Life and pensions company annuity providers and corporate pension funds have been facing, and continue to face, increased costs as a result of people living longer (longevity risk). Traditionally, annuity providers and pension funds have attempted to manage longevity risk through (i) self insurance and implicit coverage (in the case of life assurance companies); (ii) reinsurance; and (iii) “buy ins” and “buy outs”. Recently we have seen greater interest by trustees of final salary pension schemes in “buy ins” and “buy outs”. In addition, there has been a growing interest by trustees of final salary pension schemes, insurers and reinsurers in using derivatives as a weapon in the armoury to deal with longevity risk.
Buy ins and buy out policies
Buy in/buy out policies are issued by insurers to trustees of final salary pension scheme to enable these trustees to mitigate the exposure of the pension fund to longevity risk. However, they operate differently.
- In the case of a “buy out” policy, the insurer will agree to issue new policies directly to the individual pensioners thus “buying out” the trustees’ liabilities to those pensioners, with the consequence that the policy held by the trustees terminates;
- In the case of a “buy in” policy, the trustees remain directly liable to the pensioners, the insurance policy is “bought in” to cover the trustees’ liabilities and is held long term as an asset of the pension scheme. “Buy in” policies may be converted into full “buy outs” at some time in the future on agreed terms.
The premium for a “buy out” / “buy in” policy is broadly equal to the present value of the total future benefits payable to the pensioners. In the case of “buy out” policies the pensioners are directly exposed to the insurer. In the case of “buy in” policies the trustees remain liable to the pensioners but are reliant on the insurance policy to make the payments. In addition, as the corporate sponsor of the scheme remains statutorily liable for any shortfall in the scheme assets, it is also interested in the continuing solvency of the insurer.
Longevity Derivatives
Longevity derivatives may be provided to annuity providers or pension funds. There are a couple of derivative structures which have been used to transfer longevity risk.
- Longevity bond: these involve the issue of a bond to investors where the payout to investors is linked to the survival rate of a given cohort of the population. Here longevity risk is passed from the issuer to the investor by way of reduced payments to investors if the survival rate for the cohort exceeds a predefined threshold. For annuity providers and pension funds one of the principal drawbacks with longevity bonds is that they tend to be referenced to a standard index or reference pool, and this creates basis risk between (i) the reference pool for the longevity bond on the one hand and (ii) the annuity provider or pension fund’s own pool of annuitants on the other. This has driven demand for more bespoke longevity swaps;
- Longevity swaps: these are structured so that the annuity provider or pension fund pays the hedge provider a stream of fixed payments (generally based on actuarial estimates of the future annuity or pension payments) in return for the hedge provider paying a stream of payments based on the actual annuity or pension payments falling due. In this way, the longevity risk is transferred from the annuity provider/pension fund to the hedge provider. These may be tailored on a bespoke basis from deal to deal.
Reinsurances
These are economically similar to longevity swaps except that, unlike the swaps, they are structured to provide an indemnity for the annuity provider.
Key differences between buy in/out policies, reinsurance policies and derivatives
- The buy in/out policies and reinsurance policies will be issued by an insurer, whereas a bond or a derivative may be structured so that it is not categorised as a contract of insurance which gives flexibility as to who may issue a bond or be a swap provider;
- Reinsurances can also be used to lay off longevity risk taken on under a derivative structure. Conversely, derivatives may be used to transfer longevity risk assumed under a reinsurance agreement. “Buy in” and “buy out” policies may only be issued by insurers to trustees of pensions funds;
- Longevity bonds/swaps and reinsurance policies may be structured to avoid an upfront lump sum being payable;
- Unlike the other structures, there is no counterparty exposure for a pension fund under a buy out policy;
- Under buy in policies, reinsurance policies and longevity swaps, there is counterparty exposure to the transferee of longevity risk and hence security for the transferee’s obligations may well be an important issue;
- Specifically in relation to “buy in” policies, it is generally accepted that the UK Financial Services Compensation Scheme (FSCS) will cover both individual UK pensioners and trustees in the event of the insurer becoming insolvent. However there are limitations to the coverage and accordingly security for the insurer’s obligations continues to be an important factor for the trustees of pension schemes. In structuring security there is a contrast between, on the one hand, the insurer’s desire for investment freedom in relation to the assets transferred to it and the need for the assets to count as capital for regulatory accounting purposes, and, on the other hand, the trustees need for comfort/collateral in the event of insurer insolvency.
Linklaters has advised on a number of buy ins/outs, reinsurances and derivatives. Please see the following links to announcements in relation to those deals that we may disclose:
Linklaters advises JPMorgan on a Longevity Swap Transaction
Linklaters advises on the buy in of a UK pension scheme
For further information, please contact:
Mark Brown (mark.brown@linklaters.com, (44 20) 7456 5229);
Isabel France (isabel.france@linklaters.com, (44 20) 7456 3689);
Madhu Jain (madhu.jain@linklaters.com, (44 20) 7456 4700).
