The development of a capital market for longevity risk would ease the debt burden on future generations, Natasha Browne hears
- Leading academic professor David Blake says insurers face “severe” concentration of longevity risk
- Experts say the reinsurance market uses this risk as a natural hedge against its life insurance business
- A quarter of the UK population is made up of retirees, but this is expected to rise to 38% by 2050
Ageing populations driven by lower birth rates and improved life expectancy is a serious fiscal problem for advanced economies. It increases the burden on working populations to sustain the older generation.
Figures show there are 25 retirees for every 100 people of working age in the UK. But the proportion of retirees is projected to rise to 38% by 2050.
Current national debt, including state and public sector pension promises, is over three times higher than GDP, according to the director of the Pensions Institute (PI), professor David Blake. Separate figures from Hymans Robertson show private sector defined benefit (DB) liabilities have exceeded GDP for the first time too, by £200bn.
Insurance companies have stepped in to soak up DB liabilities through buyouts, buy-ins and longevity swaps. LCP has predicted the total value of annual bulk annuity deals will soon reach a "new normal" of over £10bn. Indeed, 20% of FTSE 100 businesses with UK pension plans have already agreed some form of transaction.
But speaking at Squire Patton Boggs Pensions Conference 2015, Blake warned there was a "severe" concentration of longevity risk in the insurance industry. This could drive the sector into insolvency if it gets its projections on longevity risk wrong, he said.
Blake is keen to develop a capital market for longevity risk. He has spent ten years campaigning for the government to issue longevity bonds to support the market. These would act as an additional hedging instrument. Fundamentally however, the bonds would establish a yield curve and the market price for longevity risk.
He said the major barrier was a lack of political will. "The government is not interested in this problem. It's only concerned with short term problems. It's only concerned with winning the next election.
"It says ‘if we introduce these bonds, the beneficiaries will be in ten years' time and that will probably be the opposition party, why should we do that?' I think that the next 50 years it's going to be ‘it's the demographics stupid' that we should be thinking about rather than ‘it's the economy stupid'."
Longevity bonds would provide the government with a new form of long term funding, Blake said. The government (or taxpayer) is already the insurer of last resort, especially in respect of the Pension Protection Fund (PPF). But Blake pointed out it was currently missing out on the risk premium for propping up the market.
Blake said: "In other words, the next generation is providing insurance but not earning a risk premium for providing that insurance. So longevity bonds can act as a catalyst for the development of the capital market solution.
"It would help with the construction of national longevity indices and it would aid with price discovery - the price of risk at different ages."
Another advantage of longevity bonds is that they would ease the burden of capital requirements on insurers. "If you can't hedge a systematic risk, your Solvency II capital goes up and that makes your annuities more expensive," Blake said.
The insurer view
Pension Insurance Corporation (PIC) is one of the leading players in the bulk annuity market. It has been involved in some of the biggest transactions on record so far, including the £1.5bn buyout of the EMI Group Pension Fund in 2013.
Its head of business origination Jay Shah is enthusiastic about the development of a capital market for longevity risk. But he is confident the insurance market is coping well, especially as it can offload a lot of the risk onto reinsurers. These, he says, are better placed to deal with the risk because it acts as a natural hedge against their life insurance business.
Shah explains: "Insurance companies, certainly in more recent years, have tended to hedge out that longevity risk to reinsurers. For example, Pension Insurance Corporation has hedged out somewhere between 60% and 70% of our longevity risk.
"But are we just transferring the risk? Is the concentration of risk just going from the pension scheme to us to the reinsurers? Well actually it's not because over the last several decades the reinsurers have been taking on mortality risk.
"They've been writing life insurance business and reinsuring life insurance business. They already have an exposure to people dying too early so taking on exposure that people live too long is actually a good balance for them."
Shah says the worst place longevity risk can sit is with the pension scheme. The risk is spread more efficiently when it is transferred to an insurer. This is because there is a larger proportion of average-sized policies able to absorb the shocks created by a small number of expensive policies.
He explains: "Take someone with a £100,000 pension that was inflation-proofed. If they lived for five years longer than was expected, allowing for inflation, you're probably looking at that costing the scheme something like £1m more than they were expecting.
"When that comes through to an insurer through a bulk annuity policy, the insurance company has less concentration than the pension scheme because it's got a larger number of people."
In other words, a handful of large pension pots among 100,000 pensioners averages out much more than a handful among 100 pensioners.
Shah adds: "Yes the risk remains with the insurance company, but it's pooled and averaged out among a much larger population."
A significant barrier to the development of a capital market for longevity risk is its potential to attract investors. The time horizon is too long for most. Shah says: "It would be great if the capital markets were able to provide some way of hedging longevity risk.
"But people who want to buy these interesting investments which have exposure to longevity tend to want to have an exposure for five years, or a maximum of ten years. Whereas longevity risk persists for decades.
"To date, there hasn't really been that tide of investors who are prepared to take a view on longevity risk into the very long term. That's been one practical constraint."
Although 2020 was a challenging year, Aon's Dave Barratt says the bulk annuity market was very resilient, with a well-functioning insurance market, large volumes of business written and 2020 finishing up as the second busiest year on record.
The uncertainty surrounding the potential impact of so-called long Covid and behavioural changes heightens the need for schemes to increase their longevity hedging, says Prudential Financial.
Rothesay wrote £7bn of bulk annuity business over the course of last year, with 12 further schemes now benefitting from the insurer’s policies.
Deutsche Bank AG has agreed a £570m pensioner buy-in with Legal & General for the defined benefit (DB) (UK) Pension Scheme.
Around £1trn of pension risk could be insured by just over a decade’s time as bulk annuity volumes grow rapidly, also boosting insurers’ rankings in the FTSE 100, according to Hymans Robertson.