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Liability Management: Innovation That Cuts Out The Middleman

Liability Management: Innovation That Cuts Out The Middleman

BT's defined benefit pension scheme – the largest private sector arrangement of this type in the UK with 320,000 members and an estimated funding deficit of £8.1 billion – has recently made the news… but for positive reasons.

Barely days after analysts’ predicted that BT would need to double its current £325 million contributions to the pension scheme, it was announced that the scheme has entered into a deal with the Prudential Insurance Company of America to reinsure its longevity risk.   Although the deal will not reduce employer contributions to the pension scheme, it will reduce the risk of an estimated £40 million black hole emerging if members live longer than expected.

Longevity (the fact that pension scheme members are living longer) is one of the biggest financial risks facing pension schemes. Each extra year of longevity is estimated to add an additional 3 - 4% to a scheme’s liabilities.

The BT arrangement, the biggest longevity risk transfer in the UK to date, uses an innovative structure in order to maximise the value of the deal to the pension scheme. In summary, the pension scheme set up an insurance company (as its wholly owned subsidiary), which then reinsured one quarter of the scheme’s exposure to longevity risk.

This meant that the scheme was able to improve its protection against the increased life expectancy of its members, and avoid paying significant fees to an intermediary, by reinsuring its own captive insurance company’s risk with the Prudential Insurance Company of America through an insurance broker. 

Reinsurance is an arrangement whereby a pension scheme makes regular premium payments to an insurer, which are calculated based on a given risk (in this case, mortality rates). In turn, the insurer makes payments back to the pension scheme to pay members’ pensions as they fall due – in this case, taking on the longevity risk of the scheme.

Reinsurers typically only enter into these arrangements with insurance companies or banks – not directly with pension schemes. In the normal course of events, a pension scheme would have to enter into an arrangement with an insurance company or a bank, which may then choose to manage its own risk by reinsuring it with a specialist reinsurer.  The “captive” structure in this case effectively cuts out the middleman.

This isn’t the first time such an arrangement has been implemented. But, it’s certainly the first time such an arrangement has been implemented on this scale - this deal is three times bigger than any other similar transaction in the UK.

The arrangement is part of the BT pension scheme’s investment portfolio. As such, the longevity arrangement requires no further funding from BT as the scheme employer. In addition, the scheme’s insurance subsidiary can enter into future transactions to further reduce longevity risk.  It is a ground breaking structure, and one which we think it likely other large pension schemes will copy in the future, particularly given the apparent appetite of reinsurers’ for longevity risk transfers.

Sarah Phillips

Martha Quinn