The record longevity swap announced by BT recently uses a structure that will only appeal to the largest pension schemes, say experts. However, elements of the deal might be picked up by others, particularly the idea of schemes taking on the counterparty risk of reinsurers BT's pension fund announced on July 4 a longevity swap equalling the entire volume of transactions last year, but – unusually – there was no bank or insurer as intermediary on the deal. Instead, the BT scheme transacted directly with Prudential Insurance Company of America as reinsurer, setting up a wholly owned insurance vehicle in Guernsey to make doing so possible. "By using a wholly owned insurer, the trustee was able to access capacity in the global insurance and reinsurance market directly and achieve the best value for the scheme," stated the company. BT's decision to cut out the middle man raises the question of whether intermediated longevity swaps will cease to be the norm. But market participants say such an outcome is unlikely, partly because, at £16 billion, the BT deal is incomparably large compared with anything that has come before. However, the role of intermediaries in future might change, they say, with the possibility of pension schemes taking on all or part of the credit risk of the reinsurance market. "This deal will help the market," says Martin Lockwood, head of longevity UK and Ireland life at reinsurer Munich Re, based in London. "It has introduced a new structure and makes large-capacity longevity swaps more normal. It is too early to say what the effect will be for intermediaries, especially given the enormous scale of the transaction." The swap covers the longevity risk on a quarter of total liabilities of the BT Pension scheme, with Prudential as the sole reinsurer. To get around restrictions on reinsurers writing business with non-financial institutions, BT set up a wholly owned captive insurance vehicle in Guernsey (chosen for its low capital requirements, of just £250,000) to transact with the scheme on one side and Prudential on the other. This use of an insurance subsidiary to deal directly with reinsurers was first carried out by Aviva earlier this year. But BT is the first non-insurer to test the approach. By transacting directly with Prudential, the scheme has saved the intermediary's fee, which would usually be between 1% and 1.5% of the transaction value. For a £16 billion deal, that is between £160 million and £240 million. By comparison, the initial costs of setting up the insurance vehicle might reach a few million pounds, according to industry estimates, although ongoing costs must also be taken into account. "The operational costs are fixed," says Martin Bird, head of risk settlement at Aon Hewitt, a London-based consultancy that advised the company on the swap. "You can do all the servicing of the swap if you have the scale and the appetite to do so." A small number of larger schemes are enquiring about following a similar approach, he says. However, like many market participants, he is conservative about the number of schemes that will follow suit. "You can count on one hand the number of schemes likely to repeat the same structure," he says. The reason is that potential savings for smaller schemes are much lower, because the costs for establishing an insurance vehicle, and the administration expenses for managing the swap, are fixed regardless of the size of a deal. Most market participants see the appeal diminishing for schemes below £5 billion. For schemes under £1 billion it would probably be cheaper to work through an intermediary, they say. The BT approach also brings a degree of administrative responsibility that some schemes might be reluctant to take on. Longevity swaps are typically collateralised to protect both parties from the possibility of the other defaulting, keeping in mind that this is a transaction that could last 30–40 years. (BT says the arrangement in place covers pensioners until death.) Parties to a deal usually post collateral monthly, calculated based on a forward projection of cashflows. Also the prospect of transacting through an unregulated entity outside their home jurisdiction (even if a wholly owned captive) will discourage many trustees, according to lawyers. In the UK, for example, the Financial Services Compensation Scheme (FSCS) might protect UK pension schemes against the insolvency of an EU insurer. While collateral arrangements provide similar protection, some trustees might be wary of giving up access to the FSCS by transacting through an offshore vehicle, explains Noleen John, a consultant at law firm Norton Rose Fulbright in London. "Collateral arrangements for this type of transaction can be complicated and costly, which might make such transactions more attractive to larger or more sophisticated schemes," she adds. However,market participants do expect the BT swap to influence future deals by focusing attention on the cost of individual elements of what intermediaries offer. These services typically comprise the administration of the swap, broking services (bringing together the parties to the transaction) and providing credit risk protection against the reinsurance counterparty. The BT deal shows that if a scheme is willing to carry the counterparty risk of a reinsurer or group of reinsurers, they can dispense with the credit risk part of the intermediary's offering, explains Aon Hewitt's Bird. It could also lead to deals with the credit risk shared between the pension scheme and an intermediary, he says. Ian Aley, a London-based senior consultant at Towers Watson, who advised on the BT scheme, says pass-through structures of this type could prove attractive to intermediaries. "This can work nicely for intermediaries if they have credit line limitations to reinsurers and wish to pass credit risk back to the pension fund," he says. "It means the volumes of longevity business the intermediaries can write can be significantly increased." It is understood that some intermediaries are exploring what they can offer in terms of a pass-through approach themselves. For pension schemes, the positive news is that the menu of options available to lay off their longevity risk has increased, while for the market as a whole, high-profile deals such as BT's will encourage activity. "The BT Pension Scheme transaction provides a clear and proven path for the largest defined benefit pension plans in the world to manage longevity risk," says Amy Kessler, vice president and head of Longevity Reinsurance for Prudential Retirement. "This structure can be replicated by large pension funds in the UK, US, Canada and the Netherlands." Says Aley: "The BT deal could point to more of the same type of deals on a big scale, or to transactions for schemes on a smaller scale using off-the-shelf structures. That is now a live option. It has been proved that it can work." ...
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