Pension Funds: Longevity Risk Hedging – Financial Services

The mass annuity market

The recent rise in interest rates has led to a huge increase in the funding levels of many UK Defined Benefit Pension Schemes (DB Schemes). Now in surplus, many DB Schemes are considering a bulk annuity transaction or ‘buy-in’. As a result, the mass annuity market is booming. According to a new forecast published by Ian Smith and Josephine Cumbo in Financial TimesUK businesses are expected to transfer a record £60bn of pension bonds to insurers this year. Willis also forecasts longevity swaps of £20bn in 2024. Guernsey has played a significant role in this area over the last 12 years and is well placed to benefit from the current ‘turbocharged’ market.

Longevity exchanges

The 18 longevity swaps that have taken place in Guernsey to date follow a similar structure. The pension scheme sets up a special purpose vehicle insurance company (SPV) licensed in Guernsey. The SPV insures the longevity of the DB scheme to its members and then secures those liabilities with the reinsurer. The SPV retains no net risk.

Each of the counterparties in the transaction is exposed to the credit risk of each of the others. If the reinsurer becomes insolvent, the claims against the incorporated cell may not be paid and the incorporated cell in turn will not be able to pay the DB scheme. This risk is particularly important due to the long duration of the transaction. It may take decades before the liabilities of the DB system are fully exhausted. To avoid this, long-lived transactions always include extensive security and collateral agreements.

Incorporated cells

Incorporated cells have been used in all longevity transactions structured through Guernsey to date.

An incorporated cell is a company with its own charter and articles of association, its own registration number and its own board of directors. Each incorporated cell is associated with a specific incorporated cell company. One of the directors of each registered cell must also be a director of the registered cell company. In addition, the registered office of the registered cell must be the same as the registered office of the registered cell company and the registered cell is responsible for the various administrative acts of each of its incorporated cells. More information about incorporated cells and incorporated cell companies can be found here.

Forming an incorporated company is a cost-effective way of establishing a group of specialty insurers (similar to a corporate group comprising non-cellular companies). Once a pension fund establishes an incorporated cell company and an incorporated cell to complete its first longevity risk transaction, it can easily add additional incorporated cells later to enter into further transactions.

Incorporated cells may be transferred between incorporated cell companies, converted to separate non-cellular companies, or migrated to other jurisdictions. This means that the structure can be changed in the future if necessary. This is important because, as mentioned above, a transaction can take a very long time, perhaps more than 60 years.

Regulatory mode

Insurers in Guernsey are regulated by the Insurance (Bailiwick of Guernsey) Act 2002, which requires all insurers, including those structured as SPVs, to obtain and maintain a license from the Guernsey Financial Services Commission. Licensed insurers are subject to statutory capital and solvency requirements. These include a formula-based minimum capital requirement and a risk-based regulatory capital requirement.

However, an incorporated cell used in a longevity risk transfer transaction may qualify as a special purpose unit for regulatory purposes (known as a “category 6 insurer”). This is because its underwriting risk and counterparty credit risk are effectively eliminated (in the case of its underwriting risk) by back-to-back collateral with the life insurer and (in the case of its counterparty credit risk) by collateral and collateral. the aforementioned arrangements.

The classification as a special purpose unit means that the incorporated cell does not have to meet either the Minimum Capital Requirement or the Prescribed Capital Requirement. They also do not need to create their own capital solvency calculation (OSCA). The OSCA concept is similar to the UK’s Individual Capital Assessment for insurers.

The Guernsey Financial Services Commission will also waive certain other requirements that would otherwise apply to an incorporated cell: in particular the requirement to appoint an actuary to prepare the annual report; the requirement to maintain a minimum capital of £250,000; and the requirement to hold assets representing 90% of the policyholders’ liabilities in trust in Guernsey.

Find out more about insurance regulation in Guernsey here.

Manage

Instead of employing staff to manage the incorporated cell, the shareholder(s) usually appoints a non-executive board supported by a locally licensed insurance manager. The insurance manager provides administrative services and insurance technical support. It also provides the headquarters address and acts as the general representative of the incorporated cell.

Board meetings are held in Guernsey and the majority of directors are Guernsey residents to ensure that the mind, management and control of the incorporated cell remains in Guernsey at all times.

ICC device

Several Guernsey insurance managers have established their own registered companies to facilitate longevity risk transfer transactions for their clients.

These managers can offer pension funds an incorporated cell in an already prepared incorporated cell company. These cell companies may have incorporated cells owned by different pension funds, each of which is established to operate a single longevity risk transfer transaction. This structure can be cost-effective for pension trustees considering one-off or smaller transactions; and who therefore do not wish to establish their own company registered in the commercial register.

Impact substance

In early 2019, the Economic and Financial Affairs Council of the European Union (ECOFIN) reaffirmed that Guernsey is a cooperating jurisdiction with regard to good tax administration. The ECOFIN Council has confirmed that Guernsey not only meets international standards of tax transparency, principles of fair taxation and is committed to combating base erosion and profit shifting, but that Guernsey’s tax regime ensures that profits earned by Guernsey companies are commensurate with the true economic nature of the island.

The implementation of the Guernsey tax basis requirements has not had a material impact on the operating models of the vast majority of insurers in Guernsey. This is because:

  • local regulatory requirements and the expectations of the Guernsey Financial Services Commission have always required insurance companies to be managed from Guernsey;

  • most Guernsey insurers write non-Guernsey risks and therefore have always had to be careful not to do business outside Guernsey; and

  • the boards of directors of most Guernsey insurers have a majority of directors resident in Guernsey.

As a result, the new requirements have not significantly affected the way long-lived transactions are documented or conducted.

Recent transactions

Carey Olsen has extensive experience advising on longevity risk transfer transactions. We negotiated the first such transaction relating to BT’s pension scheme in 2014 and have advised on every other Guernsey transaction completed since then, as detailed below.

  • BT (2014) – £16 billion

  • Merchant Navy Officers (2015) – £1.5 billion

  • British Airways (2017) – £1.6 billion

  • Marsh & McLennan UK (2017) – £3.4 billion

  • EU Industrial Conglomerate (2018) – £2.3 billion

  • Willis (2020) – £1 billion

  • Financial services company A (2020) – over £2 billion

  • Financial services company B (2020) – over £2 billion

  • International Industrial (2021) – over £3 billion

  • Financial services firm (2021) – over £3 billion

  • Financial services firm (2022) – over £3 billion

  • Communications services firm (2023) – over £5 billion

  • Marsh & McLennan (2023) – £2 billion

The latest transaction was the first longevity swap that included active members. The liabilities of the MMC UK Pension Fund were insured by registered cell Fission Gamma IC Limited and underwritten by leading global reinsurer Munich Re. The pension fund was advised by Mercer, a wholly owned subsidiary of Marsh McLennan. This transaction is the third long-dated swap structured through Mercer ICC.

Future development

Given its strong foundations as an international insurance centre, Guernsey is well placed to assist in funded reinsurance transactions. Funded hedging is a form of collateralized quota share hedging agreement that transfers some or all of the asset and liability risks associated with an annuity portfolio from the pooled annuity provider to a third party. Guernsey’s heritage as a jurisdiction for licensed insurers is prudent, but proportional regulation and its proximity to the UK make it an ideal location for such transactions.

The content of this article is intended to provide a general guide to the issue. Professional advice should be sought regarding your particular situation.

Leave a Comment