Delta Lloyd's regulatory battle has brought to light concerns about the booming longevity risk transfer market, in particular index-based derivatives and risk margin relief. Asa Gibson reports
Following "intense discussions" with the Dutch National Bank (DNB), Delta Lloyd had 14 percentage points (pp) wiped from its Solvency II ratio in the final quarter of 2015. According to the insurer, there was a disagreement about the inclusion of risk margin benefits from two longevity hedges beyond the duration of the hedges.
Delta agreed to restructure the hedges to "ensure reinsurance treatment" – or face a further 7pp deduction from its dwindling Solvency II ratio, which stood at 131% on 31 December. The comment by Delta was interpreted by many to mean that the DNB required longevity risk transfers to be completed via reinsurance contracts to achieve risk margin relief, bringing into question Solvency II's 'substance over form' principle – that the economic effects of contractual agreements should override differences in legal format.
In this case, Delta's transactions had been made via index-based swaps, but the insurer and the DNB have declined to comment further on their discussions and what it meant by 'ensuring reinsurance treatment' remains unclear, sparking fears in the Netherlands that index-based hedges may not be eligible for risk margin relief.
"The Delta Lloyd situation appears to have drawn concern from people" says Deutsche Bank's director of insurance solutions in London, Pretty Sagoo. "For me, it's really important as we were involved in the first index-based trade in the Netherlands and we think it works as a technology and a risk mitigation tool."
A Dutch trend
Uptake of index-based longevity transfers has been swift in the Netherlands compared with other countries, and has become a popular tool for hedging the tail-risk in longevity books – Aegon completed three swaps since 2012 with a total liability size of €19.4bn ($21.9bn), while Delta's two deals since 2014 were worth €24bn.
The reason behind the choice of index-based swaps stems more out of necessity than anything else, according to Chris Madsen, chief executive of Aegon's reinsurance business Aegon Blue Square Re.
"Insurers need size of market to hedge; most indemnity hedges cover less than €1bn in underlying reserves with some notable exceptions. For a mid-to-large sized Dutch insurer to hedge its book, indemnity is not practically possible," he says.
Concerns about the growing longevity risk transfer market emerged in the UK when comments made in April by the Prudential Regulation Authority's (PRA) director of life insurance Andrew Bulley suggested the regulator is reticent about the Dutch trend developing in the UK. In particular, he noted that the market's growth is driven largely by an incentive to reduce risk margin capital; and that given the bespoke nature of longevity risk "off-the-shelf index-based solutions can therefore be deeply unattractive to an insurer seeking to manage its risk profile."
"It would be unacceptable to us if firms were to use this market primarily as a tool to achieve regulatory arbitrage and to avoid key in-built requirements of our new solvency regime rather than to manage their risks in the interests of their policyholder and the firm," Bulley added.
To the contrary, the UK-based Life & Longevity Markets Association and Institute and Faculty of Actuaries this week entered the second phase of a project to find a readily-applicable methodology for quantifying the basis risk arising from the use of population-based mortality indices for managing longevity risk – laying the groundwork for index-based derivative trades in the UK.
Capital intentions
Bulley's comments have cast a large shadow over the future use of longevity risk transfers, which in 2014 hit a record of £40bn ($60bn), according to consultancy Hymans Robertson. Such concerns, however, are unfounded according to some observers, who argue that index-based swaps are an effective risk management tool and that characterising them as regulatory arbitrage is an overly cynical perspective.
Aegon's most recent longevity swap was arranged with Canada Life Re in July 2015 for a reported €6bn, covering a book of pensioners and deferred pensioners for 50 years, which Madsen denies being made with regulatory capital in mind.
"We are not pursuing the transactions for capital's sake per se, though of course capital relief will tend to follow risk transfer"
"The transaction with Canada Life was to tail hedge," he confirms. "The motivations were the same as with our previous transactions: risk transfer, security and efficiency. With the Canada Life transaction, we continued to develop our ability to move risk.
"Our primary objective is to transfer risk – we are not pursuing the transactions for capital's sake per se, though of course capital relief will tend to follow risk transfer – both under internal models and the standard formula."
Model planning
Risk margin relief may be a by-product for some firms, but in the case of Delta Lloyd and for many others, it remains a crucial and credible element of any deal. Sagoo understands that the DNB is not concerned whether or not an insurer uses index-based derivatives or reinsurance to gain risk margin relief, throwing more uncertainty on the context of Delta's agreement to 'ensure reinsurance treatment' of its hedges.
The Dutch life insurer's deals were structured according to the firm's partial internal model (PIM), and when the firm decided to delay its PIM application and enter the Solvency II era on the standard formula, the extra risk margin benefits were refuted by the DNB.
"For any firms planning to move to an internal model or planning a model change, it is important that they make their hedges flexible"
With internal model changes and applications expected in due course, structuring hedges with flexibility in mind is critical if firms wish to maintain risk margin benefits, says Sagoo.
"It's easier to structure an index-based swap on the standard formula because it's simply a case of stress your mortality rates down 20%. For any firms planning to move to an internal model or planning a model change, it is important that they make their hedges flexible such that they can terminate early or restrike. Contractually it's all about what you can agree with risk-takers."
Delta may throw some light on its situation tomorrow (18 May) when it publishes its first-quarter results, and will hold an investor day on 27 May when more details could be divulged.
Whether or not the firm mitigates a 7pp deduction, index-based derivatives will come under increasing scrutiny for the credibility of their risk transfer value, as national supervisors asses a rapidly growing market.