Viva Aviva! This might seem a fitting slogan to celebrate the giant UK insurer’s record-breaking longevity swap deal with three reinsurers, announced in early March.
But the phrase could also be seen as ironic – for it is precisely the increasing life expectancy of retired employees that has prompted the group to sign the deal.
The new arrangement allows Aviva to transfer £5bn (€6bn) of its defined benefit staff pension scheme’s longevity risk – around one-third of its total risk – to the global reinsurance market, protecting the scheme against the burgeoning costs of pensioner members who are living longer.
The deal, with reinsurers Swiss Re, Munich Re and SCOR Global Life, creates a new record for size, not only in the UK but worldwide. It easily outstrips the previous biggest global deal, the offloading of £3.2bn-worth of risk by the BAE Systems-2000 Plan, which was completed in February 2013, according to Aon Hewitt’s register of UK pension fund longevity swap deals (see table).
The spurt in life expectancy is now causing major headaches for occupational pension schemes, because of the resulting increases in financial costs. For instance, within the UK, on a like-for-like basis, pensions liabilities have risen by as much as 15% during the past 15 years, according to Aon Hewitt.
Aviva carried out the swap not only to support the pension fund trustee in further de-risking of the pension scheme, but also to reduce the risk from Aviva’s own perspective through reduced exposure to longevity risk as well as improving the group’s overall capital resilience.
Furthermore, one of Aviva’s key strategic priorities is the reduction of an intercompany loan owed by Aviva Group Holdings to Aviva Insurance as a result of a recent group restructuring, and which now stands at £4.1bn. Carrying out the swap helps reduce the loan by reducing risk.
Choosing more than one counterparty for a deal this size meant that Aviva could spread individual counterparty exposure. The collateralisation mechanisms within the transaction also help to reduce this risk from everyone’s point of view.
The swap covers most of the current pensioners of the Aviva Staff Pension Scheme (ASPS) – a total of 19,000 individuals – and their contingent spouses or civil partners. Deferred pensioners are not covered.
Apart from its size, the transaction has other features that distinguish it from other longevity swaps, in what is admittedly still a small club.
UK pension funds normally use an intermediary – usually an insurance company or an investment bank – to transact such a deal with the reinsurer. Typically, these intermediaries charge 1-1.5% of the value of the deal in fees.
One reason for using an intermediary is that reinsurers generally are banned by UK law from dealing directly with pension fund trustees. But there are other challenges.
“UK pension schemes are complex, with unusual benefit structures and designs – take guaranteed minimum pension benefits as an example,” says Martin Bird, senior partner and head of risk settlement at Aon Hewitt. “So setting aside the need to use an intermediary to access the reinsurance market for legal reasons, there has been a job to do to bring the global reinsurance market’s capacity to the pensions market.
“We have seen considerable developments in structures and pricing as the reinsurance market has become more familiar with the uniqueness of the UK pensions system.”
However, the Aviva deal introduced a ‘first’, in that the insurer acting as intermediary, Aviva Life, was none other than a subsidiary of the pension scheme sponsor itself, the Aviva group.
This gave comfort to the pension scheme by using a UK-based and UK-regulated insurance company. It also, of course, meant savings on the associated fees, compared with using a traditional third-party intermediary.
But, perhaps more importantly, Aviva also has existing strong relationships with all the reinsurers involved in the transaction, as well as the custodian. It is likely that Aviva’s ability to access them directly ensured all parties were aligned where necessary, and helped all sides to be flexible where this was critical.
Global reinsurers are a market with a growing appetite for this kind of deal. According to a study by Aon Hewitt, there is a global reinsurance market for longevity swap deals totalling more than £100bn over the next two years.
Reinsurers are willing to take on the risk because it hedges the mortality risk inherent in their exposure to life insurance and catastrophe risks, both of which are highly correlated with large instances of death.
Earlier-than-expected deaths not only trigger cash payments from the reinsurers to beneficiaries but they also halt the stream of premiums paid under the terms of the policy.
Insurers are also keen to take on longevity risk because lower mortality risk means they have to hold less capital. In Aviva’s case, the fact that an insurer is the sponsor led to less costly intermediation. The reinsurers were selected in a competitive process run by Hymans Robertson, who advised the ASPS trustees. The deciding factors included price, financial strength and experience.
In general terms, the structure of the Aviva deal is identical to previous longevity swaps. The swap arrangement required separate contracts to be drawn up between each of them and Aviva Life. “There were different points at issue for each of the three reinsurers,” says Jonathan Marks, partner, Slaughter and May, who represented Aviva Life. “The document had to be bespoke but what we had to do was to ensure that while there were slight differences in the terms between Aviva and the three reinsurers, the structure and documents for each agreement were broadly the same.”
He adds: “The key was to make sure the uncollateralised exposure was limited.” One interesting quirk to drawing up the agreements was to accommodate parts of the Life Assurance Act 1774, originally enacted to prevent profiteering from gambling on events such as duels.
Although passed at a time when the teenage Mozart was writing sonatas for the ruler of Salzburg, certain provisions of the Act are still in force, and can invalidate an insurance contract, including a longevity swap written as reinsurance, if it is not structured correctly.
The common approach to longevity swap agreements is that the amount of collateral to be posted will be based on a formula. Any collateral, which is likely to be modest, will have been posted around the time the agree-ment takes effect. Experience collateral – which is used to underwrite changes in longevity against expected patterns, for example, if a cure is found for a major disease – may be posted after a mortality basis review between the trustee and the reinsurer.
Generally, mortality information is shared on a regular, say quarterly, basis. The scheme’s administrators will send the reinsurer details of pensions paid, new pensioners and individuals who have died.
But in spite of local quirks such as 200-year-old laws, the UK is still effectively the only country where longevity swaps are carried out.
One reason for this, says Daniel Harrison, global head of longevity solutions at Swiss Re, is that there is a recognition between insurers, reinsurers and pension schemes as to the reasonable best estimate of life expectancy for pensioners. Once that has been arrived at, a premium will have to be paid above that best estimate to remove that risk.
However, even within the UK, the intricate nature of this type of deal might act as a deterrent to other pension funds, particularly if they cannot access experienced advisers. “What dissuades them is the scale and complexity of this type of transaction,” says Harrison. “So we will not see the number of transactions we would otherwise expect to see unless there is some simplification.”
But, he says, the Aviva deal could be partially replicated by companies with an insurance business within the same group, including property and casualty entities. In principle, if they have an approved licence to write life assurance business, the same structure could potentially apply.
Marks agrees a longevity swap might not be suitable for many UK pension schemes: “If you’re a scheme in deficit, have you got the wherewithal to do a swap and pay the risk premium needed?”
However, he adds: “There are big insurers and reinsurers with significant capital to deploy, and there are some big deals in the pipeline. However, deals are very intricate and time-consuming so they need to be big to justify the consequent cost. In fact, some providers will only make available some features, such as security, on bigger longevity deals.”
Since the Aviva swap, Slaughter and May has also acted for the ICI pension fund’s £3.6bn buy-in agreement with L&G and Prudential.
“The global reinsurance industry has suffered from a lack of familiarity with the UK market,” says Bird. “It is true that the lead time on transactions is coming down because documents are in a more standardised format.”
However, transaction lead times are falling – for example, BAE executed a deal in less than six months – and Bird believes this will continue to improve with more deal flow.
He also expects more work to be done for very large funds looking to access reinsurance market capacity more directly than via an intermediary, but considers that this kind of arrangement would only really be suitable for schemes with liabilities running at least into the billions.
However, Crawford Taylor, partner at Hymans Robertson, says: “This deal opens the door on trying to achieve something similar, not just for insurance companies but for a non-insurer to set up a captive. And this could allow smaller pension schemes in.”
Taylor, who says Hymans Robertson is looking at facilitating this kind of deal for clients, adds: “It could be made available for a lot more schemes if you could standardise the contracts and reduce the implementation cost. It might also be possible to include smaller schemes in a pooled arrangement.”
He expects attention will turn to protecting against longevity risk, as pension schemes gradually reduce what are currently greater risks such as inflation and interest rates.
But for those scheme sponsors thinking of hedging longevity risk, what is the likely cost? “Pricing is super-competitive at present,” says Bird. “There are 15 or 20 reinsurers writing business globally, a marked increase from the early days of the market when only three or four players were ready to deal.”
Bird has also noticed signs of interest elsewhere. “The market is still growing in the UK but we are now seeing structures being developed in countries such as the Netherlands, Ireland, Canada and the US,” he says. “However, as yet there is not much activity.”
“The issues and uncertainties around longer life expectancy apply globally,” says Harrison. “So the appetite to reduce this risk would apply anywhere, especially countries where there are significant DB liabilities, such as the Netherlands, Switzerland, the US and Canada.” He adds that, at present, reinsurance premiums are at a reasonable level as it is a competitive market, but he warns that could change.
“There is currently short-term capacity within the market to meet demand,” Harrison concludes. “The reason why reinsurers can take on longevity risk is because they carry a lot of mortality risk. But that risk is finite, and if it is all taken up, it could have an impact on longevity insurance premiums in the future.”
Hymans Robertson’s latest report on longevity hedging, buy-ins and buy-outs is available at: bit.ly/1myySF6