Use of Reinsurance in Pension Risk Management

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Use of Reinsurance in Pension Risk Management
Presented By Jean-François Lemay
April 16th, 2007
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Use of Reinsurance

• Overview
• Pension Buy-outs in the UK
• Longevity Bonds
• Use of reinsurance in Canada
• Pricing and asset management from a reinsurers
  perspective

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Pension Buy-outs in the UK

• Changes in regulation and accounting standards
  mean that the deficit of approx. 50 billion on
  500 billion UK pensions liabilities have become
  a serious issue for many companies
• Combining this phenomenon with some high profile
  corporate bankruptcies and restructuring, e.g.
  Marconi, so the UK became a major market
  opportunity both in buying pension liabilities
  and in buying distressed companies with even more
  distressed pension schemes
• Initially, in the UK there are two significant
  players in the bulk annuities/pensions buy-out
  market The Prudential and Legal General.
• We now have many players, some are specialized in
  the area (Paternoster), some are just private
  equity players looking for an asset-intensive
  play (Cerberus).
• UK has a much greater prevalence of payout
  annuities, hence the longevity risk has taken a
  much more prevalent place.

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Pension Buy-outs in the UK
Two main strategies to accomplish buy-out in the
UK using offshore entities ? Life Insurance
Buy-Out ? Shell Company Spin-Off
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Life Insurance Buy-Out
Offshore Reinsurer
Collateral for Counterparty risk
Reinsurance
ABC Life (Rated onshore life insurance Co.)
Insurance Contract
Company/Sponsor
Pension Plan
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Shell Company Spin-Off
Offshore Insurer
Collateral for Counterparty risk
Insurance
Shell company
Pension Plan
Buy-out
Company/Sponsor
Pension Plan
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Pension Buy-outs in the UK

• Under both UK strategies an offshore entity ends
  up with the risk. Offshore entities can offer a
  more competitive price because of lower capital
  costs and taxes.
• Both strategies call for the simple and full
  transfer of liabilities to an insurer/reinsurer
• Reinsurance is an effective way of transferring
  the longevity risk and the investment risk.
• Reinsurance would be tailored exactly to the
  pension plans mortality experience, so no
  volatility would be left on the reinsured lives.
• Reinsurance would reduce volatility of both the
  accounting liabilities and valuation liabilities.
• Reinsurance would eliminate the volatility of the
  portion of the risk reinsured.
• Accounting liabilities are going to be much more
  important with the new rules requiring that
  pension liabilities be shown on the balance sheet
  and not only as a footnote

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Longevity Bonds

• A relatively new twist
• The structure is likely to evolve
• probably all will have different twists
• The European Investment Bank / BNP Longevity bond
  issued in 2004 is a good example
• Payments are linked to a survivor index
• The interest paid is X times the proportion of
  survivors from a group aged 65 at issue
• Survivorship using UK government statistics
• Issuer is the European Investment Bank (AAA
  rated)
• Structurer and manager is BNP Paribas
• Partner Re is the reinsurer

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Longevity Bond
Reinsurer
Reinsurance
Issuer
Issue Price
Floating rate tied to longevity
Bond Holder (Pension Plan)
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Longevity Bonds

• Same net effect a reinsurer gets the mortality
  risk
• The difference is that it is transferred to the
  pension plan through a rated asset
• This fact may make it easier to enter into
• More liquid than pure reinsurance
• However the longevity bond is based on an index,
  not on the actual mortality experience of the
  plans, hence a basis risk left for the pension
  plan
• The plan may not be able to increase surplus /
  reduce deficit even if the price of the longevity
  bond is more attractive than the reserve
  calculation
• This may or may not be a more efficient structure
  from a tax or capital perspective

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Use of Reinsurance in Canada

• Reinsurance in Canada could take a similar form
  to the UK reinsurance structure.
• Assets need to stay in Canada in an
  OSFI-regulated trust in order for the ceding
  insurance company to get reserve relief
• So this is not just for counter-party risk, but
  is mandated for reserve and capital relief
• The reinsurance would likely be done on a funds
  withheld basis, meaning that the initial premium
  is never transferred from the insurer to the
  reinsurer, it is withheld and will appear as a
  payable on the insurers book.
• This would be a more efficient way from a capital
  perspective than putting all the assets in the
  trust. Assets in trust need to be 110 of Stat
  reserves, but you only need 100 of stat reserve
  on funds withheld.

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Use of Reinsurance in Canada
Offshore Reinsurer
Collateral for Reserve Relief
Reinsurance (funds withheld basis)
ABC Life (Rated onshore life insurance Co.)
Insurance Contract
Company/Sponsor
Pension Plan
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Use of Reinsurance in Canada

• The devil is in the details. While the general
  structure for each transaction may be similar,
  there will always be customizations
• What are the provisions if the assets in trusts
  are not sufficient?
• Who manages the business (pay pensions, keep
  records)?
• What are the rules relative to the assets in the
  trust?
• Any Letters of credit?
• What happens if the reinsurer gets downgraded?
• Any rights to recapture the business?
• In short, this is a mini MA exercise

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Use of Reinsurance in Canada

• Not aware of any similar transactions being done
  in Canada
• Currently, the large insurers in Canada are the
  only source of annuities
• But if you have a large plan, you may not be able
  to get a quote for your whole block
• About 1B in annuities done in Canada in a year.
  Some blocks are much larger than that.
• So basically we are at the stage where the UK was
  prior to the entry of the new players and
  offshore reinsurers.

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Use of Reinsurance in Canada

• The costs of doing one of those transactions for
  one of these offshore player is large
• They many not have the life insurance company
  setup yet, so they need to buy/borrow/build one.
• They may not have any mortality expertise in
  Canada so a lot of consulting costs to price
  the deal
• It may be easier for a very large plan to get a
  quote than for a medium-sized plan, since the
  large plan will attract more bidders willing to
  absorb the cost of setting up a structure in
  Canada.

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Pricing Reinsurance

• The cost of reinsurance will be driven mainly by
  the yield available in the markets, mortality,
  taxes and the cost of the capital needed to
  support the business.
• The cost of reinsurance may be different than the
  solvency liability, depending on
• The interest rate used for the calculation of the
  liabilities relative to the current rates
• The assumptions used (mortality being the main
  one) in the calculation of the liabilities vs.
  the best estimate mortality used in the
  reinsurance
• The relationship between the liabilities booked
  and the cost of reinsurance may also change
  depending on which piece of the liabilities is
  reinsured
• Reinsurance may target only the pieces where the
  price is than the liabilities
• There could be other accounting issues, such as
  realization of deferred gains/losses, etc.

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Pricing Reinsurance

• Following is an example of the three main factors
  in the reinsurance price would be estimated be
  the reinsurer
• Mortality
• Return on assets
• Cost of capital

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Pricing Reinsurance

• Mortality
• Experience data would be the first thing a
  reinsurer would look at.
• Only large plans would have credible data, but
  anything would help
• Refinements could be made by looking at the
  occupation, amounts, geographic distribution
• History of the plan will also be important, the
  reinsurer may look at if there was anti-selection
  at any given point in time was there an offer
  of lump sums or any other conversions?
• The reinsurer will have to use mortality
  improvement factors, for example, 1 improvement
  per year from the starting experience.

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Pricing Reinsurance

• Return on assets
• Reinsurer will look at what is the yield on a
  portfolio that he could purchase today that
  matches the liability cash flows
• Will use a set of investment guidelines to have a
  realistic mix of provincial, Canada and corporate
  bonds, as well as a credit quality mix.
• To that yield, the reinsurer will subtract an
  expected default rate, to take credit risk into
  account.
• Some would use an optimizer to generate the
  portfolio used for pricing, and for managing the
  assets.
• Often this net return on asset is converted to a
  spread over treasuries or a spread over the swap
  curve, for example, treasuries 90bps.

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Pricing Reinsurance

• A linear optimizer can be used to make the most
  optimal fixed income portfolio selection
• The optimizer would select from a list of
  available bonds the portfolio that best matches
  the liability portfolio with the highest yield,
  ensuring that
• Mismatch risk, determined through interest rate
  scenario testing is within risk tolerance and
• The portfolio fits all constraints, such as
• Overall credit quality
• Exposure per issuer, per sector, per type, per
  rating (duration-weighted)
• Any other risk metric, such as maximum negative
  cash flows in any given year
• The universe of bonds used as input to the
  optimizer would be price as of the time of the
  optimization, and would include the full
  bid-offer spread.
• The universe would also have been screened by the
  asset manager to eliminate any undesirable names
  and ratings used by the optimizer may be adjusted
  by the asset manager to reflect any view the
  manager has on that particular issue.

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Pricing Reinsurance

• Cost of capital
• Reinsurer will come up with the capital it needs
  to support the business.
• Offshore reinsurers may not have statutory
  capital requirements as such (Bermuda minimum
  capital is 250k!), so reinsurer will calculate
  an economic capital, i.e. an amount set aside
  that is a measure of the risk of the business
• Economic capital will depend on the certainty
  around the assumptions as well as the risk of the
  asset portfolio
• Then a cost of capital is calculated so that the
  reinsurer obtains its target return on capital.
  Often expressed as a reduction in the discount
  rate used, for example 30bps.
• So in our example, if we earn treasuries 90
  bps, and need 30 bps for the cost of capital,
  then the price offered will be discounting the
  liability cash flows (calculated using the
  reinsurers mortality assumption) at the treasury
  curve 60bps.

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Summary

• UK market may be an indicator of what lies ahead
• Reinsurance is a flexible tool and may ultimately
  be the only outlet for large amounts of longevity
  risks
• New accounting rules in the US may speed up
  evolution there