(Reuters) — The market that final salary pension funds are banking on to insure against the cost of longer life spans has chalked up a record £8.9 billion ($14.67 billion) in deals in 2013.
Five years after its launch, reinsurers are hoping London's "longevity swap" market will attract global business as companies struggle to provide the fixed incomes they promised to pensioners who are living longer than expected.
The industry believes the longevity market could be worth $15 trillion to $25 trillion — and reinsurers see an opportunity in the nascent market. Taking on some of the risk of pensioners living longer than expected is one way to offset the early death risk they all take on through the writing of life insurance.
The market set its record for risks hived off by schemes this year with its biggest deal to date, of £3.2 billion ($5.27 billion) from BAE Systems, along with others from AstraZeneca , Bentley and Carillion.
Life expectancy has been consistently underestimated by statisticians. To avoid the risk of being forced to pay out money for longer than expected, many plans are seeking to farm out longevity risk.
The complex deals can take years to come to fruition.
But Andrew Ward, who advises pension plan trustees for consultant Mercer L.L.C., said: "There's now a greater degree of standardization ... Everyone's confident you can do these transactions, and they're an accepted way of managing risk."
Many deals have come from larger pension plans, but Martin Bird, head of risk settlement at consultants Aon Hewitt, said the relatively small Bentley deal, at £400 million ($659.3 million), showed "the basic template is now in place."
In the swap, the pension plan agrees to pay an insurance company or a bank a fixed premium in return for them paying out if pensioners live longer than expected. They then pass on all or part of the exposure to the reinsurance market.
"It's attractive to a company to, in effect, draw a line under how long their liabilities go on increasing," said John Denning, Carillion director of group corporate affairs. "We would have had no control over it otherwise," he added.
All such swaps so far have involved British pension providers, many of which have defined benefit, or final salary, plans that come with generous inflation-linked payouts.
The headache those schemes inflict — and the trillion pounds' worth of liabilities they represent — meant that British providers were quicker to address the issue of people living longer, said Mr. Bird.
While those early deals were run almost entirely out of London, the centre for much of the global insurance industry, discussions were now taking place with pension providers in countries such as the Netherlands and Switzerland, said Mr. Bird, who expects the first deals outside the U.K. next year.
This year's transactions bumped the market's value over the past five years to over £25 billion ($41.21 billion), and Mercer's Mr. Ward expects that to grow in 2014.
The pressure on pension providers to act is strong. The International Monetary Fund estimates that for each extra year of life expectancy, current liabilities in a typical defined benefit pension scheme increase by 3% to 4%.
That means risk-holders are on the hook for an extra $450 billion to $1 trillion for every year they underestimate longevity, a December study from the Basel Committee on Banking Supervision said.
Longevity swaps, which separate longevity risk from the rest of the pension plan's liabilities, are one way of managing risk, but there are alternatives.
Under a buyout, the plan transfers all its assets and liabilities to an insurer in return for an upfront premium. At that point the plan has shed its liability to the pensioners, who each receive their annuity payouts direct from the insurer.
In a "buy-in" deal, the pension scheme pays the premium in return for regular annuity payments from the insurer, which it then uses to pay the pensioners itself.
Though there are concerns about a longevity swap demand ceiling in the reinsurance market that is estimated at between £50 billion and £200 billion ($82.41 billion and $329.64 billion), that is some distance away.
When it comes, some say the only option will be to encourage a broader range of investors, such as hedge funds or sovereign wealth funds, who may see the market as a chance to diversify because of its lack of correlation with other asset classes.
"One of the things we're trying to do is to attract risk-takers, or long-term risk-holders, into the market as well as insurers and reinsurers," said Andrew Reid, European head of pensions origination at Deutsche Bank A.G.