Pension funds that manage defined benefit plans are exposed to longevity risk; the risk that their retirees will live longer than expected. Their exposure has grown rapidly in recent years as life expectancies have increased – just one additional year of extra life expectancy can add 5% to a pension fund’s total liabilities. In today’s low interest rate environment, pension plan administrators are struggling to earn sufficient returns to compensate.
One solution to this problem is for pension funds to transfer longevity risk to the reinsurance market. Such a transfer can be interesting for both parties.
From the perspective of the pension fund, a life reinsurer is often an attractive counterparty, both because of its deep understanding of the nature of the risk transferred and because it can provide a balance sheet large enough to assume a significant share of the fund risk. The reinsurer is thus able to provide a reliable hedging solution for the fund.
From the perspective of the reinsurer, a transfer of longevity risk can provide a useful hedge against the mortality risk to which the reinsurer is exposed. This is the risk that the reinsurers’ underlying policyholders die prematurely, resulting in earlier-than-expected death payments.
The difficulty is that reinsurers are not allowed to directly insure the risks of a pension fund.
One solution is to interpose a captive insurance company between the pension administrators and the reinsurer.
Guernsey is experiencing an increasing number of transactions which use ad hoc insurance companies for this purpose, in the form of incorporated cells.
How it works
The incorporated cell company insures the liabilities of the pension fund and then reinsures its liabilities with the reinsurer. The embedded cell retains no net risk. The pension fund pays a premium to the formed cell in exchange for certainty about the level of payments it must make to its members. The incorporated cell will pay the premium to the reinsurer (less its friction costs) in exchange for reinsuring the risk it has assumed.
Each of the counterparties to the transaction is exposed to the credit risk of each of the others. For example, if the reinsurer becomes insolvent, the constituted cell will not be paid and will not in turn be able to pay the pension fund. This risk is particularly important due to the long duration of the transaction. It may take decades before pension liabilities are finally liquidated and insurance and reinsurance can be terminated.
For this reason, an important element of a risk transfer transaction is to put in place safeguards and guarantees to ensure that the transaction can be unwound in the event of default by one of the counterparties.
An incorporated cell is a registered legal entity with its own memorandum and articles of association, its own company registration number and its own board of directors. Each incorporated cell is associated with a specific incorporated cell society. An incorporated cell society may establish multiple incorporated cells.
An incorporated cell is linked to its incorporated cell company through its board of directors (which must be identical to the board of directors of the incorporated cell company), its registered office (which must be at the same address as the constituted cell), and by the liability of the constituted cell company for various administrative acts of its constituted cells. More information on incorporated cells and incorporated cell companies in Guernsey.
Incorporated cells are attractive for transferring longevity risk for several reasons.
First, forming an incorporated cellular company is a cost-effective way to establish a pool of special purpose insurers under common ownership (similar to a corporate group comprising non-cellular companies). Once a pension fund establishes an incorporated cell company and an incorporated cell to enter into a longevity risk transaction, it can easily add additional incorporated cells at a later date to enter into a longevity risk transaction. other transactions.
Second, embedded cells are structurally flexible. Incorporated cells may be transferred between incorporated cell corporations, converted to stand-alone non-cellular corporations, or migrated to other jurisdictions. This means that the structure can be modified in the future if necessary. This is important because, as noted above, a transaction can take a very long time, perhaps over 60 years.
The regulatory regime
Insurers in Guernsey are governed by the Insurance Business (Bailliage of Guernsey) Act 2002, which requires all insurers, including those structured as special purpose cells, to obtain and maintain a license from the Commission Guernsey Financial Services. Licensed insurers are subject to legal capital and solvency requirements. These include a formula-based minimum capital requirement and a risk-based prescribed capital requirement, which incorporated cells must meet on an individual basis.
However, an embedded cell used in a longevity risk transfer transaction may qualify as a special purpose entity (referred to as a “category 6 insurer”). Indeed, its underwriting risk and its counterparty credit risk are both effectively eliminated by (in the case of its underwriting risk) back-to-back reinsurance with the life reinsurer and (in the case of its counterparty credit risk) the warranty and security provisions mentioned above.
Classification as a special purpose entity means that the formed cell does not need to meet the minimum capital requirement or the prescribed capital requirement. Nor does he need to produce an Equity Solvency Calculation (or “OSCA”). The OSCA is similar in concept to the UK Individual Capital Assessment for insurers.
The Guernsey Financial Services Commission will also waive certain other requirements which would otherwise apply to the incorporated unit: – in particular, the requirement to appoint an actuary to prepare an annual report; and the requirement that life insurers hold assets representing 90% of policyholder liabilities in trust in Guernsey.
More details on insurance regulations in Guernsey.
Instead of employing staff to manage the incorporated cell, the shareholder (the pension trustees) will usually appoint a non-executive board supported by a locally licensed insurance manager. The Insurance Manager provides insurance administrative services and technical support. It also provides a registered office address and acts as the general representative of the constituted cell.
Board meetings are held in Guernsey and the majority of directors are residents of Guernsey to ensure that the spirit, management and control of the incorporated unit remains in Guernsey at all times.
Several insurance managers have created their own incorporated cell companies to facilitate longevity risk transfer transactions for their clients.
These managers can offer pension funds an incorporated cell in an off-the-shelf incorporated cell company. These incorporated cell companies may have incorporated cells held by different pension funds, each of which is established to operate a single longevity risk transfer transaction. This structure can be cost-effective for pension plan administrators considering one-time or smaller transactions; and therefore do not wish to establish their own incorporated cell society.
Impact of substances
In early 2019, the Economic and Financial Affairs Council of the European Union (ECOFIN) reaffirmed Guernsey as a cooperative tax good governance jurisdiction. ECOFIN has confirmed that Guernsey not only adheres to international standards of tax transparency, the principles of fair taxation and is committed to combating base erosion and profit shifting, but that the regime Guernsey tax ensures that profits made by Guernsey businesses are commensurate with the actual economic substance of the island country.
Guernsey’s implementation of the tax substance requirements has not had a material impact on the operating models of the vast majority of Guernsey’s insurers. This is due to the fact:
- local regulatory requirements and the expectations of the Guernsey Financial Services Commission have always required insurers to be managed from Guernsey;
- most Guernsey insurers underwrite risks located outside Guernsey and therefore have always had to be careful not to conduct insurance business outside Guernsey; and
- the boards of most Guernsey insurers contain a majority of Guernsey resident directors. Therefore, the new requirements have not had a material impact on how longevity transactions are documented or processed.
Carey Olsen has a long history of advising on longevity risk transfer transactions. We acted on the first such transaction involving BT’s pension scheme in 2014 and have advised on all other Guernsey transactions since, as detailed below.
- BT (2014) – Worth £16 billion
- Merchant Navy Officers (2015) – Worth £1.5 billion
- British Airways (2017) – Worth £1.6 billion
- Marsh & McLennan UK (2017) – Worth £3.4 billion
- EU Industrial Conglomerate (2018) – Worth £2.3 billion
- Willis (2020) – Worth £1 billion
- Financial Services Company A (2020) – Value over £2 billion
- Financial Services Company B (2020) – Value over £2 billion
- International Industrial (2021) – Worth over £3 billion
- Financial Services Business (2021) – Worth over £3 billion
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.