Longevity hedges have long been considered a hurdle to doing a bulk annuity, but a ground-breaking deal shows it doesn't have to be. Stephanie Baxter looks at why converting swaps into buy-ins is taking off.
The first longevity swap in 2009 for Babcock International was ground-breaking for the de-risking market, paving the way for schemes to hedge their longevity risk.
After eight years of more than 30 swap deals totalling around £61.2bn, and recent breakthroughs in opening up to smaller schemes, the market is undergoing its next innovation.
Trustees have been concerned that entering longevity swaps could later pose challenges to going to the bulk annuity market, while unwinding a swap to turn into a bulk annuity has been perceived as very complex.
However, this mentality is now starting to change, with Phoenix Life being the first to successfully unwind an existing swap and convert into a £1.2bn buy-in for the PGL Pension Scheme, whose sponsor is Phoenix Group.
The scheme was able to get beneficial pricing for the annuity conversion, partly from the original 2014 longevity swap undertaken with Phoenix, according to the group's senior corporate pensions actuary Richard Zugic.
Being able to take the scheme's assets was a big attraction for the insurer, which specialises in individual annuities and does not offer bulk annuities to the wider market.
"For Phoenix Life, this was a great opportunity to bring £1.2bn of very liquid assets (mostly gilts) onto its balance sheet, which could then be transitioned into a higher-yielding, matching portfolio, and thereby generate value," says Zugic.
While the PGL deal is unique because the insurer is part of the wider sponsoring employer, it proves longevity swaps can be converted, and has given rise to a lot of interest.
Many believe it can be achieved for other schemes and expect to see it become more common, but this will depend on appetite from trustees and insurers.
Zugic says: "To the extent that the longevity swap providers have appetite to take on assets and the associated market risks, along with the desire to work constructively with pension scheme trustees to deliver a valuable solution, then it's reasonable to expect that longevity swap conversions will become another source of bulk annuity transactions in years to come."
It is important to look back at the original reasons for schemes putting in longevity swaps rather than going down the buy-in route. Many needed the asset returns and could not afford to hand them over to an insurer.
So it's not obvious that all schemes would want to convert into a buy-in, and it depends on the progress made since the hedges were put in place. It could be attractive for a scheme that has hedged its longevity risk, gradually de-risked the asset side and protected the liability side of the balance sheet, but has found little scope for positive outperformance.
For example, the PGL scheme is in surplus on a technical provisions basis with a very de-risked strategy largely backed by gilts.
Dominic Grimley, risk settlement adviser at Aon Hewitt, which advised on the Phoenix deal, thinks it could work for other schemes:
"Where a scheme has implemented liability driven investment (LDI) and hedged longevity risk, a bulk annuity could be attractive as we've seen for Phoenix and potentially for others. LDI and longevity swaps are not necessarily the end game for all schemes if bulk annuity pricing is attractive."
Willis Towers Watson de-risking director Shelly Beard says her firm is now talking to several clients who are at "relatively advanced stages" of considering converting: "Schemes are getting the sort of buy-in prices which we're seeing in the market, and then generally getting the cost of the longevity hedge back, which improves the [overall] pricing."
But given there are a lot of challenges and legal complexities in converting a swap into a bulk annuity, why would insurers want to do this, and why now?
Also, aside from the Phoenix deal, attempts to convert have so far been unsuccessful.
Pinsent Masons senior associate Rob Tellwright recently worked on two potential conversions that didn't go through. One was side-tracked by a corporate development within the wider group, while the other at the start of 2017 was 65% of the way forward but fell apart because the pricing wasn't quite right.
However, he says several factors will make this attractive to insurers, and expects "at least a handful of conversion deals in the next 12-18 months".
The biggest factor at play is Solvency II, the new capital regime for insurers, which came into force in January 2016.
Buy-in providers are now incentivised to put in longevity reinsurance because Solvency II requires them to hold a risk margin, whereas before not all the providers were hedging their longevity risk.
So, a scheme that has already hedged longevity risk could look very attractive now. "If a pension scheme comes to market with a longevity hedge, some of the work has already been done for the insurer," says Aon Hewitt principal consultant Michael Walker.
Another driver for conversions is that providers which have pulled back from the longevity swap market - such as Deutsche Bank and Credit Suisse - may want to wind down their existing swaps.
Pension Insurance Corporation (PIC) head of business origination Jay Shah says there could be some interest, with those providers asking whether they should just let the swaps run off, or if is there scope to novate them if the scheme wants to move to buy-in or buyout?
These providers could approach their trustee clients and assess the options.
The next step in the evolution of conversions is looking at how to deal with the practical aspects.
"Are the longevity swap providers keen to novate, are the reinsurers backing them keen to follow suit, and is the pension scheme keen to do the same? The answer to all three is possibly more now than in the past, but all these things need to come together," adds Shah.
There are operational challenges for buy-in providers, because while it's convenient to inherit a longevity swap, they have to decide whether the terms would be acceptable. These arrangements have evolved over time, come in different forms, and are underpinned by lots of legal documentation.
Providers would also have to balance how they manage risk to the different reinsurers.
"The reinsurers and buy-in providers would need to be happy to have credit exposure to one another, and the buy-in provider would need to ensure it doesn't have too much exposure to the reinsurers," explains Beard.
Where the conversion would involve changing insurers or reinsurers, this would incur an exit penalty to cut them out of the deal. Therefore, the exit terms of the swap could pose challenges.
Tellwright says schemes should understand the novation terms written into current swaps. "That will inform any exit penalties they would have to pay, which affects what competitive pricing they can get from the markets to make this work. Because if you're changing an insurer, the pricing's got to be good but also has to absorb any exit penalty."
If a scheme has a longevity swap, and is backing its liabilities with low-risk assets like bonds, there does seem to be an opportunity to explore converting to a buy-in. There are lots of complexities to work through but factors such as Solvency II and longevity swap providers wanting to exit could speed up this innovation.
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