Life’s a game of give and take: Focus on longevity swaps

28 November 2017

Written by Graydon Bennett

BWCI Senior Manager of Actuarial Insurance Graydon Bennett discusses the ins and outs of longevity swaps.

Increases in life expectancy are a source of risk and uncertainty for trustees of defined benefit pension schemes. Over the last decade, a number of structures for managing this longevity risk have emerged, including the pension buy-in, the pension buy-out, and the most recent innovation - the longevity swap.

Structure of a longevity swap

The objective of a longevity swap is to allow the pension scheme to exchange a stream of uncertain future pension payments for the security of a known series of future payments.

The pension scheme enters into an agreement to transfer its longevity risk using a swap with fixed and floating legs. It does this by exchanging a commitment to make future fixed payments (based on estimated future pension payments) in return for another party’s commitment to meet the uncertain actual future payments (the floating leg). The ultimate counterparty in the transaction is usually a reinsurer. However, as reinsurers are not permitted to transact directly with pension schemes, often a captive insurer of the pension scheme’s sponsor will act as an intermediary.

The pension scheme usually pays an additional premium as contribution towards the costs and risks incurred by the counterparty committed to meeting the actual future payments. The transaction only covers the difference between the actual and projected pension payments. Therefore, the investment risk remains primarily with the pension scheme.

Collateral requirements

The operation of the swap depends on monitoring the actual cash flows and comparing these with the agreed fixed payments. Both parties will be concerned that any changes in actual or projected experience could have a material impact on future collateral payments. To address this concern the pension scheme and the insurance company are each required to post collateral, depending on past experience and the projected net cash flow. The collateral is held by a custodian.

Calculation agent

A calculation agent determines the value of collateral to be posted at the inception of the swap. The agent also re-values it periodically throughout the life of the transaction. This work is usually undertaken by an actuary.

Guernsey as a jurisdiction

Guernsey has established itself as the predominant location for longevity swaps placed through captives. It is important that the captive demonstrates its presence in Guernsey, to avoid potential tax risks that could arise when dealing with a UK pension scheme.

In 2014 the British Telecom pension scheme executed a £16 billion longevity swap with a US-based life insurer through a Guernsey captive. This was followed by a £1.5 billion transaction for the Merchant Navy Officers Pension Fund.

To date, all the major longevity swaps transacted in Guernsey have been completed using an incorporated cell company (ICC) – a structure which is not possible in the UK.

Recent transactions

Details of a further two large longevity risk transfers, which were executed in Guernsey, were announced in September 2017. First, the pension scheme for Marsh & McLennan companies completed a longevity swap using a Guernsey-domiciled ICC to hedge the longevity exposure in £3.4 billion of its pension liabilities. A week later, it was announced that one of the British Airways pension schemes had agreed a deal to hedge the longevity risk inherent in £1.6 billion of its defined benefit pension liabilities.

Conclusion

Over the last few years longevity swaps have become the ‘hot topic’ among pension scheme trustees concerned about their scheme’s exposure to longevity risk. Guernsey has presented a compelling case and solid track record to be the preferred domicile for a captive or ICC solution to the longevity risk question.

An original version of this article first appeared in the Q4 2017 edition of Bandwagon, The BWCI Group's newsletter.

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