Flexibility for longevity swaps in the long term
There has been a recent increase in the volume of longevity swaps being entered into by pension schemes. In 2020, the reported transaction volume for longevity swaps was judged by one consultant to be three quarters of the volume of pensions liabilities covered by buy-ins/buy-outs. While longevity swaps are still mainly used by larger schemes and the liabilities covered per swap tend to be high, some in-roads are being made to make a longevity swap market for smaller schemes.
Trustees are right to be concerned about the implications of entering into longevity swaps in the longer term. The scheme’s circumstances might change and trustees will want to be sure that they are well prepared if they do. Below we explore some of the key points that trustees ought to take into account and how these might be addressed during the negotiation.
Buy-ins and buy-outs
If the scheme funding position improves or bulk annuity pricing becomes more favourable, trustees might want to look at switching out of the longevity swap and entering into a buy-in (or even buy-out) instead? This is certainly possible and we set out below our thoughts on some of the key points to consider.
What would the transition from longevity swap to buy-out look like?
It will almost certainly be too expensive for trustees to simply terminate the longevity swap and move to buy-in or buy-out. That would likely be possible, because longevity swaps usually include an optional termination right for the trustee. But this will usually trigger an early termination payment including all future expected fees of the reinsurer from the point of termination to the end of the transaction’s scheduled term. Fees may be payable to an intermediating insurer taking credit risk too. The expense would inevitably include an element of double counting in this case. The premium payable to the insurer in relation to a buy-in or buy-out would also include the insurer’s fees for covering longevity risk, just as the longevity swap includes the reinsurer’s fees for covering longevity risk.
To avoid paying twice for the longevity protection, the preferred option would be for the longevity swap contracts to be novated by agreement with both the existing parties to the longevity swap and with the UK insurer offering the buy-in/buy-out. The longevity swap between the trustee and the intermediary insurer would be novated to the UK insurer providing the buy-in or buy-out, and the reinsurance agreement between the intermediary insurer and the reinsurer(s) would be novated to create a contract between the UK insurer and the relevant reinsurer(s). Related contracts such as those relating to collateral would also need to be novated. We consider below what can be done at the outset to position things favourably for this route.
Is a transition to buy-in/buy out realistic? What can be done to smooth the transition?
It is not difficult to see why a longevity swap novation can be attractive to a UK insurer offering buy-in/buy-out. UK insurers reinsure substantially all their longevity risk with the reinsurance market and are likely to continue doing so unless there is a material change in the capital regime for insurers under UK Solvency II. A longevity swap includes a ready-made reinsurance arrangement with a particular reinsurer(s) and so novation is potentially workable in this way.
Some changes may be required to the terms of the reinsurance and related agreements (such as those relating to collateral) on novation. There is possible complexity here and it can take time to work through the issues with all the parties. The change in terms could potentially add additional cost to the novation. It is also worth noting that a transaction with a favoured insurer is not guaranteed. The insurer offering the best buy-in/buy-out pricing may have reached its maximum capacity with a particular reinsurer, or may not have an existing relationship with the reinsurer (though in the right circumstances this ought to be surmountable).
That said, transitions of this sort have been done in recent years and the market is becoming more familiar with them. As more transitions happen, they will likely become easier to implement.
Maximising the chance of novation
In order to increase the chance of novation occurring, the best thing to do is negotiate terms upfront with the reinsurer, and intermediary insurer, to contractually limit their ability to block a transition. As noted above, novation requires agreement by all parties including the bulk annuity insurer to make it work but, having some carefully agreed wording with the reinsurer and intermediary is likely to be extremely helpful.
Whatever terms are agreed should take into account practical points as to how the novation will be carried out and it should deal with the likely objections of the reinsurer (and, where applicable, intermediary insurer). A word of caution: schemes may not want to make these overly prescriptive; if they are too inflexible, the terms may make the process more difficult to administer rather than less, but having some clear agreed situations and conditions where these parties are not able to block a novation can be very helpful.
Changes to the trustee or the scheme
It is impossible to foretell what could happen during the life of a longevity swap. Schemes may sectionalise or de-sectionalise, or, as a result of corporate restructuring, schemes may merge or de-merge. The terms of the longevity swap should specify what would happen in such circumstances.
Schemes with individual trustees will almost certainly have incorporated their trustee before entering into a longevity swap. That said, a change of trustee may occur. If a scheme were to go into the PPF, for instance, the corporate trustee would likely be changed as part of that process. Provisions in the document can help facilitate this.
If trustees are considering liability management exercises like pension increase exchange exercises, they will likely want to make sure appropriate flexibility to do this is included in the longevity swap. Reinsurers may need to increase their pricing as a result of a PIE exercise and the longevity swap should set out how the trustee and reinsurer would work together to agree a solution.
If you would like to discuss a proposed longevity swap or any of the issues raised in this blog post, please don’t hesitate to contact Paul Phillips or James Geer directly or the usual members of your Sackers team.