Tom Scott, Partner, Aon
While the bulk annuity market often grabs the headlines, there remains a healthy demand and supply for longevity swaps, which has resulted in another busy year for the longevity swaps market. With four publicly announced transactions, and a combined value exceeding £10Bn for the fifth year in a row, this provides further evidence that longevity swaps continue to provide a valuable risk reduction tool for pension schemes.
Activity continues to be dominated by large schemes with all four 2023 transactions in excess of £1Bn, and with most longevity hedges also continuing to be for pensioners. However, we are also seeing an increase of longevity reinsurance for non-pensioners, which provides hedging over a much longer term and addresses the increasingly dominant longevity risk for many schemes.
For some, the plan to mitigate this, and broader demographic risk exposures, is to fully insure and ultimately buy out - with this being a nearer term prospect than expected for many. However, what about those schemes facing a long-term process to unwind illiquid asset positions, constraining the ability to purchase bulk annuities? Or schemes who wish to run-on?
For these, longevity swaps provide a flexible, cost-effective option to mitigate longevity risk. As such, we fully expect pension scheme demand for longevity swaps will continue for the foreseeable future, backed by strong appetite and capacity from reinsurers to facilitate these transactions.
This appetite and capacity has helped to drive very attractive pricing versus historic levels, allowing schemes to hedge their longevity risk exposure for a relatively marginal cost above best-estimate liabilities, often within existing funding reserves.
Investment flexibility is a key attraction
A key driver for schemes looking at longevity swaps over bulk annuities is that longevity swaps are unfunded - by this we mean that schemes do not need to set aside £1 of assets to hedge longevity risk for £1 of liabilities. As a result, schemes retain investment flexibility.
This can allow a scheme to target a higher investment return while maintaining a high level of hedging of rates and inflation exposures, which simply would not be possible with bulk annuities.
For other schemes who now find themselves with illiquid asset holdings representing a higher proportion of assets than intended, and in some cases with pressure on liquidity for rates and inflation hedging, longevity swaps can be a valuable tool. With the timeframe to run off / sell down illiquid assets and relieve these pressures potentially being around 5-10 years, during this period longevity swaps offer a ‘capital light' option to mitigate longevity risk.
Structural flexibility to future-proof is also important
The volatility in investment markets and resulting impacts on scheme funding levels has demonstrated the need for schemes to develop investment and insurance strategies that are flexible, and capable of adapting to changing circumstances and objectives. A key element of such ‘future-proofing' for a longevity swap is the ability to efficiently and cost effectively restructure into annuity at a later point.
This has long been a key structural requirement for transactions, with the different forms of ‘intermediation' options available for accessing reinsurance capacity having evolved accordingly.
Understanding Intermediation options
There are two main intermediation structures:
· Pass-through: A UK insurer sits between the scheme and the reinsurer, with the credit risk exposure between the two principal counterparties ‘passed-through' by the insurer. The insurer also acts as ‘calculation agent' to run the transaction. Zurich remains the primary insurer in this market.
· Offshore captive-based structure: The scheme or sponsor owns an offshore (e.g. Guernsey or Bermuda-based) insurance cell entity through which the scheme accesses the reinsurance.
During 2023 both options have been utilised by schemes, with the Nationwide Pension Fund and Yorkshire and Clydesdale Bank Pension Scheme opting for Zurich's pass-through solution, and BT Pension Scheme and MMC UK Pension Fund opting for the captive approach.
An alternative approach
While the stellar growth of the bulk annuity market dominates pensions news, schemes should not forget about alternative risk management structures available. The continued steady level of longevity swap activity during 2023 provides evidence that this option remains an important risk management tool for many schemes. As such, we expect the market to remain active for several years to come, utilised by schemes with objectives and constraints which are most effectively managed by these types of arrangements.
If you would like to discuss if a longevity swap may be suitable for your scheme, Aon's risk settlement specialists will be delighted to help.
