Bulk annuity pricing and longevity risk
A life insurer is pricing a bulk annuity buy-in for a pension scheme with 1,200 pensioners and annual pensions of £6.5m. The scheme's own valuation shows liabilities of £118m using a 3.5% discount rate. The insurer's pricing basis uses a 3.9% discount rate, SAPS mortality tables with a 1.5% annual improvement rate, expenses of 1.2% of premium and a 3% profit margin. Member data includes date of birth, pension amount and postcode, but no medical underwriting. About 15% of the pensioners have pensions above £25,000 a year and are concentrated in affluent postcodes; the scheme has no data on dependants. The insurer's longevity swap counterparty has offered a 20-year swap at Sonia plus 45bp. The insurer is already close to its longevity risk appetite and has a Solvency II SCR coverage of 142%.
1. Assess the main pricing and basis risks in this buy-in and recommend what adjustments the insurer should make before quoting.
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The main risk is that the standard SAPS tables do not reflect the scheme's affluence. Pensioners with pensions above £25,000 in affluent postcodes typically have lighter mortality and live longer, which increases annuity cost. The insurer should apply a socio-economic or postcode adjustment and test the pension-size effect. Missing dependant data is also material: if spouses' pensions are payable, liabilities could be understated, so a data contingency or an explicit dependant loading is needed.
The 3.9% discount rate versus the scheme's 3.5% reduces the assessed liability, but the insurer must hold a market-consistent margin for longevity improvement, expenses and profit. The 1.5% improvement rate should be challenged against recent experience and the insurer's own book. With 1,200 members, concentration risk is significant if a few large pensions dominate.
Recommendation: do not quote on the standard tables alone. Adjust mortality for affluence and pension size, add a dependant-data contingency, stress longevity improvement by 0.5% a year, and include the 1.2% expense and 3% profit margins. If the scheme cannot provide dependant data, quote with a clear loading or decline the case.
2. Explain how the insurer could use the longevity swap and what remains unhedged, and whether it should proceed given SCR coverage.
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The swap would hedge the scheme's longevity experience, but the hedge is not perfect. The swap references the scheme's own members, while the insurer's annuity book has different mortality. Basis risk remains if the scheme's experience diverges from the insurer's other liabilities. The swap also introduces counterparty default risk, collateral and liquidity requirements, and operational risk. The 45bp spread is a cost that must be included in the premium.
The insurer's SCR coverage is 142%, close to its risk appetite. Adding longevity risk from a £118m scheme could reduce coverage further, especially since the firm is already near its longevity limit. Proceeding without the swap may breach appetite; proceeding with the swap still requires capital for basis risk, counterparty risk and expenses.
Recommendation: proceed only if the swap is in place, the price includes the 45bp cost, and the ORSA shows coverage remains above appetite after stress. Otherwise, decline or seek reinsurance and additional capital. The board should also consider whether the scheme data are sufficient to price the swap and the buy-in consistently.