In this world nothing can be said to be certain, except death and taxes,” proclaimed Benjamin Franklin in 1789. One uncertainty does, however, remain about death: when you will die. This is the problem facing pension funds and annuities, which make payments to individuals as long as they are alive. With people now living longer, it means millions more in extra payouts.
Faced with this dilemma, many pension funds are looking to longevity swaps for security. These serve as a type of insurance for pension funds, which pay a fixed regular premium to offload the risk of pension-scheme members living longer. The fund’s partners, normally an investment bank and a reinsurer, pay a floating premium in return, which increases the longer people live. In essence, the insurance policy covers the extra payouts occasioned by the increase in life expectancy. The sponsor remains responsible for making benefit payments to its employees, and the assets remain with the seller, explains Bernhard Brunner of risklab, a subsidiary of Allianz Global Investors.
STANDARD OR TAILORED SOLUTION?
Two types of longevity swaps exist: bespoke and standardized or index-based instruments. With bespoke longevity swaps, the cash flow depends on the number of survivors among the pension scheme members, so it includes a full longevity risk transfer. In the case of index-based longevity swaps, the cashflow depends on the observed mortality rate or life expectancy of a population.
To date, the largest deal of this kind has been the bespoke longevity swap between BMW Operations Pension Scheme and Abbey Life (a Deutsche Bank subsidiary). This covered the liabilities of 60,000 pensioners for the rest of their lives to the value of £3 billion (app. $4.8 billion). Hannover Re assumed almost half of the transaction’s longevity risk. The first standardized longevity swap, meanwhile, was between Pall (UK) Pension Fund and JPMorgan in 2011. This covered 1,800 scheme members with a 10-year term. “Pall receives money from JPMorgan if the life expectancy is higher than assumed in order to offset the additional retirement payments,” says Brunner.
The one danger of standardized swaps is that the cash flow depends on the mortality index of a pension population, which can differ from the hedger’s mortality experience and expectations, explains Enrico Biffis, associate professor of Actuarial Finance at the Imperial College of London. “This can introduce a mismatch, or wedge, between the mortality rates of the hedger and the one in which the index is based,” he says. “That means that the hedger needs to carefully design the hedge and possibly rebalance it in a clever way to minimize hedging error.”
Overall, longevity swaps offer a number of clear advantages. Firstly, they are flexible – payment can be made monthly or quarterly, for example. In addition, they require minimal upfront capital and can be tailored to address explicitly the longevity risk of specific portions of pension liabilities. This makes them highly attractive for a pension fund that has already addressed other risks. Assets also remain with the sponsor.
AN ILLIQUID MARKET
Until now, all swaps have included a reinsurer. The capital markets offer additional risk-bearing capacity, but the market now needs to develop further. “It is hard for a normal investor to invest, as longevity swaps are not standardized, the market isn’t liquid yet and documentation isn’t in place,” Brunner explains. “But the first steps are being taken towards the creation of a liquid capital market.” With this in mind, a group of banks and insurers have set up the Life and Longevity Markets Association (LLMA) in a bid to speed up transactions via methods such as standardizing documentation.
If more liquidity is introduced into the market, other longevity hedging solutions are likely to emerge in popularity alongside longevity swaps, such as q-forwards and s-forwards, which are currently more theoretical instruments. A q-forward is essentially a mini swap that uses a one-year death probability rate. The main difference between this and the s-forwards swap is the underlying mortality rate, which in the case of the latter is linked to the survival rate of a given population.
LONGEVITY BONDS AN OPTION
Longevity bonds could also be useful instruments in reducing longevity risk. There are two important kinds of these: “principal at risk” longevity bonds, which are hedges against catastrophic mortality risk; and “coupon-based” longevity bonds, which link payments to the survival rate of a cohort.
In Biffis’s opinion, longevity swaps hold the advantage over coupon-based bonds. “Bonds involve huge upfront payments, plus they have the issue of how dividend payments are specified,” he says. “They are very capital intensive and have basis risk. Swaps, meanwhile, aren’t as capital intensive, don’t drain much capital, and the floating rate can be linked to different ages and cohorts of interest.” On the other hand, “principal at risk” longevity bonds could appeal to investors familiar with Insurance-Linked Securities (ILS), such as catastrophe bonds. The challenge here is to design payments that are both beneficial to the hedgers and appealing to ILS investors.
By issuing standardized longevity bonds that are index-based on the country’s own population, however, governments would make prices publicly available, Brunner points out. These would then be used as reference points for other transactions and assist the growth of a longevity derivatives market, solving the problem of transparency that is also holding back the market in current over-the-counter deals.
These are among the many reasons why longevity swaps are attracting interest from countries such as the US, Canada and the Netherlands as well as the UK, where all deals have taken place so far. But for longevity swaps to reach their full potential, the right regulatory environment needs to be in place. “The insurance capital market can provide huge risk sharing opportunities,” Biffis acknowledges, “but it is clear that we need substantial engagement from governments and regulators.”
Q-forward, S-forward or fast-forward? Over the coming weeks, PROJECT M online will dedicate a number of articles to longevity risk, examining its challenges and potential solutions from the point of view of insurers, investors and practitioners