Longevity Risk Transfer: A PPF Perspective
Sixth International Longevity Risk and Capital Markets Solutions Conference
9th & 10th September 2010
Martin Clarke,
PPF Executive Director of Financial Risk
Pension Protection Fund (PPF) was established in April 2005 to
protect members of defined benefit pension schemes
•
PPF pays compensation to members of DB pension schemes where the
scheme sponsor becomes insolvent and there are insufficient assets to buy
compensation on the open market
–
–
•
PPF is funded by:
–
–
–
•
PPF compensation is 100% of pensions in payment and 90% of pensions in deferment
There is a cap in the case of deferred members and indexation/escalation is also capped
A levy on eligible pension schemes currently £720 million per annum
The assets of schemes that it takes over
Recoveries from insolvent scheme sponsors
PPF is a public corporation established by Act of Parliament but it has no
Government guarantee
Vision: Protecting people’s futures.
Mission: Pay the right people the right amount at the right time
Its easy to see why we’re worried about longevity…..
Nobody is disputing the
evidence on mortality
improvements – people are
living longer and this will impact
upon pension scheme costs”
The Pensions Regulator 2008
…but how do you assess the available options?
•
For a traditional carrier, risk is measured as cost of the economic capital
required to cover extreme outcomes
–
•
•
A UK pension scheme it is not required to hold a reserve against
uncertain outcomes although its funding has to be based on prudent
assumptions
Schemes can evaluate the cost of risk as threats to their funding
objectives
–
•
Hedging solutions such as reinsurance can be judged by the net effect on risk adjusted profit
Do they apply risk pricing techniques? Are they looking at all risks or just longevity?
There is still room for a qualitative overlay which may come from the
sponsor’s overriding desire for stability/predictability
In PPF’s case the position is complicated by its potential to continue to
accrue additional liabilities as a result of future insolvencies
PPF targets “self sufficiency” in 20 years’ time; off-balance sheet
risks will then be limited and on balance sheet liabilities mature:
PPF claimsRatio
as %
of PPF
liabilities
of Claims
to PPF
Projected Liability
The impact of claims will decline over
time
–
–
–
Scheme funding will improve
Risk mitigation trends continue including buy
outs
Scheme closures to new entrants / accruals
Mean average
50th percentile (median)
75th percentile
10.00%
90th percentile
8.00%
C/L
•
12.00%
6.00%
4.00%
r2
0
r1
9
Ye
a
r1
8
Ye
a
r1
7
Ye
a
r1
6
Ye
a
r1
5
Ye
a
r1
4
Ye
a
r1
3
Ye
a
r1
2
Ye
a
r1
1
Ye
a
Ye
a
r9
r8
r7
r1
0
Ye
a
Ye
a
Ye
a
r6
Ye
a
r4
r5
Ye
a
Ye
a
r3
Ye
a
r2
r1
Overall members
age distribution
Age distribution of PPF
1000
Now
900
10 Years time
20 Years time
600
500
400
300
200
100
Age
0
12
6
11
8
4
0
2
11
10
10
10
96
92
88
84
80
76
72
68
64
60
56
52
48
44
40
0
36
Number of levy payers may halve
PPF liabilities become 10 to 15% of total
DB
32
–
–
30 Years time
700
28
The population of levy payers will
continue to decline
800
24
•
0.00%
Ye
a
–
–
Average age of DB members will increase from
56 to 71
70% of DB liabilities will be pensioner
Outstanding duration of PPF liabilities will fall
from 21 to 12
Ye
a
–
2.00%
Ye
a
Both UK DB & PPF liabilities will mature
over the next 20 years
20
•
“Self sufficiency” means that the potential future burden on
residual levy payers by 2030 remains affordable
•
PPF investment risk will be reduced to a minimal level
–
•
Residual interest rate and inflation risk will be hedged
–
•
Scope to underwrite investment risk positions limited by capacity and appetite of levy
payers
Dependent on market for available instruments
Margin for “unhedgable” risks such as residual claims and longevity
–
–
–
–
Margin initially set at 10% to give a 90% certainty over the remaining period of the fund
Balances interests of levy payers and beneficiaries
Extreme longevity scenarios likely to prompt a policy reaction
But how do we decide to hedge and if so when?
The PPF Board believes that, given future uncertainty and the absence of any
external guarantee, a chance of success of 80% over 20 years is reasonable
A good hedge for PPF is one that improves the funding success rate during
the accumulation phase or that reduces the reserve for adverse experience
in the decumulation phase
Note that PPF’s appetite for longevity risk
transfer will progressively increase
PPF risk composition through time
100
Diversification effect
• Over 20 years credit/market risk reduces
by two thirds (in economic capital terms
from £10 bn to £3bn)
• Longevity risk rises from 0.8% of
liabilities to 7.5%
• Impact of stochastic vs deterministic
mortality in accumulation phase is 1% to
success rate
Market risk
%
Credit risk
Longevity risk
0
2010
Base Case
• PPF base case has 83% success
percentage
• 1.5% reduction to our funding target
improves success rate by 1% (equivalent
to a levy reduction of £50m)
2020
Accumulation phase
2030
Decumulation phase
Using our funding model we can evaluate the impact of our diversification
effect on hedging strategies as shown in this example
• Let base case assume that PPF will hedge when it becomes self sufficient in 2030
• We also assume this will be at the current price points we have discovered
• We can compare alternative strategies that hedge liabilities at an earlier date
• Breakeven margin is price below which our probability of success improves on base case
Breakeven liability margin vs market prices
Year
Price
Base probability of
success*
100%
Forecast
margin
75%
2010
2020
Breakeven liability
margin/market
price*
2010
83%
75%
2015
85%
85%
2020
88%
100%
2030
100% (by definition)
100%
2030
*Note that the numbers in this slide have been camouflaged to disguise actual price information in our possession.
The feature illustrated is however based on actual price information
Supported by this analysis we can evaluate different strategies and, in
principle, develop a hedging dashboard to reflect our appetite for business
PPF longevity risk dashboard*
•
•
•
Basic principle is to seek solutions
that improve on our probability of
success
Although we might eventually
have an appetite to hedge, the
diversifying effects of other risks
suggests we might hold off for a
while
A wait and see strategy incurs the
hazard that market rates may
trend adversely
Current pricing
(relative to PPF liabilities)
Current pricing
(relative to breakeven margin)
Market capacity
(assessment of appetite amongst buyers)
Deal activity
(assessment of appetite amongst sellers)
Pricing outlook
(is pricing going to soften or harden?)
*The ratings in the longevity risk dashboard are for illustration purposes only
This theoretical model is subject to a number of questions and
assumptions that must be understood to make any real world decision
•
Base mortality assumptions will differ between the PPF basis and
the market
–
•
Diversification benefits may be overstated
–
–
•
Sensitivities on key modelling assumptions: ESG calibration, pension scheme risk and
behaviours
Scenario analysis (in this case a benign economic scenario with few claims and low
market volatility)
Potential arbitrage of longevity model assumptions and
methodology
–
•
Data accuracy; up to date experience investigations; modern factorial analysis;
sensitivity tests
Stress test model and assumptions
Robustness of PPF assumption to only fund to a 90% level of
confidence on longevity risk
Summary and conclusions
•
A financial framework to evaluate hedging options objectively
–
–
•
Decisions dependent on market pricing and risk composition
–
–
•
How will market pricing and capacity develop in future?
PPF is not alone in managing a maturing book of pension liabilities
The process is model and assumption dependent
–
•
Linked to funding objective and Board’s expressed risk appetite
Framework and criteria can be flexed to consider different hedging instruments and segments of portfolio
The ideal-world solution is perfect knowledge or at least agreed assumptions that strip out any knowledge
imbalances
Hedging all the risk may not be the best strategy
–
–
It is possible that market pricing makes some segments of the risk portfolio more attractive to hedge
If PPF has effectively hedged the risk above the 90% confidence kevel post 2030, is there more appetite
in the market for capped risk?
Longevity Risk Transfer: A PPF Perspective
Sixth International Longevity Risk and Capital Markets Solutions Conference
9th & 10th September 2010
Martin Clarke,
PPF Executive Director of Financial Risk