4 Quarter 4 - 2015 Introduction Guernsey’s long-established captive insurance industry is well-known and internationally respected for its fl exibility in providing innovative insurance solutions. In this article we look at the latest development which sees captive insurers providing defi ned benefi t occupational pension schemes with an additional option for managing some of their pension scheme risks. Pension Scheme Risks In recent years trustees of defi ned benefi ts pension schemes have become more aware of their schemes’ exposure to risks, resulting in risk management moving up their agenda. Initially investment risk was seen as the key area to be addressed. As a result there is now a range of strategies available to manage this. Having considered investment risk, many trustees have now turned their attention to longevity risk. On average, pensioners are living for signifi cantly longer than was expected when they fi rst joined the scheme; in addition, while diffi cult to predict accurately, the trend towards further improvements in life expectancy is expected to continue. As more information on trends in life expectancy is analysed and published, actuaries have been recommending the adoption of more prudent mortality assumptions. Without any steps to manage longevity risk, further unanticipated increases in life expectancy coupled with the historically low long-term interest rate environment, could have a material adverse impact on many pension schemes’ fi nances. Managing Longevity Risk Historically trustees have had limited options to manage longevity risk. It has been, and indeed it still is possible to buy annuities from an insurer. This simultaneously removes both longevity and investment risk. However, the problem at present is that this approach involves a high fi nancial outlay, as interest rates are very low. Consequently annuity rates appear correspondingly high by historical standards. In addition, insurers have also been impacted by the introduction of Solvency II which is expected to increase the capital cost of writing annuity business and refl ected in premiums. Captive innovation “a ground-breaking approach” Ian Morris Other Options For larger schemes an alternative to purchasing annuities, as a means of managing longevity risk, is to effect a longevity swap. This is where a pension scheme exchanges its obligation to pay pensions to the pensioners for an unknown period, for an obligation to pay a series of payments over a specifi ed period to the counterparty to the swap. In this way the exposure to future longevity is passed from the pension scheme to the counterparty to the swap. A key advantage of a longevity swap is that the pension scheme is not locked into purchasing annuities at current low interest rates (and the associated cost). Typically the scheme pays an annual fee for the swap so there is little initial fi nancial impact. The pension scheme does of course retain the investment risk, but can continue to manage that risk independently of limiting its exposure to longevity risk. Limitations While the initial outlay associated with a longevity swap is much less than the cost of purchasing annuities, the cost may still appear to be high. The expenses associated with implementing a longevity swap are typically of the order of 1% to 2% of the value of the liabilities swapped; given that the value of longevity swaps can easily run into billions of pounds, the expenses are signifi cant. Often this is justifi ed by the need for the insurer (or other counterparty) to meet solvency requirements. In addition, for large transactions the insurer may need to rely on reinsurer support. While this is generally available, it is arguably ineffi cient to involve more parties than needed. Captive Innovation With assets of around £40 billion and around 300,000 members, the BT Pension Scheme is certainly large enough to take out a longevity swap. However the BT trustees decided to embark on an alternative and ground-breaking new approach, focusing on the concept that a natural and frequently used way to secure cost effective access to the reinsurance market is through a captive. Bandwagon The BWCI Group Newsletter Captive Jargon Buster In July 2014 the BT trustees announced that a captive insurer had been established in Guernsey to facilitate the transfer of longevity risk to a reinsurer. The deal, which covered £16 billion of the scheme’s liabilities, was the largest swap recorded to date. Despite this, it still only represented 25% of the value of the scheme’s liabilities. The BT captive was structured as an incorporated cell company (“ICC”). As the ICC has a cell structure, it is possible to place deals for different entities in independent cells. Such an approach should generate administrative cost savings and effi ciencies for the parties involved. In addition, this structure should give maximum fl exibility in future if further deals are contemplated by the BT Pension Scheme. Amy Kessler the Head of Longevity Risk Transfer at Prudential Retirement described the transaction as “the largest and most innovative in the market”. It is believed to be the largest such transaction globally. Guernsey Leads The Way The BT deal is not unique. It was followed by an announcement in January 2015 by the Merchant Navy Offi cers Pension Fund that they had undertaken a similar transaction for £1.5 billion of liabilities with another ICC established in Guernsey. Other longevity risk management initiatives are also being developed in Guernsey’s captive insurance market. Final Thoughts These latest developments in the captive market demonstrate that Guernsey has emerged as a key location for facilitating longevity swaps for pension schemes looking to access cost effective rates. Guernsey offers appropriate insurance and legal technical expertise, together with specialist structures, such as ICCs, that make it an ideal location. Opinions may differ on the precise fi nancial level at which such a captive insurance solution is appropriate, but the deals done to date illustrate that there is an appetite for such solutions. Captive A captive insurer is an insurance company that is set up to insure all or parts of the risks of its owner. In practice, the owner may represent a group covering linked industrial or commercial companies. Captives may sometimes insure risks that relate to third parties but such business is not strictly “captive” business. Incorporated Cell Company (ICC) An ICC is an incorporated entity which consists of a core and one or more separately incorporated cells. Each incorporated cell (and the core) is an independent legal entity with the ability to contract in its own name. Longevity Risk Longevity risk is the risk that a pension scheme or an insurance company will have to pay out an income stream for a longer period than expected, due to unanticipated increases in life expectancy, leading to more funds than expected being paid out. Reinsurer A reinsurer is a company that provides cover to insurance companies. The reinsurer will usually pay a proportion of the claims incurred by the insurance company in accordance with a contract (referred to a reinsurance treaty). More information If you would like further information on longevity swaps or the insurance solutions available in Guernsey please contact Ian Morris ([email protected]) or Clair Le Poidevin ([email protected]).