use of reinsurance in pension risk management april 16 th, 2007 presented by jean-françois lemay

Use of Reinsurance in Use of Reinsurance in Pension Risk Pension Risk ManagementManagement

April 16April 16thth, 2007, 2007

Presented ByPresented By

Jean-François LemayJean-François Lemay

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Use of ReinsuranceUse of Reinsurance

• Overview

• Pension Buy-outs in the UK

• Longevity Bonds

• Use of reinsurance in Canada

• Pricing and asset management from a reinsurer’s perspective

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Pension Buy-outs in the UKPension 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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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

ABC Life (Rated onshore

life insurance Co.)

Collateral fo

r

Counterparty ris

k

Pension Plan Insurance C

ontract

Reinsurance

Company/Sponsor

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Shell Company Spin-OffShell Company Spin-Off

Offshore Insurer

Collateral fo

r

Counterparty ris

k

Pension Plan Buy-out

Insurance

Company/Sponsor

Pension Plan

Shell company

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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 plan’s 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 BondsLongevity 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 BondLongevity Bond

Bond Holder (Pension Plan)

Issuer

Issue Price

Reinsurer

Reinsura

nce

Floating rate

tied to

longevity

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Longevity BondsLongevity 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 CanadaUse 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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Offshore Reinsurer

ABC Life (Rated onshore

life insurance Co.)

Collateral fo

r

Reserve Relie

f

Pension Plan Insurance C

ontract

Reinsurance

(funds

withheld

basis)

Company/Sponsor

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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 M&A exercise

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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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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 ReinsurancePricing 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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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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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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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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• 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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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 it’s 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 reinsurer’s mortality assumption) at the treasury curve + 60bps.

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SummarySummary

• 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

use of reinsurance in pension risk management april 16 th, 2007 presented by jean-françois lemay

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