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February 9, 2014 8:58 am
Pension funds are notoriously slow-moving beasts, so perhaps the sloth-like rollout of the market for longevity hedging is apt.
Back in 2009 there was widespread excitement that pension schemes would jump at the chance to offload the risk of their members living to a ripe, and costly, old age. Moreover, it was believed this would create a shiny new, uncorrelated asset class for hedge funds and the like to play with.
However, five years on just 19 UK companies have bought longevity swaps, hedging just £26bn of their liabilities, according to Towers Watson, the consultancy. This is a tiny proportion of the £1.16tn of liabilities that weigh on the balance sheets of UK companies, says the Pension Protection Fund, the safety net for underfunded schemes.
Hedge funds are conspicuous by their absence. Instead, reinsurers are swallowing the bulk of the longevity risk offloaded by pension funds.
Pension funds are falling over themselves to hedge their interest rate and inflation risks, with the market for the latter estimated at £300bn-£400bn in the UK alone. Furthermore, a one-year rise in life expectancy increases liabilities by around 3 per cent, according to the Pension Insurance Corporation, the pension buyout group. So why has the market not gained more traction?
“It has been a slow-moving market. Pension trustees are pretty cautious,” says Martin Bird, head of the risk settlement practice at Aon Hewitt, the consultancy. “It is a bit lumpy. There have been a handful of big deals a year, but it is still a relatively immature market, focused on £1bn-plus transactions.”
Sadie Hayes, senior consultant at Towers Watson, adds: “It has not taken off and become as widespread as the bulk annuity market [where pension schemes can offload their entire risk via a buyout with an insurer or a chunk of it via a buy-in].
“It requires schemes to be of a certain size, to be able to create assumptions for death rates. [Reinsurers] are locked in, so they want good data and if you do not have that, the price will be higher.”
One problem has been a lack of competition in the market. Initially, banks were active here, but neither Credit Suisse nor JPMorgan have concluded a longevity swap since 2011, leaving Deutsche Bank as the sole active participant.
“In the early days the banks were heavily in that space, they were matching buyers and sellers and taking a cut,” says Ms Hayes. She blames the retreat on the Basel III capital adequacy banking rules. They “look quite unpleasant” for longevity swaps, which are long-term (typically more than 20 years), illiquid instruments.
This is despite the fact that the longevity risk leaves a bank’s books immediately. The banks retain counterparty risk exposure to both the reinsurer and the pension scheme, as well as day-to-day responsibility for managing collateral payments and monitoring and maintenance.
Among insurers, Legal & General is the only group to have concluded a swap since Goldman Sachs’ Rothesay Life arm tied up a £1.3bn deal with British Airways in 2011.
However Ms Hayes claims several large insurers are looking at entering the sector, driven by a belief that if they conclude a longevity swap with a pension fund they will be first in line for follow-up business if the scheme later enters buyout or buy-in.
Despite this paucity of middlemen, there does appear to be a ravenous appetite for longevity risk among reinsurers; not only does it help offset the mortality risk they carry as a result of subsuming life assurance and catastrophe risk, but it is a diversifier for other forms of insurance.
“There is quite a lot of capital flying around the reinsurance market at the moment looking for a home,” says Mr Bird, who believes more reinsurers will follow the lead of Swiss Re, which has written three swaps directly, cutting out the middlemen.
“We know that a number of reinsurers are looking at writing business directly. Disintermediation is a hot topic at the moment,” he adds.
Despite the lack of activity from the capital markets, Mr Bird talks of a “ton of interest” in the longevity market from sovereign wealth funds, hedge funds, asset managers and others already dabbling in insurance-linked securities such as catastrophe bonds.
“There is a ton of capacity out there in the capital markets because they see it as uncorrelated with market risks and providing a source of yield. They are absolutely desperate for it,” says Mr Bird. “I’m hugely positive about the capital markets but I don’t think it has found its feet yet.”
However, the drawback is that capital market participants want to invest in simple, liquid, tradable products that are based on a widely accepted index, such as mortality data for an entire country.
The only deal struck to date by JPMorgan, a £70m swap with the UK pension scheme of Pall, the engineering group, in 2011, was based on the bank’s proprietary population index.
But, Pall aside, most pension funds want a swap that is customised to the mortality experience of their own scheme members.
According to Mr Bird, a standardised swap may well cover 80 per cent of a large scheme’s specific longevity risk, but this still leaves a 20 per cent mismatch, known as basis risk. A pension fund might be willing to enter such a contract if the price were right, “but there is not much price difference, so they take the 100 per cent, not the 80 per cent”, he says.
“Moreover, many financial investors also want to invest alongside a reinsurer that has the expertise to understand the risk,” Mr Bird adds.
Some believe the longevity swap market will remain small forever. Patrick McCoy, head of investment advisory at KPMG, the professional services group, says longevity risk is “not massively high on the agenda” of most pension funds. He argues that concluding a swap makes matters “messy” if a fund later enters buyout or buy-in.
Despite the difficulties, some consultants remain upbeat. Last year was the busiest year on record. Five swaps covering £8.8bn of liabilities were agreed, including a flurry of activity in December when the Carillion, BAE and AstraZeneca pension schemes all sealed deals.
The talk is of market standards emerging, swaps now being completed in six months rather than 12 and pension funds becoming increasingly conscious of longevity risk.
Paul Puleo, head of pension and insurance risk markets at Deutsche, which wrote three swaps last year after drawing a blank in 2012, says awareness of the issue is rising, and takes comfort from the wide variety of industries, from pharmaceuticals and airlines to carmakers and insurance companies, that have now concluded longevity swaps.
International expansion is also on the agenda. Mr Puleo says Germany could be the next market to develop, although the US may prove a laggard as the lack of inflation proofing in the country’s pension schemes renders longevity risk a lesser problem than in Europe.
Deutsche and Aegon, the insurer, have already concluded a swap for a Dutch annuity book based on broad population indices in that country, says Ms Hayes, who believes Canada is another attractive market.
“We know there are other people looking at it and we know the reinsurers can price in different countries,” she says.
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