Investment banks looking to profit as companies try to insure the risk they will pay pensions for longer have a struggle on their hands.
The bankers want to do longevity swaps — deals where a counterparty takes on the liabilities for a period, pocketing the difference if payouts fall short of trustee estimates, and paying out if they overshoot.
The deals amount to bets on when people will die, and they offer an alternative to directly insuring the risk of a pension funding shortfall through a specialist insurer. These insurance deals are known as buy-ins or buy-outs.
Industry experts say pension trustees, who hold the purse-strings on multi-billion pound schemes, prefer working with insurers to cover part or all of their liabilities because they are better regulated and offer products they can understand more easily.
Trustees are also wary of the way bank counterparties in longevity swaps manage the risks they assume.
“Counterparty risk is always going to be an issue, particularly where the counterparty with whom one does the initial deal may not be the holder of that risk for many hours in some cases, let alone many years,” said Alan Pickering, chairman of independent trustees firm BESTrustees.
The counterparty makes money if pensioners collectively live shorter lives than assumed in the terms of the swap contract, because they are entitled to retain the difference in payments. They lose money if the reverse happens.
But Pickering notes that the counterparties can offload newly structured swaps in the secondary market — either in the hope of turning a faster profit, or to adjust their risk exposure. This makes counterparty risk even more of a concern.
Longevity swaps amount to a bet on when people will die, and in that regard resemble the life settlement market, also called death bonds, a secondary market in U.S. life insurance policies.
The UK is the most advanced and sophisticated longevity insurance market in Europe, where heavyweight insurers like Prudential, specialists like Pension Insurance Corporation, and banks like Credit Suisse vie for a slice of the market.
Companies in the UK assume their employees will live longer than their U.S., Dutch, German and Spanish counterparts, according to a study by consultancy Lane Clark and Peacock. UK companies assume a 60-year-old man retiring in 2010 will live until 87, an estimate second only to French companies, which budget for longevity of just over 88 years.
In the first nine months of 2010 there were 119 buy-in and buy-out deals insuring about 3.5 billion pounds ($5.5 billion) of pension scheme liability, according to a report by consultancy Hymans Robertson.
There was only one longevity swap transaction, between the BMW UK pension fund and Deutsche Bank’s subsidiary Abbey Life, which underwrote the former’s 3 billion pounds longevity liabilities.
Despite the potential appeal of swaps when cash is scarce, trustees view these types of product with unease due to their complexity and lingering doubts about whether the counterparty will pay out if it ends up on the ‘losing’ side of the deal.
“It is very difficult to measure longevity risk and make an opinion on where the pricing is,” said Jeremy Williams, head of pension risk at the schemes sponsored by Daily Mail and General Trust.
Investment banks are competing for longevity swap deals notwithstanding the relatively modest fees on offer because they can serve as catalyst to more lucrative fee-earning transactions, said Lane Clark and Peacock Partner Jerome Melcer.
“They say: ‘We will do the longevity hedge, but at the same time, why don’t we do inflation, interest rate hedges? There are also very clever things we can do to boost returns on your assets.’ They use it also as a marketing tool,” he said.
The easiest way a trustee can decide between using a longevity swap and a buy-out to manage their risk is by examining the strength of the counterparty considered, said Richard Butcher, managing director of Pitmans Trustees.
“We would rather use a more reputable, long-term — albeit more expensive — firm, on the basis that there is a better chance they are going to be around. Counterparty risk is always a risk, the longevity of the provider is an unknown,” he said.
One factor that could favour investment banks and their longevity swaps is on the horizon. A deal with an insurer may become more expensive with the introduction in the European Union of the Solvency II regime in 2013, which will require insurers to set aside more capital to closely match risks on their books.
Higher prices for insurance against spiralling liabilities may deter some pension schemes, but short-term expenses could spare funds from indeterminate costs over the longer-term as life expectancy nudges higher each year.
“Trustees and companies have to think about whether to pay a little bit more to buy the insurance framework or paying a little bit less and going with investment banking solutions. It is a trade off,” Melcer said.
(Editing by Sinead Cruise and Andrew Callus)
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