Insight Investment

The ICL Group Pension Plan insured the longevity risk associated with over £3.7bn of liabilities in early 2021, using an Insight Investment platform to provide access to the reinsurance market.

Richard Cooper, who is Senior Partner and Head of Momentum Investment Solutions and Consulting, is the Plan’s CIO. In this interview, he explains the rationale for conducting a longevity hedge, why the Plan opted against a buy-in, and how they worked through the practical details – as well as considering lessons learned from the process.

• The Plan’s investment strategy
• Why did the Trustees consider longevity hedging?
• Why a longevity swap and not a buy-in?
• Pricing assessment
• The intermediation structure
• Was the investment strategy changed?
• Learnings from the process

Can you summarise the investment strategy of the Plan?

The primary objective of the Trustees is to work towards a position of low dependency from the sponsor within the next six to seven years. To maximise the certainty of delivering this objective, the Plan’s journey has so far involved hedging an increasingly high proportion of liability-related interest rate and inflation risks, combined with an increased use of contractual assets to generate the required investment returns.

What incentivised the Trustees to consider longevity hedging?

With the bulk of their interest rate and inflation risks hedged, the natural next step was to consider the hedging of longevity risk. Whilst this was a hedging decision rather than a ‘market-timing’ decision, market appetite for this risk allowed the Trustees to lock down the risk at favourable levels, at least relative to medium-term history.

Why did the Trustees prefer a longevity swap to a buy-in?

Although a buy-in would have achieved the objective of hedging longevity risk, there were a number of factors that led the Trustees to favour a longevity swap:

1. The Trustees are happy with the balance of investment-related risk and reward within their asset portfolio and at this stage don’t feel the need to pass that risk across to an insurer.
   
   
2. The effective yield on the buy-in would have been lower than the expected return on the assets that the Trustees would need to sell in order to pay for it, putting additional pressure on the residual assets managed by the Trustees
   
   
3. A buy-in is more capital intensive given the requirement to pay the premium upfront. Using a buy-in to hedge the same amount of longevity risk as they did via the longevity swap would have required the Plan to set aside around 70% of its assets; the Trustees could have implemented a smaller buy-in, but that would have left them more exposed to the longevity risk that they were trying to hedge.

How did you assess the pricing of the longevity swap, and whether it was well suited to the Trustees’ overall goals?

The main point of reference for the Trustees when assessing the price of the longevity swap was the comparison of the fixed leg cashflows that they would be required to pay under the longevity swap, versus the equivalent cashflows on their existing Technical Provisions (TP) basis.

Allowing for the risk fee that the Plan would have to pay to the reinsurer to remove the longevity risk plus the cost of accessing the reinsurance market, initial expectations were that the fixed leg of the longevity swap would be higher than the TP cashflows.

However, following price negotiation the actual difference was almost negligible, and slightly in our favour. This meant that it was a relatively easy decision for the Trustees, as they were able to hedge a significant proportion of their longevity risk at a slightly lower price than the amount already reserved for within the TP basis.

The Trustees were also mindful of the counterparty risk associated with the transaction. Ultimately, the Trustees were comfortable with the credit rating of their chosen reinsurer, Swiss Re, the fact that the transaction is fully collateralised on a quarterly basis and the termination provisions agreed.

How did you decide on the intermediation structure?

Once we had selected our reinsurer, we considered both onshore and offshore intermediation structures¹. Ultimately, the Trustees opted for an offshore route, using an existing third-party owned Guernsey Incorporated Cell Company (ICC) to set up a new cell that acted as the insurer for the transaction. The Trustees' primary motivations for taking this approach were the fact that it offered more control and lower costs. The Trustees were also reassured that the process of setting up the cell and managing it on an ongoing basis would not represent a significant governance burden.

The offshore route also meant that the Trustees could work closely with their existing risk manager, Insight Investment. Insight had put forward a joint proposition with White Rock, a provider of offshore insurance vehicles, under which White Rock provided the ICC and Insight provided all of the required ongoing services including collateral management and reporting, and played the roles of valuation agent and calculation agent. The Trustees held a preference for working strategically with a single risk management partner as part of its longer-term strategy and having a centralised view of its risk-management requirements.

Having Insight take a central role in the longevity transaction was beneficial for a number of reasons, not least because of the collateral management requirements. Indeed, having a collateral manager who was aware of all aspects of the longevity swap and also the Plan’s broader investment strategy, helped to ensure collateral is able to be managed efficiently across the portfolio and that all decisions made were made with awareness of the wider context.

Were any changes to investment strategy required?

The longevity swap allowed the Plan to hedge a significant proportion of its longevity risk with almost no disruption to its investment strategy. There were two main reasons for this:

1. The nature of a longevity swap itself: unlike a buy in, a longevity swap does not involve any upfront capital to be passed across to the insurer. In this sense a longevity swap can be thought of as an ‘unfunded’ form of hedging.
   
   
2. The excellent work undertaken by both Swiss Re and Insight, alongside the Trustee’s legal and transaction advisers, with respect to the collateralisation process and terms: the most important element in this regard was designing a process that allowed the Plan’s corporate bonds to be posted as collateral. Were this not possible, the Trustees would likely have needed to source either cash or gilts from the LDI collateral pool. This in turn would have meant that we would have needed to sell other higher-returning assets to top up the depleted collateral pool.

However, the Trustees were required to significantly re-structure the way in which their assets were held. Originally, Plan assets were held within a Common Investment Fund (CIF), but for the purpose of the longevity swap this presented a number of potential hurdles and a segregated account was deemed advantageous. We worked closely with Insight to implement this transition ahead of the longevity swap being executed. This involved a substantial amount of work on Insight’s part, including setting up new accounts, drafting new investment guidelines and transitioning assets.

What did you learn through the process?

At their core, longevity swaps are trying to achieve something relatively simple. But the bespoke nature of a longevity swap means they are a complex transaction to put in place, requiring a significant amount of work from a range of counterparties, advisors and lawyers. Further simplification and standardisation would be very welcome, as it would potentially allow more schemes to consider using these instruments.

Importantly, the investment and operational aspects need to be thought of in advance, as they can have a significant impact. Working with partners who know how everything fits together can allow all parties involved to bring their best insights to the table and ensure all the key issues are addressed effectively.

More specifically, it is clear that collateral management needs careful consideration at an early stage of the process. For an interest rate or inflation swap, collateralisation happens almost automatically, but for a longevity swap the approach to collateralisation can differ depending on the particular transaction. Careful planning is needed to put all the necessary processes in place.

On the subject of collateralisation, longevity swaps may offer the potential for pension schemes to use corporate bonds as collateral, which as explained above, can limit any disruption to the wider investment strategy. However, even if both the scheme and the reinsurer are happy to use corporate bonds, the scheme must ensure that its chosen reinsurer is able to return collateral relatively quickly, so that the ability to manage those assets is not impaired. For this transaction, having an experienced collateral manager in Insight helped to confirm this was possible.