Longevity transfer

02 February 2015

Written by Kate Storey

Advocate Kate Storey, counsel for corporate and commercial at law firm Appleby in Guernsey, discusses how pension schemes are using ICCs to transfer longevity risk.

The growing level of longevity risk faced by defined benefit pension schemes has been well docu­mented and has led to pension schemes seeking solutions to manage this risk.

Such solutions have included pension buy-outs (for example, the General Motors pension buy-out arrangement with Pru­dential Financial Inc. in 2012), but more recently the trend has been towards lon­gevity swap arrangements.

Typically in a longevity swap transaction the employer sponsor and/or the trustee of the pension scheme will agree to pay fixed monthly amounts to a financial institu­tion or commercial insurer that in return makes variable monthly payments to the pension trustee.

The variable payments are calculated based on the pension amounts that the trustee is obliged to pay to the members of the pension plan. In this way, the risk of members living longer than anticipated (and the liability for pension payments subsequently being more than anticipated) now rests with the financial institution/ commercial insurer, which can then enter into a reinsurance arrangement with one or more commercial reinsurers.

However, using insurance intermedi­aries (commercial insurers and banks) in these risk transfer arrangements has become increasingly expensive. In response to this, the last year has seen two ground-breaking longevity swap struc­tures being established in Guernsey using a captive insurance company in place of an insurance intermediary, thereby cutting out intermediary fees and removing the need for price averaging.

Price averaging occurs where interme­diaries engage with several reinsurers to spread credit and counterparty risks and exposure limits, which inevitably incurs several levels of fees.

Instead of engaging in price averaging it is open to the captive to select a single reinsurer at the best pricing available in the market. The first of these two structures was the BT scheme whereby the trustees of the BT Pension Scheme set up its own captive to transact directly with the reinsurance mar­ket (The Prudential Insurance Company of America), in what is believed to be the larg­est longevity risk transfer transaction to date, in the form of a £16bn longevity swap.

The second (on which the author pro­vided the Guernsey legal advice) was the Towers Watson ‘Longevity Direct’ struc­ture, which extends this captive solution to Towers Watson’s pension scheme clients through a form of rent-a-captive.

The solution

Both the BT and the Towers Watson struc­tures utilised a Guernsey incorporated cell company (GICC) as the vehicle for the cap­tive insurance company. So, why Guernsey and why an incorporated cell company as opposed to a protected cell company, or standard company?

Guernsey is recognised as the leading captive domicile in Europe, the fourth largest in the world and compared with competitor jurisdictions has the further advantages (as far as business with the UK is concerned) of having the closest prox­imity to the UK and a special constitutional relationship with the UK, while being out­side the European Union.

It pioneered the concept of a protected cell company in 1997 and has always led on innovation in the insurance sector and financial services generally, aided by having a receptive regulator, the Guernsey Finan­cial Services Commission, which appreci­ates industry needs for speed of licensing and appropriate, high quality regulation to recognised international standards.

Guernsey’s insurance legislation and regulations are more suited to captive insurance than other parts of Europe, par­ticularly given it is not seeking Solvency II equivalence and is instead implementing a “captive appropriate” risk-based solvency regime in line with IAIS standards. It has also introduced a possible exemption from audit for captives.

On top of these advantages, to date Guernsey is the only major captive domi­ cile to offer the incorporated cell company. Cayman will shortly introduce the ability to incorporate a portfolio insurance company (“PIC”) underneath a cell which will take over the insurance business of the cell.

This does not work however, in the same way as a GICC and as the PIC must be owned by the Cayman segregated port­folio company on behalf of its cell, the cell owner does not achieve control over the PIC as it does with an incorporated cell of a GICC.

The attraction of an incorporated cell company compared to a protected cell company is that each of the GICC’s cells is incorporated and a separate legal entity in itself, which provides an extra layer of ring-fencing of the assets and liabilities in a cell by the fact that it is a separate company from the GICC and its other cells.

This has proved particularly attractive to companies from jurisdictions which do not have cell company legislation. As with a protected cell company, the cells sit under­neath the umbrella of the cell company, but are not subsidiaries of the cell com­pany (rather, in the case of incorporated cells, they are ‘associated companies’ of the GICC).

Where a GICC is used as the captive of one company, each incorporated cell can be used for a separate hedging transaction of that company. In the case of a rent-a-captive, the service provider owns the shares in the GICC and each client owns the shares in a separate incorporated cell of the GICC, which is used to facilitate the hedging transaction(s) for that client.

The board of directors is the same for the GICC and each of its cells. Each of the GICC and its incorporated cells is separately licensed as an insurer in Guernsey under the Insurance Busi­ness (Bailiwick of Guernsey) Law, 2002, as amended (the Guernsey Insurance Law). Each cell therefore has to meet the cap­ital resources requirements set by the Guernsey Financial Services Commission, although the Commission maintains a discretion to modify capital and solvency requirements in appropriate cases, for example where the insurance business is fully hedged.

A further advantage of a GICC compared with a protected cell company is that an incorporated cell of a GICC can be hived off into a standalone company separate from the GICC structure, although in response to industry demand Guernsey will shortly introduce this facility for protected cells also. So, in the rent-a-captive example a cli­ent could convert its incorporated cell into a standard company independent from the rent-a-captive structure and the cell’s insurance licence would automatically transfer over to the standalone company. Alternatively, an incorporated cell can be transferred to another GICC.

Another advantage of a GICC compared with a protected cell company is that incor­porated cells, being separate legal entities, can contract with each other and with their GICC (which is not possible for the unin­corporated cells of protected cell compa­nies).

The advantages of using a cell in a pre-ex­isting structure as opposed to a standard company are well known in the captive insurance industry, producing both time and cost savings. In Guernsey a cell can be established and licensed as an insurer in a matter of weeks rather than months.

How it works

Once the GICC has incorporated the incor­porated cell and the cell has been licensed as an insurer under the Guernsey Insur­ance Law (which takes considerably less time than setting up and licensing a stan­dalone company), an insurance contract can then be written between the trustee of the pension scheme and its incorporated cell.

At the same time a reinsurance contract, mirroring the terms of the insurance con­tract, is entered into between the incorpo­rated cell and the chosen reinsurer, so no risk is retained in the cell. The insurance contract and reinsurance contract need not be governed by Guernsey law.

The future

Because of the advantages the GICC model offers and the successful implementation of two major schemes to date, with the abil­ity to easily and quickly insure and reinsure longevity risk through a ready-made rent-a-captive structure, it is considered that there is considerable growth potential in this space.

An original version of this article was published in Captive Review, February 2015.

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