Actuarial discussions over life expectancy often contain an air of black humour. Heavy mortality (people dying earlier) is good for those managing liabilities, whereas light mortality (a lower-than-expected number meeting their maker) has the opposite effect. The unspoken subtext is what is good for the general public, such as advances in medical science and smoking bans, is bad for the insurers and pensions funds that have to foot the bill for increased life expectancy.
And the bill for this is significant. The precipitous falls in investment values in 2008 and 2009 placed market risk at the front of risk managers' minds. The much-vaunted Dutch pension system, for example, witnessed funding ratios decline across the board by 30%. But in a reversal of the addendum tagged onto the adverts for financial products in the UK - the value of investments can go up as well as down - a more benign economic future could see some of these losses clawed back.
The steady upward march of life expectancy, however, is unlikely to be reversed - at least among the insured and pension-owning sections of the population. And with every increase in life expectancy estimated to add about 3% to a scheme's liabilities this problem is set to keep growing. Denmark, for example, has witnessed a life expectation increase by two-and-a-half months a year, each year since 1996. Add the compound effect of inflation-linked benefits that applied to many of these liabilities and it is clear to see why longevity could be the death of the pension sector.
It equally plain to see why, given the carnage wrought in recent years by complex products structured around flawed models, that structures designed to transfer longevity risk to the capital markets have met with scepticism from some quarters. Life & Pension Risk recently came across a particularly hysterical description of longevity swaps as ‘death derivatives', likening trading in them to "buying fire insurance on a neighbour's property". The clear implication being holders of longevity instruments would be incentivised to reduce the life expectancy of the underlying population.
It seems far-fetched to think an evil genius will emerge with to execute such a plan but clearly any product with a duration of decades, rather than months or years, is potentially dangerous.
Understanding the risk posed is a major hurdle to the acceptance of longevity instruments as mainstream financial products. Therefore it is the perfect time for Longevity Risk to appear on the bookshelves. Edited by Emma McWilliam, London-based actuary with consultancy Milliman, it takes a holistic perspective of managing longevity risk, and goes from a bird's eye view of the demographic changes that will see half of babies born today in certain countries to become centenarians to an intricate description of the types of hedges which can be constructed.
Longevity Risk takes a five-fold look at how to understand the main issues at stake - part one focuses on the demographics and the opportunities this presents for the financial sector. The second part looks at the thorny issue of how to price longevity risk. The last two decades have seen insurers and pension funds take massive hits as estimates of life expectancy have proved seriously pessimistic, so the book looks at how the two main variables - baseline mortality and future improvements - can be assessed. The third part focuses on reserving and capital requirements for longevity risk.
The penultimate section looks at how to derisk existing portfolios, both from an annuity and pension fund perspective and how reinsurance can play a role in mitigating this. Finally, it looks at how the capital markets themselves can play a role, with particular focus on the indexes required to underpin them and the legal complications, which some in the industry have blamed for the failure of more than a handful of longevity deals to reach the market.
Longevity Risk provides a compendium of information on a sector of the financial services industry that has the potential to expand into a major part of the capital markets. In addition to the deals already completed in the UK, attempts are being made to repeat this in other mature economies, principally the Netherlands, but also Germany and the Nordic region. But it is not just the mature economies of Europe that are looking at this issue. Significant efforts have been made to launch - so far unsuccessfully - a longevity bond in Chile, with rumours suggesting other recent economic success stories such as Mexico or South Korea could host a major longevity derisking deal in the near future.
The 400 or so pages includes a rollcall of both leading experts and headline names in the longevity sector such as Guy Coughlan, who in his role at JP Morgan, developed the LifeMetrics indexes which formed the basis of the £500 million notional longevity swap between Canada Life and the investment bank, one of the first public longevity hedges. It also includes input from the University of Kent's Professor Sweeting, who has been one of the leading longevity experts in academia for some time, and senior figures from Swiss Re and RGA - winner's respectively of Life & Pension Risk's mortality and longevity risk transfer awards in 2010 - are just two of the heavyweight practitioners included.
One question that remains unanswered, however, is where the final investors will come from? When a series of high-profile deals were completed in late 2009, one leading figure suggested to Life & Pension Risk that longevity could ultimately become a retail product that would sit alongside bonds and equities in private investors' retirement portfolios.
This idea now seems an even more distant prospect than it did at the time and while Coughlan's chapter, Capital Markets and Longevity Risk Transfer, outlines the key requirements to overcome the present bottleneck of reinsurance longevity capacity, market sources estimate it sits at about £10 billion a year, well short of the £1 trillion of total UK defined benefit pension liabilities.
Coughlan argues that a capital market solution would also provide greater diversity, liquidity, fungibility and a reduced counterparty risk in addition to greater capacity. He also points out the need for indexes to bridge the gap between the desire for pension funds to have a tailored longevity risk and capital markets' need for standardisation. Work by the Pensions Institute at London's Cass Business school - where Coughlan is also a member - on producing a gravity model which aims to calculate how specific groups' life expectancy will correlate to general movements, thereby making it easier to strike deals related to general population data, should go someway to remedying this.
But this still leaves one crucial problem - the length of contracts. Even striking a deal that focuses on pensions in payments will require a contract of at least 30 years' duration to be meaningful to pension schemes and it is not clear how much market appetite there is for this type of paper. There is a significant number of hedge funds already investing in insurance-linked securities but these have traditionally focused on property and casualty-based investments - though this is changing - which are inherently shorter in nature than a longevity transaction.
And while family offices have the sort of long-term time horizons and desire for diversification that should make them amenable to longevity-based investment products, the main home for long-dated assets are the insurance and pension sectors. Whether a market in which the main buyers and main sellers are the same institutions will take off is something that will only become apparent over time, but Longevity Risk is an excellent starting point to understanding the issues as they are today.
Longevity Risk is published by Risk Books, paperback, 355 pages, £145.
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