Executives split over possible pension risk transfer crunch

A growing number of large pension risk transfer deals in the U.K. and U.S., coupled with an anticipated influx of deals across both markets, have left industry executives split over the potential for a capacity crunch.

Some market participants are worried the reinsurance market, which ultimately takes on the majority of liabilities taken off plan sponsors' balance sheets through buyouts, buy-ins or longevity swaps, will struggle to cope with demand for an increasing number of transactions.

“Last year's buy-in and buyout business volumes (in the U.K.) were around £8 billion ($13.5 billion),” said Jay Shah, London-based co-head of origination at Pension Insurance Corp. Ltd. “That represents about 0.5% of the total £1.5 trillion of final-salary (pension) liabilities in the U.K. private sector. It wouldn't take a lot — if that became 1% or 5% — before we start to see capacity constraints coming into play,” he said, because insurance companies writing the business have to hold solvency capital against the transferred risk.

The concern is that capital and other resources, such as executives with the right expertise, at the longevity reinsurers, will not be sufficient to cope with this increased demand.

With £70 billion and counting of longevity risk transferred by U.K. pension plans since 2008 — including a record deal by London-based Aviva PLC in March to transfer £5 billion of risk to three reinsurers — “a supply-and-demand tipping point is expected to be coming soon,” said Suthan Rajagopalan, London-based principal, financial strategy group at Mercer Ltd. “What happens when the longevity reinsurance market hits capacity? Prices may well go up.”

Reinsurance firms are also concerned. “Reinsurers have large mortality books, which to date have provided capacity,” said Martin Lockwood, London-based head of longevity at reinsurance company Munich Re — one of the reinsurers in the Aviva deal in March. “But as there is over £1 trillion in the U.K. of defined benefit liabilities, (and) a further trillion in Canada and Holland, it is likely capacity will become an issue. Additionally, we are seeing increased demand/interest from insurers in several jurisdictions. We would imagine the introduction of Solvency 2 (capital requirements rules) will only further increase this.”

However, other executives working in the risk transfer market disagree. Matt Wilmington, partner at Aon Hewitt in London, thinks the volume of transferred assets is merely “a drop in the ocean relative to available capacity. There is a lot of capacity in the market. The global reinsurance market is now happy to take on billions of liability at a time for these deals.”

The bigger deals that have taken place across the globe are proof that capacity is not an issue, said Amy Kessler, Woodbridge, N.J.-based senior vice president and head of longevity reinsurance in Prudential Financial Inc.'s retirement business. “A lot of things have changed in the last two or three years — after General Motors Co. (which transferred $26 billion of pension obligations to Prudential in 2012) and Verizon Communications Inc. (which transferred $7.5 billion of pension obligations to Prudential in 2012) in the U.S., it became evident to the U.K. market participants that the global reinsurance community had more capacity to reinsure the transactions in the U.K than people thought,” she said.

Progressively larger deals in the U.K., she said — citing Aviva's £5 billion deal and London-based ICI Pension Fund's £3.6 billion transaction with Legal & General PLC and Prudential Retirement Income Ltd. — show “there is not a meaningful constraint at this point.” And any threat of constraint is likely to ease given that “companies from places as far as Southeast Asia are beginning to think about putting their capacity into the mix for longevity insurance in the U.K.,” she said, and that changes in U.K. financial rules should encourage new entrants.

The reinsurers take on longevity risk to offset the mortality or catastrophe risk that they underwrite in everyday in their core business. “But each time they take on more longevity business, the offset diminishes,” said Mr. Rajagopalan. “They will come to a point where capital benefits of more longevity risk are reduced, and taking further longevity risk will require additional capital from shareholders to continue to underwrite business.”

The constraints also will hit on the human capital side. “I think a more natural limiter of buy-in and buyout (transactions) is resources at the insurance companies and advisers,” said Emma Watkins, partner at Lane Clark & Peacock LLP in London. “These are very specialist transactions.”

“There has been a general year-on-year increase in derisking transactions since the 2008 crisis (in the U.K.), a period where most pension schemes' funding positions deteriorated significantly,” said Pension Insurance Corp.'s Mr. Shah. “Despite the recession, schemes and sponsors have (gone down the risk transfer route), very often writing a check to ensure (those deals) can happen. We are aware of a number of other very significant potential transactions (in the U.K.).”

Prudential Financial expects to see an increase in transactions in the U.S., too. A recent survey found 35% of closed U.S. defined benefit plans are actively considering derisking or very likely to derisk this year by transferring risk to a third-party insurer. Of plans with less than $1 billion of assets, 31% are looking at the risk-transfer route; and among private plans that are still open, 27% are considering, or very likely to consider a risk-transfer.

One U.S.-based executive at a life insurer who asked not to be named said: “We tend to be bullish (on the U.S. market for risk transfer). This is driven by a combination of an expectation of increasing interest rates, which will reduce liabilities and so reduce the cost to (do a) buyout and recent equity market recovery, with rising asset value having a positive effect on funding levels,” he said. “Sponsors with previously high deficits will likely jump at the chance to take risk off the table as attractive market conditions bridge some of the gap that sponsors would otherwise have to make up by writing a large check.”

New mortality tables in the U.S. are set to make buy-ins and buyouts more of a focus, making buyout pricing “appear more attractive relative to the pension plan liabilities” on their balance sheets, he said.

“In 2013, schemes completing risk transfer in the U.S. (totaled) about $3.2 billion,” he said. While that's “nowhere near 2012 numbers,” he said that by discounting the General Motors and Verizon deals, 2013 actually was the best year in terms of sales since 2008. “We see a pipeline of very large transactions in the U.S.”

Ms. Kessler at Prudential Financial agreed, seeing longevity swaps as a part of that future. “There has never been a longevity insurance deal in the U.S. and Canada, but we believe that this time, with new longevity expectations and greater appreciation (of the longevity risk) that longevity-only transactions will happen in both markets.”