The Longevity Swap Market has rarely been so active in the last few months. 2016 might be another record year! The graph below shows longevity swaps transactions executed by UK pensions schemes since 2010.
Expectations are quite logically for the upward trend to continue. Longevity swaps now form part of the de-risking solutions that pension schemes commonly look at when executing LDI strategy and with longevity risk on top of the agenda the push towards such transactions should continue.
However the growth of the market is only sustainable on the long term if the “supply” for longevity risk protection remains strong. And the 1 trillion of UK defined benefits pension liabilities massively out-weight the estimated 100bn longevity capacity available from the reinsurers, the main suppliers of longevity risk for the time being.
In the absence of additional capacity, the expectations are logically that at some point longevity pricing will increase making it less affordable/attractive for pension schemes to hedge their exposure. But at this time there are no such signs of reduced appetite from the reinsurance community.
Looking at the chart below, one might wonder if the constraining factor to the continuing growth of the longevity swap market is not going to arise first from the low number of intermediaries rather than the lack of longevity appetite from the reinsurers.
When a pensions scheme enters into a longevity swap transaction, an intermediary is needed to transform the longevity risk into an insurance risk that can then be reinsured. There have only been few entities acting in this capacity and with more pressure coming from the regulator on balance sheet usage and credit risk concentration, couple of them have retreated with the last standing ones becoming quite selective on the transactions. Since 2015 only two insurance companies are active in underwriting longevity risk from pension schemes through longevity swaps transactions.
So why have we not seen already some signs of slowdown?
There are two explanations to the resilience of the market to the “disappearance of the intermediaries”:
- Firstly a significant number of 2015 transactions have involved pension schemes liabilities where the sponsor was an insurance company. Under Solvency II, the new capital regulation for insurance companies that came in force in January 2016, insurance companies that are already exposed to longevity risk through their annuity portfolio had incentive to hedge the longevity risk of their own pension funds liabilities. In this specific situation a new solution emerged where the sponsor is used as the intermediary between the pension scheme and the reinsurers. The Axa and Aviva longevity swaps transactions are recent example of such a structure.
- Another reason is the recent use of captives/insurance vehicles. Here the pension scheme faces an insurance entity specifically created for the longevity transaction. British Telecom and MNOPF have recently hedged some of their pension liabilities with the use of an offshore insurance company in order to transfer it to reinsurers.
Clearly the development of the captives’ solution might be the answer to the reduced number of active intermediaries. In addition under these structures there could be some cost efficiency to be gained. By outsourcing the calculation and valuation agent roles to companies dedicated to these tasks the total cost associated with a longevity hedge would be reduced.
The market is going to stay active for the next couple of years thanks to the des-intermediation of the traditional intermediaries and the development of companies using new technologies to automate the reporting and calculations required by longevity swap transactions.