Life Expectancy - What's the Big Deal?
The Prudential Regulation Authority (PRA) has updated its guidance for insurers participating in longevity risk transfers (PS1/20 and SS18/16), clarifying the risks that should be considered and its expectations of pre-notification for transactions that are large and/or complex.
Longevity risk is the risk that policyholders or pension scheme members, in the aggregate, live longer than expected. Insurers can be particularly exposed to longevity risk when they insure books of annuity business or pay out claims subject to periodic payment orders (e.g. in catastrophic personal injury cases). Defined benefit pension schemes can also be exposed. The longer the policyholder lives, the more the insurer or pension scheme must pay out, leading to unprofitable business for insurers and shrinking funds for pension schemes. The risk is increased by growing life expectancy trends and more people reaching retirement age.
What are longevity risk transfers?
Insurers and pension schemes can mitigate longevity risk through various types of transactions, backed by insurance or capital markets. A growing market has developed with a flow of pensions liabilities and annuities being insured and reinsured.
- Longevity risk (re)insurance contracts – an insurer of annuities or a pension scheme operator will (re)insure its liabilities to policyholders / members under a reinsurance contract. Insurers of annuities can go on to achieve legal finality with a transfer of the assets pursuant to a Part VII transfer (as illustrated by the transfer of £6.4bn of annuity policies from Aegon to Rothesay Life).
- By reinsuring longevity, an insurer can reduce the amount of capital it must hold pursuant to its Solvency Capital Requirement (SCR) under Solvency II. Life insurers are often recipients of annuity reinsurance business as a diversification technique; its own portfolio of life policies is typically sensitive to longevity risk in the opposing way
- Longevity risk swap – similar to the above but structured as a derivative backed by an investment bank.
- Buy-ins – the pension scheme purchases an insurance contract as an asset of the pension plan, whereby the insurer agrees to pay benefits to the pension scheme in exchange for an up-front premium. The pension scheme remains liable to its members for payment and administration.
- Buy-outs – a finality solution for de-risking a pension scheme. The pension scheme purchases an insurance contract on behalf of its members, with the effect that the pension scheme no longer has any future liability to the members. The insurer has a direct relationship with the members and pays them directly.
What are the risks?
The PRA expects insurers accepting risk and transferring risk to understand the risk transfer taking place and to ensure that the economic impact is adequately reflected in business planning and capital setting. Insurers must have a clear articulation of their exposure and tolerance of risks arising from longevity risk transfers within a clearly defined risk appetite.
An insurer accepting risk from, transferring risk to, or hedging risk with, a single or small number of counterparties (or connected counterparties) may expose itself to possibly significant levels of risk that a counterparty defaults on its credit obligations.
The PRA expects firms to manage and mitigate this counterparty credit default risk under Solvency II. Firms must have an effective risk management system which should cover risks which are covered by the SCR as well as those which are not, or not fully, included in the calculation of the SCR. Holding capital under the SCR in relation to counterparty default risk may not be sufficient in and of itself to mitigate the risk, and firms should consider other measures.
Basis risk is the residual risk that can arise where an insurer transfers or receives longevity risk using an index-based transfer structure (for example based on a population mortality rates index). As the reference population of the index is not identical to the population of the pension scheme or annuity portfolio subject to the hedge, there is a risk that the cash flows from the hedge will not match the liabilities of the scheme or portfolio. The PRA requires insurers to understand the risk associated with this imperfect hedging as part of their risk management frameworks.
What are the PRA notification requirements?
In order to supervise firms' risk management practices, the PRA expects to be notified of new large and/or complex longevity risk transfer and hedge arrangements and the firm's proposed approach to risk management well in advance of the completion of any transaction.
A large and/or complex transaction is one that has:
- a value or financial impact that is larger than typically transacted on a BAU basis;
- a structure more complex than a BAU transaction (examples include where the risk transfer is structured using less tested instruments such as insurance linked securities or automatic reinsurance pools);
- a material incremental impact on the firm's ability to meet its SCR.
The PRA has simplified the pre-notification requirement for all other longevity risk transfers and created a reporting template for firms to complete. Key components of the form, and of interest to the PRA, include whether it is an intra-group transaction, the structure of the transaction, any collateral or funds-withheld elements, and any additional features, for example if it is a precursor to a Part VII Transfer.