Open-access content
18th May 2016
Caspar Young explains why longevity insurance transactions using a third-party segregated account cell company are more cost effective for a wider range of pension schemes than traditional approaches
For many years, trustees of defined benefit schemes have been concerned about how future mortality improvements will ultimately affect funding levels and if they should transfer the risk to an insurer.
Many pension schemes that have a matched investment portfolio but are not ready for buy-in or buyouts may find longevity is their largest unaddressed risk and are now exploring longevity insurance as a de-risking option.
Longevity insurance is where the scheme transfers the financial impact of uncertain life spans to an insurer. The trustees receive claim payments ('the floating leg') that cover the actual pensions paid out by the scheme to its members, and in exchange pay monthly premiums at a pre-agreed rate ('the fixed leg'), an arrangement sometimes referred to as a longevity 'swap'.
By law, UK pension schemes cannot access the reinsurance market directly. Traditionally, they have transferred longevity risk through UK-based insurers or using bespoke arrangements organised by investment banks. These arrangements involve paying an intermediary to take on the risk of the reinsurer defaulting and, even when mitigated with collateral, this leads to significant costs. More recently, some schemes have used captives, or sponsor-owned, insurers. These can require complex legal drafting and involve material administrative and ongoing governance costs, but they are cheaper than the traditional approach because they avoid the intermediary costs relating to removing reinsurer risk (the downside being that the scheme retains the risk of the reinsurer defaulting).
Much of the development over the last two years has been to create alternative solutions that transfer longevity risks to reinsurers using a third party segregated account cell (SAC) company. Segregated accounts (SA) within the SAC act as insurers and allows the pension scheme to engage with the reinsurer. The SA is typically owned by the pension scheme but relies on the main SAC structure for administration and oversight. As such, the governance requirements for the trustees are limited.
The main advantage of a SAC-based longevity transaction compared with the traditional approach is that it may save up to half of the intermediation costs, around 0.5% rather than 1.0%, say, of the underlying liability value. A significant proportion of the saving arises from elimination of required counterparty risk charges, as with the captive option. The remainder of the savings are from lower overhead costs due to the simplicity of the structure, a key advantage compared to captives.
SAC structures are not for everyone though, as the cost savings are offset by the trustees' additional responsibilities and risks in having to negotiate directly with reinsurers and to accept and mitigate reinsurer counterparty risk. Typically, a SAC structure should be considered for plans with pensioner liabilities of £1bn or more. The savings in absolute monetary terms are significant for larger plans. Smaller plans with pensioner liabilities below £1bn can consider a SAC but the absolute savings are offset by material costs related to negotiating directly with reinsurers, and smaller plans may prefer dealing with a UK-based insurer. For example, a SAC-type structure was used by the Merchant Navy Officers Pension Fund for a £1.5bn longevity transaction announced in January 2015.
SAC-type structures exist in a number of jurisdictions such as Bermuda (called a Segregated Account Company) and Guernsey (called an Incorporated Cell Company or Protected Cell Company). The Government of Gibraltar has recently announced new legislation to support a SAC-type structure. The UK government is planning to legislate to create a framework for SAC-type companies, but it may be some time before the necessary details are finalised so we can assess the usefulness to pension schemes.
As an added benefit, a SAC structure is very portable. At the trustees' request, the SA can be removed from the transaction and the existing reinsurance agreements can be novated to a bulk annuity provider, subject only to agreement by the reinsurer, which can often be pre-agreed based on defined criteria being met.
SAC-based longevity insurance adds a cost-effective tool to the options available for trustees and their advisers. Most pension schemes are on a de-risking journey, starting with asset de-risking and leading to longevity de-risking, buy-ins and ultimately full scheme buyouts. Removing the longevity risk via a SAC structure integrates seamlessly into this journey.
Caspar Young is chief business development officer of Legal & General Re
Many pension schemes that have a matched investment portfolio but are not ready for buy-in or buyouts may find longevity is their largest unaddressed risk and are now exploring longevity insurance as a de-risking option.
Longevity insurance is where the scheme transfers the financial impact of uncertain life spans to an insurer. The trustees receive claim payments ('the floating leg') that cover the actual pensions paid out by the scheme to its members, and in exchange pay monthly premiums at a pre-agreed rate ('the fixed leg'), an arrangement sometimes referred to as a longevity 'swap'.
By law, UK pension schemes cannot access the reinsurance market directly. Traditionally, they have transferred longevity risk through UK-based insurers or using bespoke arrangements organised by investment banks. These arrangements involve paying an intermediary to take on the risk of the reinsurer defaulting and, even when mitigated with collateral, this leads to significant costs. More recently, some schemes have used captives, or sponsor-owned, insurers. These can require complex legal drafting and involve material administrative and ongoing governance costs, but they are cheaper than the traditional approach because they avoid the intermediary costs relating to removing reinsurer risk (the downside being that the scheme retains the risk of the reinsurer defaulting).
Much of the development over the last two years has been to create alternative solutions that transfer longevity risks to reinsurers using a third party segregated account cell (SAC) company. Segregated accounts (SA) within the SAC act as insurers and allows the pension scheme to engage with the reinsurer. The SA is typically owned by the pension scheme but relies on the main SAC structure for administration and oversight. As such, the governance requirements for the trustees are limited.
The main advantage of a SAC-based longevity transaction compared with the traditional approach is that it may save up to half of the intermediation costs, around 0.5% rather than 1.0%, say, of the underlying liability value. A significant proportion of the saving arises from elimination of required counterparty risk charges, as with the captive option. The remainder of the savings are from lower overhead costs due to the simplicity of the structure, a key advantage compared to captives.
SAC structures are not for everyone though, as the cost savings are offset by the trustees' additional responsibilities and risks in having to negotiate directly with reinsurers and to accept and mitigate reinsurer counterparty risk. Typically, a SAC structure should be considered for plans with pensioner liabilities of £1bn or more. The savings in absolute monetary terms are significant for larger plans. Smaller plans with pensioner liabilities below £1bn can consider a SAC but the absolute savings are offset by material costs related to negotiating directly with reinsurers, and smaller plans may prefer dealing with a UK-based insurer. For example, a SAC-type structure was used by the Merchant Navy Officers Pension Fund for a £1.5bn longevity transaction announced in January 2015.
SAC-type structures exist in a number of jurisdictions such as Bermuda (called a Segregated Account Company) and Guernsey (called an Incorporated Cell Company or Protected Cell Company). The Government of Gibraltar has recently announced new legislation to support a SAC-type structure. The UK government is planning to legislate to create a framework for SAC-type companies, but it may be some time before the necessary details are finalised so we can assess the usefulness to pension schemes.
As an added benefit, a SAC structure is very portable. At the trustees' request, the SA can be removed from the transaction and the existing reinsurance agreements can be novated to a bulk annuity provider, subject only to agreement by the reinsurer, which can often be pre-agreed based on defined criteria being met.
SAC-based longevity insurance adds a cost-effective tool to the options available for trustees and their advisers. Most pension schemes are on a de-risking journey, starting with asset de-risking and leading to longevity de-risking, buy-ins and ultimately full scheme buyouts. Removing the longevity risk via a SAC structure integrates seamlessly into this journey.
Caspar Young is chief business development officer of Legal & General Re
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