Whilst 2023 is not quite in the books just yet, it has been another busy year in the UK pension risk transfer (PRT) market. In October, consulting firm Barnett Waddingham published a blog post suggesting that this year is set to break records in terms of both the number and volume of deals.
Those in the UK licking their lips at the prospect for 2024 bringing ever more deals might want to rein in their excitement, as the regulator is paying close attention.
In mid-November, the Bank of England’s Prudential Regulation Authority (PRA) issued a consultation about the funded reinsurance market, in which it identifies four areas of potential risks posed by the funded reinsurance space; probability of recapture, correlated probability of recapture, loss given recapture, and management actions.
The consultation comes on the heels of a letter published in June which the PRA sent to chief risk officers that explained its preliminary thematic review work on funded reinsurance arrangements, and a speech at a conference in April by Charlotte Gerken, Executive Director for Insurance Supervision, in which she expressed concerns about the exposure to illiquid assets during the buy-in or buy-out journey.
Time will tell what the PRA plans to do to address these risks. But another risk looms much larger over the entire industry – that of overall concentration risk.
“What the PRT insurers are doing – in the UK, the Netherlands, the US – to avoid being overly exposed to longevity risk is that they transfer it to reinsurers using longevity swaps. But all of these insurers are hedging their longevity risk with the same limited number of life reinsurers,” said David Schrager, CFO at Longitude Exchange.
For life reinsurers, a natural hedge exists on their balance sheet – that of mortality risk. The problem is that, as a hedge, it’s not quite as effective as it might appear on the surface, according to Avery Michaelson, CEO at Longitude Exchange.
“When an extreme mortality event, such as Covid, occurs it is almost certain to produce an offsetting move in a reinsurer’s longevity exposures in the form of reduced liabilities. However, in extreme longevity scenarios resulting from broad-based increases in life expectancy, it’s less certain to produce significant gains from a reinsurer’s mortality business as these are typically shorter duration contracts whose pricing can reset to current expectations about mortality.”
The second problem noted by Michaelson is that the scope for this offset is not unlimited.
“The pension risk transfer market is growing at a blistering rate as higher interest rates have accelerated a structural change that’s been underway for over a decade. For those reinsurers that have been writing longevity swaps for that whole period, a good portion of the mortality offset has been used up, and the demand for longevity risk capacity is growing much faster than for mortality.”
Those in the market have known about the bigger picture for more than a decade. Back in 2014, Michaelson, then at Société Générale, co-authored a paper entitled, ‘Strategy for Increasing the Global Capacity for Longevity Risk Transfer: Developing Transactions that Attract Capital Markets Investors,’ that showed that the entire insurance industry – including non-life – held approximately $3.6trn in assets at the time. Similarly, the approximate retirement obligation of OECD countries was between $60-80trn.
Michaelson and Schrager, along with longevity experts Prof Andrew Cairns and Prof David Blake, are spearheading a new organisation, the Index Longevity Market Action Committee (ILMAC). The organisation was formed to promote the use of index-based longevity hedging – enabling greater participation from capital markets investors such as asset managers and sovereign wealth funds as the risk-holder – as an alternative option for pensions and insurers to transfer away longevity risk. In this model, capital markets investors assume the longevity risk over and above a certain level based upon a general-population mortality index. By providing a broad and diversified set of new counterparties, this model would go some way to diluting the concentration risk currently present – and growing – in the market.
The process to involve the capital markets is not without its challenges, which provided part of the impetus for forming ILMAC. The committee is currently working on a case study that calculates the capital relief a Solvency II insurer could take using an index-based longevity hedge, considering factors like basis risk; this is a key part of the requirement to get regulatory approval for this model.
That could take some time. In the short term, the market will be watching the FundedRe consultation, which closes in February, and any changes that the PRA wishes to implement to de-risk the bulk annuity reinsurance market. But in the long term, for Michaelson and ILMAC, the future is inevitable.
“There could be as much as $500bn of longevity risk transfer demand annually, which is nearly the same size as the entire reinsurance industry,” said Michaelson. “It’s not sustainable to move all of the longevity risk globally to just a few balance sheets – this could introduce a ‘too big to fail’ situation that regulators are right to be concerned about. The natural solution is to encourage greater involvement from the capital markets.”