Longevity swaps –
do they create a barrier to buy-in or ultimate buy-out?

Our viewpoint

Having taken significant steps in de-risking their investment strategies, pension schemes are increasingly turning their attention to longevity risk. For larger schemes, this involves deciding whether to address longevity risk through buy-ins or longevity swaps, and a key consideration for those contemplating a swap is whether it can easily be passed to an insurer on buy-in or buy-out.

The challenges

The key challenge associated with transferring longevity swaps to an insurer is avoiding unnecessary additional costs. Longevity swap contracts will normally include provisions to allow future transfer to an insurer, but it cannot be guaranteed that the insurer will be able to accept the swap or that the swap provider can transact with the insurer. This means that the scheme may face a costly penalty to unwind the swap.

An associated challenge is ensuring competitive pricing for future buy-in/out policies, which means designing the swap so it is easy for insurers to price and take on. No pension scheme has yet transferred a longevity swap, but we have practical experience of redesigning and transferring other insurance contracts such as buy-ins. In our experience, there are a number of steps pension schemes can take before and after implementing a swap to minimise costs and simplify the transfer process.

1. Planning

Pension schemes should be clear about their objectives from the outset, explaining to the swap providers when/how often they will want to enter into buy-in or buy-out policies in the future. You should also discuss the practicalities of converting the swap with at least one (but ideally multiple) insurers so that their requirements are taken into consideration.

2. Design

It is important to design your swap in a way that will make it easier to move to buy-in/ out in the future. For example, agreeing when the swap could be passed to an insurer, any conditions the swap provider has, and, if a solution couldn’t be reached, the cost to terminate the swap. Having a clear understanding of the scheme’s objectives will mean sufficient flexibilities can be included in the contract (without making it unfavourable for the swap provider and therefore expensive).
Recent design innovations (eg schemes transacting directly with a reinsurer using an insurance captive) can simplify conversion by minimising the number of parties involved in the process.

3. Regular discussions

Pension schemes should have regular discussions with their swap provider and the insurers, to gain an understanding of their financial strengths and whether they have placed a significant amount of business with each other. This will help to reduce the risk that the swap cannot be transferred to an insurer at reasonable cost.

A potential advantage?

The swap providers understand that the majority of schemes will ultimately want to fully buy-out and will generally be happy to work with you to design a sensible process for this. Insurers may actually welcome pension schemes that have existing, well-designed swap contracts, as the Solvency II insurance regime encourages insurers to use swaps to reinsure the longevity risk within their buy-in/out business.

Therefore, if you are clear about your intentions from the outset, design the swap well, and maintain close dialogue with the providers, a longevity swap, rather than being a barrier to ultimate buy-out, can help facilitate that final step.

Murray Blake is a consultant in LCP’s insurance de-risking practice and has completed longevity reinsurance transactions covering over £4bn of pension liabilities. Murray joined LCP’s de-risking practice last year from Pacific Life Re where he completed longevity reinsurance transactions covering over £4bn of pension liabilities, including a dis-intermediated swap with the MNOPF.