Making sense of longevity swaps

“For most pension schemes, we see the longevity swap debate as an interesting
intellectual exercise, but one that currently has little real-world
application.” That was the opinion of Norwich Union’s head of defined benefit
risk management Nick Johnson last March, in a debate hosted by Professional
Pensions magazine on the emerging topic.

“There are a number of practical complications for which we haven’t seen any
workable solutions. These include cost effectiveness, difficulties of
understanding and documenting exactly what you are getting.”

Johnson remains correct in the latter, at least. The risks of these products
have not been examined as closely as the perceived benefits ­ but this is an
important part of the process of understanding them, which some report trustees
and FDs need to pay closer attention to.

The resounding entrance into the longevity swap market by some very large
businesses has raised interest from many other UK businesses. But there are
voices warning that FDs need to swot up on the potential for costly problems
down the line. Finance directors should be taking note of the longevity risk
swap market as a way to avoid closing schemes altogether and as a sophisticated
way to manage pensions volatility that is hitting profit margins with alarming
force.

Richard Giles, pensions director at PricewaterhouseCoopers says some
attractive prices for longevity swaps are starting to come through, as some of
the providers look to break into the market and some schemes’ own assessment of
future life expectancy moves more in line with what counterparties price. “The
gap between what providers want to charge and what schemes are willing to pay is
beginning to close,” he explains.

But even before the first UK deal had been made in 2009, law firm Slaughter
& May issued guidance around the possible ramifications from the emerging
idea of insurers transferring pension risk out to the wider financial markets.
While advising that those looking into these products will need to retain the
advice of both swaps, insurance and financial regulatory experts ­ in itself, an
expensive business ­ it outlines a series of concerns that FDs could use as an
initial checklist when looking into longevity swaps. These include:

• Satisfying regulators as to the extent of risk transfer ­ which it thinks
has a profound effect on termination rights, warranty protection and premium
adjustment;
• Ensuring the swap is not at risk from counterparty default or other change in
the credit environment;
• Establishing who is responsible and where the rights lie in respect to the
administration of4 underlying insurance policies, asset management and custody
arrangements;
• Outlining how the swap is affected if the business from which the pension
scheme emanates changes hands, or if there is a merger. For example, outlining
what happens if your business becomes insolvent
• Deciding if the swap arrangements themselves should be characterised as a
contract of reinsurance, for legal and regulatory purposes, and what the
consequences are;
• Establishing that rights under the swap amount to an admissible asset from the
insurer’s perspective that can count towards the coverage the insurer has of its
technical provisions ­ and do not lead to a capital deduction of the insurer;
and
• Establishing provisions relating to the calculation and adjustment of any
longevity index used and the swap payment flows.

Derivative or insurance
Touching on another angle, PwC’s Giles says there are two particularly fine
points of which FDs should be aware. “One is to consider whether the cover you
buy is written as a derivative, or as plain insurance,” he says. “The second is
whether the cover is written against the longevity risk from the members of the
scheme, or against the longevity risk from the population index used by the
arranging counterparty.”

Giles adds that risks to all longevity swap contracts include the risk that
the cover doesn’t match the schemes liabilities such as spousal benefits and the
potential for the effect of inflation ­ something many are worried about in the
future. There is, of course, the risk that the counterparty will go bust.

“Care must be taken to future-proof the contract,” says Giles, meaning that
buyers must ensure either they insure against this eventuality or write into the
swap a surrender clause that ensures the counterparty will surrender the swap to
another party that can ensure continuity if it can’t, such as the Pensions
Protection Fund.

Cost remains prohibitive for many companies who might otherwise undertake a
longevity swap and counterparties are likely to charge extra for insurance cover
as well as taking a rather juicy margin. If you can afford it and can weigh that
against what you save in transferring the pension risk out, it is worth a look.
“It’s a case of, is that peace of mind worth it,” says Giles. “For many pension
schemes it proves to be a vital lifeline.”

Too difficult
Ensuring all relevant parties understand what’s on offer is not a simple
undertaking. There are significant obstacles to pension fund managers from
feeling confident in taking out a hedge on their longevity risk. According to
Noel Hillmann, managing director at pensions research outfit Clear Path
Analysis, more than 80% of pension schemes it contacted in a recent report on
longevity hedging reported their greatest concern and challenge is simply
understanding the details of the swap they were entering into. “Collateral,
counterparty risk, impact on the sponsors financial reserves and education of
trustees and corporate sponsors were all issues that they felt they needed to
understand before progressing further,” he reveals.

Robert Gardner, founder of risk management advisory Redington, supports this
view. He believes there has been a tendency to dismiss longevity as too
difficult, with many schemes using prudent actuarial assumptions to provide the
‘illusion’ of risk management. “However, the emergence of longevity risk
transfer concepts in the UK appears to provide the elusive final piece of the
liability-driven investment risk management jigsaw puzzle,” Gardner says. And
with the creation of the Life & Longevity Markets Association, which is
aiming to increase understanding and, in doing so, bolster activity in the
market, the idea that longevity risk swaps are simply too brain-zapping to
consider may ebb away.