Why longevity swaps and LDI are losing out in current market conditions

Each has their own legal and commercial complexities but current market conditions pose particular challenges to longevity risk transfers and LDI mandates.

To date, longevity risk transfer transactions have involved pension schemes transacting with either a bank under a derivative contract or an insurance company under an insurance contract.

The bank or insurer usually then passed all or part of its risk to a reinsurer. The role of the bank or insurer was essentially that of an intermediary between the pension scheme and the reinsurance market.

In return for structuring the transaction and administering the contract, the intermediary extracted a fee. Recent years have seen a decline in the number of intermediaries willing to enter into longevity risk transfer transactions, while at the same time reinsurance capacity has increased.

The challenge for investment consultants is to find a structural solution which allows pension schemes to access the reinsurance market directly. This has led people to look at using captive insurance companies as potential intermediaries. 

The DIY approach

A captive insurer is an insurance company owned by the person who is buying insurance. For longevity risk transfer transactions this would mean using a captive insurer as the intermediary, which is either owned by the pension scheme or the sponsoring employer.

The commercial rationale behind this structure is that the fees which would otherwise go to a third-party intermediary could be saved – but note that the captive insurance structure will come at a cost as well – and pension schemes could access the reinsurance market directly.

Using a captive insurer intermediary requires a pension scheme and its advisers to consider a number of questions.

For example, if the captive insurer is to be part of the sponsor group, how does this affect the credit exposure of the scheme to the sponsor?

If the captive insurer is to be part of the pension scheme, the following questions should be asked:

• How can this be achieved within the existing pension scheme set-up?

• What additional liabilities will the trustees of the pension scheme face as a result?

• In the absence of the third-party intermediary, who will be administering the longevity risk transfer transaction?

• How will the reinsurance market react to this proposed new structure?

A number of the transactions completed earlier this year used insurance companies within the sponsor group.

However, we are yet to see a longevity risk transfer transaction which manages the transfer between the scheme and the reinsurance market solely at the pension scheme level.

Regulatory pressure

Typically, LDI portfolios use a combination of physical assets and derivatives to manage interest rate and inflation risk.

As the European Market Infrastructure Regulation moves to the next implementation phase, which ultimately will require pension schemes to clear certain derivatives and collateralise all non-cleared derivatives, pension schemes need to consider the impact this will have on their LDI portfolios. Two areas stand out. First, collateral management. All derivative positions will have to be collateralised.

Cleared derivatives will be subject to the collateral rules imposed by the clearing house. Non-cleared derivatives will be subject to the collateral rules agreed with the relevant counterparty, but subject to satisfying the Emir requirements on eligibility and concentration limits. Having ready access to appropriate collateral will need to be managed.

Returns on the LDI portfolio could be negatively affected where large cash collateral holdings become necessary. Schemes need to understand and stress-test their collateral requirements if the market moves against them.   

Second, the collateral rules will apply across the market and will be binding on – among others – banks and insurance companies.

Pension schemes need to consider whether a general demand for certain types of assets for use as collateral such as gilts could affect the return on the LDI portfolio.      

Sebastian Reger is an associate director at law firm Sackers