Pension fund trustees and sponsors need to ensure that they fully understand their obligations before entering into longevity swaps, particularly if they bypass intermediaries using new methods of direct access to reinsurance, according to advice from Aon Hewitt.
Aon Hewitt, the retirement, pensions and health solutions arm of insurance and reinsurance broker Aon, said that it welcomes the wide range of developments seen in the longevity swap and hedging market in 2014, but warned trustees and sponsors that they need to ensure they appreciate some of the obligations they taken on.
So far, pension fund longevity swap transactions have involved the use of one or more global reinsurance firms to ultimately assume the risk. However, reinsurance firms are unable to underwrite business directly with UK pension funds, meaning that a third party intermediary is often required.
Martin Bird, senior partner and head of risk settlement at Aon Hewitt commented; “Intermediaries in longevity swap transactions typically carry out a number of functions. Primarily, they allow the fund to access the reinsurance market, but they also carry out the lion’s share of the servicing of the contract and perform all the necessary calculations, as well as providing credit risk protection against the reinsurers – many of whom like to use offshore subsidiaries to write this type of business.”
Traditionally, Aon Hewitt notes, either a UK bank or insurer has acted as the intermediary, between the pension fund and the reinsurance market. Up until the start of 2014 every longevity swap transactions completed had used this model, with Legal & General and Deutsche Bank the two most prominent intermediaries in the UK market.
Martin Bird continued; “2014 has seen a major change in the approach to intermediation. We have advised on a number of new solutions which have made the headlines over the year. The Phoenix Group Trustees, having the benefit of an insurance sponsor, has carried out a longevity swap transaction using a sponsor owned insurer as the intermediary, and Aviva has done the same. The BT Trustees have set up and own their own insurance company in Guernsey to carry out these intermediation functions. All of these new structures are known as ‘self-intermediation’.”
Aon Hewitt notes that setting up and owning its own intermediary is not without risks and complexities for pension schemes. A number of new solutions have been designed by the traditional longevity risk transfer market to mitigate the risks associated with self-intermediation, but still offering most of the price improvement, as they seek to hold onto this business.
Matt Wilmington, partner in the risk settlement group at Aon Hewitt added; “The primary driver for opting for self-intermediation has been cost. Traditionally, a pension fund may have paid 1% to 1.5% to a bank or insurer to intermediate the swap. While this can represent good value for sub-£3 billion funds, the costs can begin to outweigh the benefits when transaction sizes grow into the multi-billions. New solutions with pricing structures which do not depend on scale have therefore been sought.
“Self-intermediation is one such option, but for the fund owning the intermediary this can be fraught with practical, legal and regulatory risks as well as the additional complexity of establishing the vehicle and negotiating the reinsurance contracts. Furthermore, the use of offshore arrangements also introduces a significantly greater governance burden that needs to be thoroughly evaluated and understood.”
Interestingly just yesterday Towers Watson launched a new solution where it offers pension funds a cell in a Guernsey insurance vehicle as a way to disintermediate the market. This allows pensions to get closer to the reinsurance market, owning the transaction and taking out the traditional middle man.
Matt Wilmington added; “A middle ground solution has been made available in which the bank or insurer accepts these risks and provides expertise, but the fund faces the credit risk of the reinsurers. The cost of this type of solution is very similar to self-ownership and we expect a number of larger funds to carry out this type of transaction in the coming months. Trustees and sponsors thinking of entering into a longevity swap should be aware of all of these options, assess the relative value of each against the potential additional risks they are taking on and ensure that they make a fully informed decision about which structure is most suitable to meet their needs.”
Aon Hewitt is right to warn of the risks and obligations associated with removing the intermediary, with pension schemes then taking on more responsibility for their own longevity swap transaction. However this is an efficient step towards reducing costs and friction in longevity swap transactions and as a result we expect this trend of disintermediation will continue.