Longevity Risk Transfer Transactions - PowerPoint Presentation

1. Longevity Risk Transfer Transactions – a legal and regulatory perspective Parallel Session IIIKirsty Maclean | Nicholas Bugler Longevity 14Amsterdam21 September 2018

2. Agenda Session 1: Origination and structuring of longevity risk transfer transactions, including collateralisation Session 2: A typical longevity-only (re)insurance transaction – converting the deal into a contract; key terms and protectionsSession 3: The UK's regulatory landscape, including solvency capital requirements and risk margin relief in a post-Brexit world2

3. Session 1Origination and structuring of longevity risk transfer transactions, including collateralisation3

4. Longevity Risk Origination In Society4Defined benefit pension funds sponsored by private companiesDefined benefit pensions sponsored by governmentsDefined contribution pension schemesMembers live longer than expected and exhaust pension fund assetsLongevity risk borne by shareholdersAdditional funds must be deployed by the companyRetirees live longer than expectedAdditional funds must be deployed by the governmentLongevity risk borne by taxpayersIndividual purchases annuity with assetsIndividual funds retirement through investment income and asset salesLongevity risk borne by insurerLongevity risk borne by individualIndividual accumulates retirement assetsPension schemes avoid passing the risk to the corporate / shareholders by purchasing insuranceInsurers hold the risk from their own annuity portfolios or take on the risk by insuring pension schemesInsurers insure the risk with other insurers (reinsurers)(Re)insurers can further transfer the risk to capital markets investors

5. Pension scheme de-risking – the solutionsPension scheme trustees are continuously looking at strategies to de-risk inflation, investment and longevity riskVarious options available, depending on:how prepared the scheme is to transact (i.e. how accurate the member data is)insurer pricing / interest rate environment overall de-risking strategy Options: Liability Driven Investment (LDI) Insurance“Longevity-only” insurance/reinsurance Bulk AnnuitiesInsurance Buy-InInsurance Buy-OutUltimate goal is “self-sufficiency” or scheme winding-up, which can ultimately be achieved through a number of partial buy-outs and following which there is a statutory discharge for the sponsor (no ongoing liability for shortfall)5

6. Evolution of the longevity risk transfer marketBuy-ins Traditional: Cadbury, MNOPFPhased / Umbrella buy-ins: ICI Pension Fund, M&S Pension Scheme Buy-outsEMI, BHS, Lehman BrothersBack-book annuity reinsurance / legal finality solutions (Part VII transfers)Sale of Prudential’s UK annuity business to Rothesay LifeSale of Aegon’s UK annuity business to Rothesay Life and Legal & GeneralLongevity derivativesInsurers: Norwich Union, Aegon, Delta Lloyd, NN GroupPension Schemes: Babcock International, Pall (UK) Pension FundLongevity-only insurance and reinsuranceScottish & Newcastle Pension Plan / Friends Life / Swiss RePension Insurance Corporation / Prudential Insurance Company of AmericaLegal & General / Prudential Insurance Company of America6

7. Evolution of the longevity risk transfer marketLongevity-only “disintermediation”Aviva Staff Pension Scheme & RAC (2003) Pension Scheme accessed reinsurance capacity using insurer in the Sponsoring Employer’s groupScottish Hydro-Electric Pension Scheme / Legal & General through to reinsurance market using a pass-through structureCaptive/offshore intermediationBT Pension Scheme / Prudential Insurance Company of AmericaMMC UK Pension Fund / Prudential Insurance Company of America & Canada Life ReLongevity plus market risk transfer transactionsLV= / Reinsurance Group of AmericaLongevity plus market risk funded by third party investorsAegon USA / Athene Life Re (Highland Re) Smaller pension scheme “streamlined” solutions Zurich Insurance/Skanska Pension FundZurich Insurance/Pirelli Pension Plan7

8. Insurance buy-in8MembersSchemeInsurerBulk annuity insurance policy issued to TrusteesScheme continues to pay MembersAn insurance contract that transfers investment and longevity risk (and sometimes inflation risk) to an insurerThe insurer agrees to pay agreed benefits in exchange for an up-front premiumcash or securitiesin-specie transferThe insurance policy becomes an “asset” of the schemeTrustees remain liable to the membersInsurer pays the scheme who pays the membersTrustee continues to be responsible for administration (however in some cases this may also be transferred to the insurer)Given the premium transfer, the insurer’s credit strength is a major factor for the trusteesTypical to see premium deposited with a custodian and a security interest granted to the trustees

9. Insurance buy-out9MembersInsurerIndividual policies issued to individualsIndividual annuity insurance policies purchased by the trustees in the name of the members / the benefit of the policy is transferred to the members directlyTrustees no longer have any future liability with respect to such individual’s benefitsInsurer has direct relationship (including administration) with each member and pays the members/beneficiaries directlyGiven the ultimate de-risking goals of a pension scheme, most buy-in insurance agreement include terms to convert the longevity-only insurance into a buy-out for individuals in the futurePrior to buy-out, members’ benefits are protected by the PPF; after buy-out, the ultimate fall-back for insurer failure is the Financial Services Compensation Scheme (FSCS)

10. 10March 2017April 2017May 2017June 2019July 2019March 2022April 2022May 2022Trustee paymentProduct Provider Payment1001001001001001001001000010010010010000Pensioner dies quicker than expectedPensioner lives longer than expectedNet Payment0000100 by Trustee100 by product provider100 by product provider100 by TrusteeLongevity-only cashflows (simplified)The pensioner example is a 60 year old male. It is agreed upfront, based on the Insurer’s “best estimate”, that the male will survive until March 2022. He has an annuity of £100 a monthFixed leg: This is a proxy for the Insurer’s best estimate. The Scheme locks its premium cashflow in at £100 a month until March 2022Floating leg: While the male is alive, the Insurer will pay the Scheme a £100 a month claim. The fixed and floating legs will net off against each otherIf the male dies before March 2022 then the Insurer ceases paying the floating leg but still receives the fixed leg from the schemeIf the male survives past March 2022, the scheme will no longer be paying the fixed leg but will continue to receive the floating leg (to offset the liability linked to the male living longer than expected) [This example excludes the risk fee]

11. Longevity-only (re)insurance (simplified)11Scheme/Insurer Members/AnnuitantsInsurer/ReinsurerLongevity insurance/reinsurance policyScheme/Insurer continues to pay Member/AnnuitantPension Scheme buyer: insurance product issued by an insurer, constitutes an asset of the scheme; suitable for a pension scheme wanting to retain assets Insurer buyer (annuities or pension risk): reinsurance as a risk mitigation technique, lowering of capital requirementsOnly longevity risk is transferredSometimes referred to as a “longevity swap” but typically structured as insurance/reinsuranceFixed payments, agreed at the outset, paid by the risk protection buyer in exchange for floating payments (actual benefits, simplified) paid by the risk protection seller (payments netted and no up-front premium)Not an indemnity, but similarCounterparty credit risk mitigation key to longevity-only transactions

12. Longevity-only “swap” reinsurance12InsurerReinsurerCharged AccountFixed Premiums and FeesClaimsFloating ChargeReinsurance FeePension SchemeClaimsFloating ChargeUp-front PremiumTitle Transfer (MTE)Title Transfer (MTE)

13. Longevity-only “swap” reinsurance – pass-through / limited recourse13Insurer / CaptiveReinsuranceREINSURANCE AGREEMENTClaimsPension SchemeClaimsINSURANCE AGREEMENTFixed Premiums and FeesFixed Premiums and FeesSecurity Interest (fee)Security Interest (fee)Security Interest (fee)Security Interest (fee)Title Transfer (MTE)Title Transfer (MTE)TripartiteFrameworkAgreement

14. Collateralising a longevity (re)insurance transaction Counterparty credit risk is a key component of any longevity transactionTransactions are expected to be long-term and stay in place until last member/beneficiary dies (sometimes up to 50 years in duration)Transactions only terminate early where something has gone wrong (failure to pay, other breach) and in which case, assuming that life expectancies have increased, an “innocent” cedant expects to be made whole for all future expected payments (i.e. the present value of all future fixed (premium and fee) payments minus the present value of all future floating (claim/benefit) payments).If the (re)insurer is in financial difficulty, how will the scheme be sure that it will be paid on termination?Collateral is therefore used to secure the payment of amounts on terminationTwo-way MTE (Marked to Experience) collateral is posted in favour of a party who is “in the money” Fee collateral (an amount that runs down over the lifetime of the transaction) is posted by the pension scheme/ceding insurerInvestment Guidelines (specifying eligible assets and haircuts) agreed by the parties14

15. Title transfer / pledge and rehypothecation (MTE) 15Scheme/InsurerInsurer/ReinsurerCash or securitiesEquivalent obligation to deliver cash or securities if mark to market moves or transaction terminatesISDA Credit Support Annex (CSA) style “title transfer” mechanics for U.K. parties (adapted and built into English law insurance/reinsurance agreements)UCC Pledge with right of rehypothecation for U.S. parties (standalone agreements, NY law governed)Pros: recipient right to use collateral, unlikely to trip over negative pledge and where title has been transferred no enforcement action is requiredCons: Potential for overcollateralisation exposure for posting party, assets off balance sheet

16. Custody account and security interest (Fee)16Charged AccountScheme/InsurerInsurer/ReinsurerCash or securitiesSecurity InterestPresent value of the future risk fee is typically collateralised by the security provider granting a security interest (fixed charge) over a ring-fenced account of cash and securities held with a custodian (pursuant to a tri-partite arrangement) in favour of the secured partyStructured to constitute a “Security Financial Collateral Arrangement” pursuant to the Financial Collateral Arrangements (No.2) Regulations 2003 (SI 2003/3226) Pros: transferor retains proprietary interest in the charged assetsCons: additional costs and agreements, possibility of recharachterisation of security interest, enforcement action required

17. Transformer (swap and reinsurance)17SwapSwapInsuranceReinsuranceSecuritySecuritySecuritySecurityTitle TransferPension fundBankCell 1Cell 2Reinsurer

18. 18ReinsuranceSwapAccount SecurityInsurerCell companyBankInvestorAccount SecurityTitle TransferTitle TransferInvestorInvestorSwapSwapSwapTransformer (reinsurance and swap out to the capital markets)

19. Q-forward longevity derivative (mortality rates)19Longevity Protection Buyer (Floating Rate Payer)Longevity Protection Seller (Fixed Rate Payer)Q-forwardNotional x Realised Aggregate Mortality RateNotional x Fixed Aggregate Mortality RateQ-forward payoff at maturityFixed (forward mortality rate)Realised MortalityNet Payment to Protection BuyerLower realised mortality results in a payout

20. S-forward longevity derivative (survival rates)20Longevity Protection Buyer (Fixed Rate Payer)Longevity Protection Seller (Floating Rate Payer)S-forwardNotional x Realised Survival RateNotional x Fixed Survival RateS-forward payoff at maturityFixed (forward mortality rate)Realised Survival RateNet Payment to Protection BuyerHigher realised survival results in a payout

21. Longevity plus market risk (split between two reinsurers)21ReinsurerRetrocessionaireCollateral AccountFixed Premiums and FeesClaimsFloating ChargeFee CollateralInsurerClaimsFloating ChargeSingle PremiumTitle Transfer (MTE)Title Transfer (MTE)Transfer of Longevity RiskTransfer of Market and Longevity Risk

22. 22Longevity plus market risk – using a side-car / third party capitalPremium amount will equal excess investment returns plus an agreed spread.Initially funded by the proceeds of the securities issued by the Sidecar.Alternatively, the Sidecar could purchase longevity reinsurance.

23. Session 2A typical longevity-only (re)insurance transaction – converting the deal into a contract; key terms and protections23

24. Setting the Reinsurer’s best estimate assumptions and priceGenderDate of Birth/AgePostcodeSecond LivesBest Estimate: (i) Base Mortality and (ii) Future Improvements Base Mortality refers to the current levels of life expectancyBase / Life tables split by genderQx : the probability that someone aged exactly x will die before reaching age (x+1)Future Improvements refer to the assumption regarding how mortality rates/life expectancy will change in the future Analysis of in-force and historic data so that the reinsurer can assess past experience of members when setting assumptionsReinsurers charge a “risk fee” to cover the uncertainty in longevity expectations The level of the risk fee charged by reinsurer is a function of a number of drivers, e.g.:the amount of capital that an insurer/reinsurer allocates to absorb adverse fluctuations in their best estimate assumptions over timecompetitive pressure in the marketthe nature of the pension scheme (duration of liabilities, uncertainties in the scheme’s data, complexity of coverage and benefits)Pricing the transaction 24

25. Nature of the risk transferNotional (versus actual liability)Contingency insurance Defining the scope of the reinsurer’s liabilityIndividuals covered by the reinsurance?Retired members / deferred membersFinancial Dependants Spouses and Civil PartnershipsPre-Inception deathsCashflows projected / modelled using the pension scheme dataHow are the premiums and claims defined?What benefits are being reinsured?Benefits model; pre-agreed simplified benefit specification, recorded in the AgreementHas the reinsurer priced for changes to the benefits during the course of the transaction?pension increase exchange exerciselump sum / trivial commutation paymentspension sharing orders / divorce settlementsfuture indexation changesEx gratia payments excluded from reinsured liabilities Defining the scope of the reinsured liabilities 25

26. Existence CheckingFundamental to the Reinsurer – only pay floating leg until actual date of death of member or contingent beneficiaryElectronic Tracing (e.g. Lexis Nexis)Certificate of Existence Suspensions and Reinstatement of benefitsSanctionsHM Treasury’s Consolidated List of Financial Sanctions TargetsUnited States Office of Foreign Assets Control (OFAC)Treatment of suspended individuals on terminationAdministrationAdministers in accordance with prudent insurer practice without the benefit of the reinsuranceSkin in the game – is the insurer being asked to retain a percentage of the risk unreinsured?Reinsurer audit rightsAccess to scheme data Remedies for failures by the insured with respect to existence checking and administrationRemedial actionEconomic sanctionsTermination Administration – ensuring accuracy of reinsured liabilities26

27. Data accuracy27Accuracy of the dataDay 1 Policy FileUpdating the Policy File from time to time Cashflow Adjustments – time lag / interestWhat terms apply to updating the Policy File and correcting errors identified in the Day 1 Policy File?Remedies for Data ErrorsImpact of data errors on the Reinsurer’s best estimate mortality basis and risk fee – adjusting the Reinsurer’s priceTransparencyResolution of disputesDuty of disclosure and warranty protectionWhat information is being warranted?Contractual damages claimCompared against other “good faith” insurance contractsMarine Insurance Act 1906 – no right of rescission Remedies – limited to those set out in the agreementInsurance Act 2015 – contracting out

28. Mortality Basis Review 28Ensuring that, on termination, party “in the money” is secured and collateral is accurate“Mortality Basis Review” / “MBR” processCan be called from time to time when a party believes there has been a change in underlying longevity assumptions that would impact cashflows (over an agreed threshold)Must be justified by a party (typically subject to determination by an independent expert) using:Mortality experience of the members of the schemeOther credible information relating to other similar schemes or socio-economic mixAnticipated future trends in experience, based on opinions from life insurance industry, medical professionals etc.

29. Termination 29Termination – complex matrix, particularly in multi-party transactions Cedant Fault: 100% of the risk feeFailure to pay/postMaterial breach of covenant (including administration and existence checking terms)Insolvency / PPF EventReinsurer Fault: 0% of the risk feeFailure to pay/postMaterial breach of covenant Neutral: 50% of the risk fee / agreed step-up to [x]% of the risk feeForce Majeure; Change in Law; Tax Event where a party took reasonable steps to mitigate event giving rise to such circumstancesCould in some scenarios flip into a fault-based termination Always include appropriate cure-periods to avoid hair triggers Termination ProcessesProvisional versus final termination payments

30. Moving from longevity-only to buy-in or buy-out (Restructuring)30Trustees may see longevity-only as a de-risking tool along the path to full buy-out of liabilitiesTerms to permit a conversion to an insurance buy-in / issuance of individual policies (buy-out)Complicated contractual restructuring arrangements to be negotiated Vague parameters for future negotiations versus locking down the terms?

31. Session 3The UK's regulatory landscape, including solvency capital requirements and risk margin relief in a post-Brexit world31

32. Solvency II and the Risk MarginSolvency II has applied to UK insurers since January 2016Risk margin seen as too high in low interest rate environmentProblem especially acute for insurers holding large amounts of longevity (non-hedgeable)riskPRA reviewing calculation of risk margin, no decisions made in light of Brexit uncertainty32

33. How does reinsurance help?SCR is lower if credit is given for reinsurance – less capital must be heldReinsurance also lowers the risk margin as SCR of the “reference undertaking” includes reinsurance if it satisfies relevant criteriaCoC = Cost of Capital∑ = all integers including 0SCR(t) = SCR of the “reference undertaking” after t yearsr(t+1) = basic risk-free interest rate for a maturity of t + 1 yearsHowever, counterparty credit risk is introduced – mitigated to some extent by collateral 33

34. The UK regulators’ perspectivePRA has expressed concern around potential risks of longevity risk transfers, especially more complex arrangementsParticular concern is concentrated counterparty credit risk – may not be sufficiently mitigated by holding extra capital under SCRExpects firms to notify the PRA well in advance of completion of any risk transfer/hedging arrangements and to satisfy PRA of their approach to risk managementIn particular boards should:Understand risk transfer and ensure effective transfer of riskEnsure economic impact is adequately reflected, including appropriate SCR impactUnderstand wider risks (e.g. counterparty credit risk, including concentration risk)34“We therefore look to Boards to monitor, manage and mitigate these risks with a critical, searching perspective and with a particular focus on collateral arrangements.”

35. UK/EU Withdrawal Agreement, which governs the terms of the UK’s exit, is c. 80% agreed (as of August 2018)Future Framework Agreement, which governs the ongoing relationship between the UK and the EU, is still under discussionChequers White Paper set up Government’s positionNo continuing freedom of servicesNo passportingMutual recognition of rules, but ability to diverge if desiredUK would want to remain equivalent, so divergence only likely if no impact on equivalenceNo deal on financial services?Brexit – status of negotiations35

36. Brexit – effect on the marketAssumption is that UK will want to be equivalent for Solvency II purposes (and that EU will want Solvency II to be equivalent for UK purposes)Equivalence guaranteed on Day 1 – UK rules will match Solvency IIHow fundamental is the risk margin to equivalence?PRA has indicated desire to look at the risk margin again post-BrexitBermuda and Switzerland both have some form of risk marginFinding other methods of calculating level of additional capital to reflect risk, without same sensitivity to interest rates, should be achievableWhat will happen to the market if the risk margin’s sensitivity is reduced?Possible decrease in activity – risk margin is a big driver for longevity reinsuranceHowever, there are other drivers – expansion of capacity, removing risk from the balance sheet36