15 December 2008

Published in: Investment risk, Longevity - mortality

Life remains in the longevity market

The buyout market may be challenging but there are some attractive opportunities to transfer risk, and the case for longevity protection is strengthening, argues Gordon Fletcher.

The longevity market has long been warmed by words, but the truth is that deals in death rates have been as cold as a coroner's handshake. However, activity has hotted up with some recent under-publicised deals and one longevity deal in the first quarter of 2008 where a staggering fourteen players - including banks, insurers, re-insurers, and hedge funds - initially showed interest.

The longevity market started to appear in earnest in 2007. The rapid growth in the number of insurance companies active in pension buyouts, coupled with some reinsurance deals, meant that there was considerable interest in taking on longevity risk - albeit holding hands with the assets. The launch of several longevity "indices" signalled the entrance of the capital markets into an area that was traditionally insurer-led.

Deals were not, however, forthcoming and we had to wait until 2008 for the first publicised deal. The new "mono-line" insurer Lucida has confirmed that it has written a contract on JP Morgan's life expectancy index to hedge its exposure to longevity risk. This deal is significant in that it seeks to isolate longevity, and cede this risk without having to hand across assets. In addition a large UK insurer has transacted a member-specific longevity swap with JP Morgan - a swap based on a particular list of lives and whose payout depends on the survival of those lives. In general, life companies have trail-blazed pension plans in many respects, so we might expect a pension plan to follow suit early next year. Also in 2008, another investment bank that is leading the charge has written a bespoke (member-specific) longevity swap on a non-UK pension plan in Europe.

It is now possible for pension plans to approach the market for a longevity-only solution. This may take the form of a swap, derivative or perhaps a bond. The key is that the plan locks into a pre-agreed level of future longevity, typically based on a common actuarial table which assumes that a 65 year old male lives 22 years in retirement. This level may be specific to the plan and its own members, or it may be based on general population longevity via an index. The players who are chasing this business are varied, and generally fall into two groups. Firstly the buy-to-hold players take on longevity risk and aim to hold it for the medium- to long-term on their balance sheet. These might typically be insurers, re-insurers and some hedge funds. In contrast the remaining players are "risk distributors", generally investment banks. They seek to structure deals, and act as the middle man, repackaging longevity risk and selling it on to investors.

For some plans the management of risks may lead to a longevity-only deal as an interim solution, but the endgame is likely to be a buyout. When done properly, a buyout provides the sponsor and trustees with a near-complete exit from pension liability.

Buyout innovations

During 2008 innovation in the buyout market continued with some genuinely new offerings. Buyouts have traditionally taken a considerable time - often measured in years. The main source of delay has often been the level of due diligence that has to be undertaken before the insurer is willing to take on the plan. Remember that the insurer only has one shot to get the price right and has no recourse to the sponsor for extra funds if the liability has been misjudged. Finalising the data and benefits is key, but doing this can be a very complex exercise for a large plan. In late 2007, Mercer brooked the first "all risks" transfer where an insurer agreed to take on the plan and buyout from day one.

For example, in preparation for corporate restructuring, Emap asked Mercer to approach the buyout market to seek a complete liability exit. Timescales necessitated a rapid solution and, after a competitive bidding exercise, Paternoster assumed sponsorship of both of Emap's plans with combined assets of £170m ($252m) and secured the liabilities with a bulk annuity. For an additional premium the original sponsor achieved a complete discharge from their obligation.

The competition for buyout business remains fierce, with many insurers looking to write business.

We are aware of at least six insurers who are prepared to transact a similar deal. The main driving factor in determining the magnitude of the all-risks premium is the coherence of the plan member data. For plans that have maintained sound records with a history of little, or no, change in administrator and little M&A activity, the premium is likely to be quite small.

In 2008 Mercer led the negotiations for a deal that enabled the gaming group Rank to exit their pension obligations rapidly and immediately claw back some of the "trapped" surplus to provide a much-needed boost to their corporate balance sheet. In early 2008, the company transferred its whole plan (and virtually all associated risks) to Goldman Sachs, the investment bank, and Goldmans' FSA-authorised insurer, Rothesay Life. The plan's assets and liabilities were first transferred to an otherwise empty plan sponsored by Goldman Sachs and then all the benefits in the new plan were secured with a bulk annuity from Rothesay Life.

This allowed Rank to break the link from day one, and immediately recover a portion of the surplus in the plan. It is notoriously difficult to establish a definitive claim on a pension fund surplus, with multiple claims arising from the sponsor and the trustees on behalf of the members. Surplus apportionment, when combined with a buyout and wind-up, can be a lengthy and legally complex process. Clearly a process that can provide a sponsor with relatively quick access to funds that satisfies all the relevant stakeholders will be welcomed by companies in a similar position.

Stiff competition for buyouts

The competition for buyout business remains fierce, with many insurers looking to write business. Whilst price remains an important issue for many buyers, we have seen many sponsors explore issues such as insurer security, operational effectiveness, efficient deal execution and the size of capital backing the promise. For large deals the complexity can be enormous, and the role of the broker can be critical in ensuring that all aspects are met to the satisfaction of all stakeholders. For the small to mid-sized plans where there is more desire for a "plain vanilla" product, sponsors have been leveraging market supply and conducting online auctions. Mercer pioneered online buyout auctions in 2007 to ensure the efficiency and integrity of the negotiation process. The Italian oil company Eni took advantage of this method when seeking a buyout of one of their UK pension plans. This was the largest auction to date, with a premium of around £150m ($222m). The frantic bidding that took place over a two hour period resulted in material savings for the sponsor and a water-tight audit trail for the trustees.

In the early part of 2008 the pricing in the buyout market was very keen. In the tussle for business, margins were slashed and return on capital eroded to the point where some providers that were not writing business were claiming that they were more profitable than those that were! When combining this competitiveness with the common practice of not pricing solely on gilts, but instead including high quality corporate debt and allowing for some future default, then the high spread (the gap in yield between government securities and corporate bonds) meant that buyout premiums had come within reach of many that thought they were unattainable.

Insurers were also seeking to cut margins in other areas. Insurers are now much more sophisticated in their pricing, incorporating complex member longevity models that will take account of an individual's home address, as a proxy for socio-economic class, to estimate their personal life expectancy. Insurers will even go the extra mile in estimating the likelihood of members being married, as any small margins here will make its way into the premium.

Credit crisis hits the market

During the later part of 2008 the credit crisis has made the completion of a transaction difficult, with buyout prices changing daily. The concept of a "point-cost" in time is now disappearing with much more sophistication being required as to the timing and nature of an asset transfer. For example the pricing offered by insurers may change depending on which companies are issuing or trading corporate debt, and with the increased nervousness surrounding default risks, buyout insurers are carefully choosing the bonds that they hold.

So there is no doubt that carrying out an asset transaction involving hundreds of millions of pounds in the current environment is now more difficult to achieve than in the past. However, at least four bulk annuity insurers continue to guarantee their quotations and state that they are happy to carry out an asset transaction if the buyer enters into exclusive negotiations with them. The market is, therefore, more "alive" than people believe.

Similarly, the insurers are reacting well to the credit crisis by "reformatting" their products as necessary to ensure that transactions continue in the future. For example, many insurers are now willing to spread payment of the premium over a period of several months (if not significantly longer). Also, the collateral arrangements now being offered by insurers can mean that discussions focus on agreeing the investment strategy in the collateral account rather than transferring ownership of assets at a single point in time - again, making an asset transaction easier to achieve.

Longevity protection becomes more popular

Until the recent credit crisis it certainly seemed that market conditions were favouring buyouts. But with longevity protection rising on the agenda, along with large falls in risky assets, a widening of default risks and a reduction in available capital, longevity protection may be coming into the ascendancy.

In assessing the value of longevity risk mitigation, price is clearly key, and inevitably comparison with a buyout premium will be an obvious benchmark. But these are two quite different animals - a buyout requires the plan to surrender its assets to secure a premium, whilst longevity mitigation allows ownership and investment to continue. This key point has been missed by some commentators in dismissing outright any advantages of longevity protection over a buyout. For a sponsor with a sound investment strategy, longevity protection may result in a better value proposition that meets its objectives.

With many of the solutions being offered today, the risk is often simply transformed into a counter-party credit risk. 

While buyouts are the most high profile solutions, pension plans are on a journey to the "end-game", and a commercial sponsor should not necessarily expect the market to direct him to those solutions that best work under his constraints. The market has, however, reached the point where there are some genuinely compelling opportunities to transfer risk, and indeed some other solutions for partial risk transfer, say for pensioners.

Against this background, sponsors should seek to understand the risks that they carry, through modelling and evidence-based longevity studies, examine their business constraints and establish objectives that work within the above constraints. Sponsors must understand the market offerings available, examine the feasibility and impact of any transaction and monitor the ever changing environment.

In summary, risk management can mean reducing, hedging, insuring or pooling the risks - or it can mean transforming one undesired risk into a risk that is more familiar. With many of the solutions being offered today, the risk is often simply transformed into a counter-party credit risk. Here the risk that has been ceded has been replaced with the risk that the provider will simply be unable to meet its promises in the future.

It has been said that life must be lived forwards, but can only be understood backwards. However, for the pensions risk manager, the road ahead cannot be safely navigated with both eyes on the rear-view mirror.

Gordon Fletcher is an associate in Mercer's Financial Strategy Group. Tel 44 161 837 6529; email gordon.fletcher@mercer.com

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