Activity in the pension scheme longevity swap and hedging market should increase in 2017 as a number of market forces that slowed activity this year bed in, and pensions become more of a focus for reinsurance capital, according to Shelly Beard of Willis Towers Watson.
The year 2016 saw just £2 billion of pension scheme longevity risk transferred to reinsurance markets through hedging transactions (details of some of those can be found in our Deal Directory here), but there are reasons for the relative slowdown, Beard, a Senior Consultant at Willis Towers Watson (WTW) explains in a recent paper.
2016 seemed like a very quiet year for longevity hedging, swaps and risk transfer, as the number of deals involving pension schemes dropped significantly during the year, with just the £2 billion of transactions completing.
However, in reality activity in the transfer of longevity risk to reinsurance capital had not slowed, just the shape of transactions changed, with Solvency II one of the drivers, Beard said.
Over £20 billion of longevity risk was transferred to the reinsurance market over the last 18 months, Beard says WTW research has found, but the majority of this is via insurers looking to reduce their longevity related liabilities on back books of risk.
This is a Solvency II related action in many cases, Beard explained, since it has become very expensive to hold longevity risk on balance-sheet insurers have increasingly sought to transfer it to the reinsurance market.
“This activity has kept the reinsurers very busy over the past 18 months and taken their attention away from pension schemes,” Beard said, explaining that due to this focus on insurer longevity reinsurance transactions some of WTW’s pension clients have elected to hold back and wait for some of this activity to subside before hedging their risk.
“We believe that going into 2017, the surge of back book activity is now over,” Beard continued.
Beard also noted that as insurers enter into buy-ins they require the reinsurance capacity to be lined up for a simultaneous transfer of longevity risk, meaning that pricing and terms has to be fully understood and again that has been keeping reinsurers busy in 2016.
Looking ahead, Beard explained, “Over the course of 2017, we expect these effects to settle down, and for there to be more activity in the pension scheme longevity swap market. In fact, there is positive news for pension schemes as a result of this change.”
There is now more opportunity for smaller pension schemes to hedge their longevity risk with reinsurers, Beard notes, as with the increased size and regularity of deals reinsurers pricing has become more transparent, meaning smaller pensions can benefit from similar prices to transfer their risk.
At the same time the efforts to streamline the longevity swap and hedges have continued, resulting in lower frictional costs to enter into a longevity risk transfer deal and a greater chance that a small pension fund can afford it.
Beard said, “Over the course of 2017, we are expecting a considerable uptake in smaller schemes – perhaps down to £100m of pensioner liabilities – completing longevity swaps.”
There is also enhanced flexibility for smaller pensions, as the ability to move from a longevity swap to a full buy-in is becoming much simpler and more readily available. WTW is working on a number of deals that will see clients converting all or part of their longevity hedge into a buy-in and expects to close one of these deals in 2017.
Beard notes one potential downside of recent trends, that insurers may be less willing to act as an intermediary between a pension and a reinsurance firm, especially on more sizable deals. This is due to the credit exposure and in future it may be that larger deals see the pensions having to take on that risk themselves.
This can be achieved through a cell structure, and Beard says that this isn’t all bad news for pension scheme’s looking into potential longevity swaps.
“Firstly, such structures are cheaper. Secondly, having completed due diligence on the reinsurer, trustees typically get comfortable with the exposure, bearing in mind that (i) the longevity swap is fully collateralised and (ii) the cash flows (including the fee) are paid over the course of the contract, rather than up front,” she explained.
Overall, Beard believes that this is a market that is still developing as it is maturing, and the introduction of Solvency II has exacerbated that. However options for pensions hedging longevity risk are generally becoming cheaper and as a result activity in 2017 is expected to pick up.
View details of many historical longevity swap and reinsurance transactions in our Longevity Risk Deal Directory.