well as protect against improvements in life expectancy.
- Do-it-Yourself De-risking Approach: Very large schemes that follow a sophisticated investment strategy such as a liability-driven investment (LDI) approach remain exposed to the risk that members live longer than expected. In fact, for these schemes, longevity risk becomes the dominant residual risk once investment risks are hedged. A longevity hedge is an appropriate solution for such large and sophisticated plan sponsors. By executing a longevity risk transfer solution, the scheme can transfer the risk of having to pay pensions to members for longer than expected to an insurance company.
- Schemes that cannot afford a buy-in or buy-out: Longevity risk transfer is also a solution for trustees whose schemes are not quite at the point where they can enter into a buy-in or buy-out, but want to manage their longevity risk. For many schemes with a high fixed income allocation, longevity risk is a significant contributor to funded status volatility along with asset risks. By executing a longevity risk transfer solution, the scheme can reduce its exposure to risk and funded status volatility for a lower overall cost, and can pay for their de-risking over time. Later, as funded status improves, and the scheme can afford a buy-in or a buy-out, the longevity risk transfer contract can be novated to an insurance company providing a buy-in or buy-out.
Novation of a Longevity Risk Transfer Contract: Rolls-Royce
Rolls-Royce first entered into a £3 billion longevity swap for retirees of its pension scheme with Deutsche Bank in 2011, which was reinsured by The Prudential Insurance Company of America (PICA) and several other reinsurers. In June 2019, when Rolls-Royce completed its £4.6 billion bulk annuity transaction with L&G, it included the novation of its preexisting longevity risk transfer contracts from its 2011 deal (Figure 2). The transaction secures the pension benefits of 33,000 total members of the Rolls-Royce UK Pension Fund. The bulk annuity and the novation of the existing contracts were both completed within weeks of the decision to transact. The economics of the original transaction were preserved, while L&G and PICA leveraged their existing ways of doing business together to help the pension scheme achieve its de-risking goals efficiently and expeditiously.
Figure 2. Illustration of a Longevity Risk Transfer Contract and its Novation to a Pension Insurer
Longevity Risk Transfer
Longevity Risk Transfer Contracts Novated in Conjunction with a Pension Buy-in or Buy-out
Pension schemes focused on longevity hedging have long wanted to know if their longevity contracts could be restructured in support of a future buy-in or buy-out. The Rolls-Royce transaction has proven that it is not only possible, but reasonable and efficient. In order to have such an expeditious and efficient novation, it is important for a reinsurer to have established relationships with virtually all primary pension insurers in the market, so they can leverage existing ways of doing business, and established legal documents and processes. This makes the novation more certain and straightforward. It also allows pension insurers to simultaneously obtain capital relief because the longevity risk transfer contract functions as reinsurance of the longevity risk under the new buy-in or buy-out.
Longevity contracts can also be transferred to an acquiring insurer under a Part VII transfer of an annuity portfolio from one insurer to another.
We expect a continued increase in interest from pension schemes to execute longevity contracts as the market becomes more aware of the Rolls-Royce transaction, and of the flexibility schemes retain to novate and pursue different de-risking avenues when their strategy evolves in the future.