(Clarifies definition of buy-out and buy-in in paragraphs 17 and 18)
* Record year takes longevity market issuance to 25.1 bln
* Final salary pension schemes drive growing market
* Record 3.2 bln stg deal for BAE Systems
* AstraZeneca, Carillion, Bentley also come to market
By Simon Jessop
LONDON, Dec 30 The market that final salary pension funds are banking on to insure against the cost of longer lifespans has chalked up a record 8.9 billion pounds ($14.7 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-$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 pounds 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 schemes are seeking to farm out longevity risk.
The complex deals can take years to come to fruition.
But Andrew Ward, who advises pension scheme trustees for consultants Mercer, said: "There's now a greater degree of standardisation ... Everyone's confident you can do these transactions and they're an accepted way of managing risk."
Many deals have come from larger pension schemes, but Martin Bird, head of risk settlement at consultants Aon Hewitt, said the relatively small Bentley deal, at 400 million pounds, showed "the basic template is now in place".
In the swap, the pension scheme 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.
All such swaps so far have involved British pension providers, many of which have defined benefit, or final salary, schemes that come with generous inflation-linked payouts.
The headache those schemes inflict - and the 1 trillion pounds worth of liabilities they represent - meant that British providers were quicker to address the issue of people living longer, said 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 Bird, who expects the first deals outside the UK next year.
NEED TO ACT
This year's transactions bumped the market's value over the past five years to over 25 billion pounds, and Mercer's 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 percent.
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 scheme's liabilities, are one way of managing risk, but there are alternatives.
Under a "buy-out", the scheme transfers all its assets and liabilities to an insurer in return for an upfront premium. At that point the scheme 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 pounds, 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. ($1 = 0.6063 British pounds) (Graphic by Matthew Weber; Editing by Ruth Pitchford)