Investors must get involved in longevity risk transfer as insurance capacity insufficient

Pension plans and schemes are increasingly looking at their ability to fund their obligations to pensioners as their returns fall due to the wider economic and financial market issues and their pensioners live longer meaning they are on the hook for more payments than expected. This scenario is leading pension plans to look to ways to hedge or offload their longevity risks, with a variety of methods being favored so far. Longevity risk transfer is a growing sector but there is a growing problem, a lack of re/insurance capacity.

An article published yesterday in the Financial Times looks at the market for longevity risk, discussing the buy-out, buy-in and longevity hedging mechanisms which we see in use today. The article suggests that one area which is cause for concern is where insurance or reinsurance capacity is designed to soak up longevity risks, there just isn’t sufficient capacity available for this to become widespread.

Our regular readers will know that we’ve been saying this for a number of years now, watching the longevity insurance and reinsurance markets and asking how they will continue to soak up longevity risk without having a clear way to offload it themselves. The capital markets provide the natural destination for longevity risk to be transferred to, with instruments such as longevity swaps, derivatives and securitization in insurance-linked security (ILS) form the likely structures that we’ll see utilised. Insurers and reinsurers just cannot continue to assume large amounts of longevity risks and liabilities without a way to offload them. The natural hedge of longevity versus mortality does allow some re/insurers to assume rather more longevity risk than you may have thought sensible, but even these active hedgers cannot afford to become over exposed to longevity risks.

Pretty Sagoo, Director of Structured Insurance Solutions at Deutsche Bank, is quoted in the article as estimating that the UK alone has defined benefit pension liabilities of £1.5 trillion, but the European insurance industry only has the capacity to absorb £10 billion to £20 billion per year. That’s quite a mismatch in volume, and the gap won’t be closed while pension scheme liabilities are growing and the re/insurance sector remains conservative on capitalisation. Sagoo says that it is imperative for investors to get involved in the longevity risk transfer market. By cleaning up the risk and making it easier to track she says investors will come to the market.

We’ve seen this already in a number of transactions where investors from the capital markets have assumed longevity risk in derivative or securities form in return for a payment.

The FT article suggests that the longevity swaps market is expected to grow significantly as the cost for arranging these derivative type transactions is seen to be more affordable than a buy-out, particularly for any pension plans which are in funding difficulty.

Openly published longevity indices, such as the Xpect Indices from Deutsche Börse and the LLMA’s indices, are developments in the market which helps to keep the costs of a transaction down and make the tracking and measurement of its success more transparent. we expect to see greater focus on these indices over the next few years as market participants find the best way to utilise them within risk transfer deals. We also suspect that we might see further attempts to transfer longevity risk in ILS form, with reinsurers particularly likely to assess this route to allow them to provide more capacity down the risk transfer chain.