Time of life

Longevity risk


Life is fast becoming the must-have commodity for a growing number of investors. Life expectancy has been increasing at a continuous rate over the past 50 years, and, seen as any other commodity, the life span 'bull run' certainly looks impressive. Now, hedge funds and other institutional investors believe they have spotted a way of investing in life as an asset class - and making a profit to boot.

At the heart of this burgeoning market lies longevity risk - in layman's terms, the risks posed to a liability from changes in life expectancy. In the life assurance and pension sectors, where cashflows are intricately linked to life expectancy, tiny adjustments in mortality assumptions can add billions of dollars on to liabilities.

Traditionally, this exposure has been difficult to hedge, partly because future life expectancy trends have been difficult to map, so deterring potential counterparties from getting involved. However, the past few months have seen a rush of participants into the UK bulk-purchase annuity business. Essentially, the start-ups offer to take on to their own books - at a price - the assets and liabilities of closed pension schemes, with a promise to honour all current commitments. To make any money, the start-ups have to manage the investments, and risk manage and administer the scheme until every last member has died.

Around a dozen new entities have entered the space this year, backed by long-standing market-makers such as Royal Bank of Scotland, JP Morgan and some large hedge funds. While many of the new entrants envisage higher returns and better risk management because of their financial institution backgrounds, they still remain exposed to longevity risk - and some intend not to hedge it.

Bulk-purchase vehicle Paternoster, for example, was launched earlier this year as a £500 million joint venture between Deutsche Bank and the UK-based hedge fund Eton Park. According to high-level sources at Paternoster, the company will not hedge longevity exposure: instead, it will use its own actuarial assessments of each scheme's longevity risk profile and will add its own estimation of how long members will live directly into the bulk-purchase price.

"Existing buy-out providers and the newer entrants to the market are quite comfortable with taking on and managing longevity risk," says Serkan Bektas, head of UK asset/liability management solutions at Barclays Capital in London. "There is plenty of capital out there chasing pension scheme and annuity risk - and consequently within that, chasing longevity risk."

Many of the newer vehicles have recruited heavily from the insurance and actuarial sectors, and have been working vigorously on developing models to map out predicted life expectancy levels, based on a number of factors including region and type of work, among others. It is not an exact science, but the funds are confident that their pricing levels for annuity buy-outs present a good risk/return opportunity.

Meanwhile, companies are slowly realising the impact that longevity can have on their liabilities. In October, the consultancy firm Pension Capital Strategies (PSC) released a report claiming that FTSE 100 companies were underestimating life spans by up to four years in their pension calculations (Risk November 2006, page 12), with many firms expecting life expectancy to increase at lower than historical levels.

The most recent data from Credit Suisse, however, indicates that rates could continue to rise steeply over the next decade. US citizens now live 80.58 years - that's 2.86 years longer than in 1983 (see figure 1). And on current predictions, life expectancy could reach 82.52 years by 2036, adding billions of dollars on to liabilities.

According to the PSC, because of longevity underestimations, FTSE 100 companies could already be under-reporting liabilities to the tune of £60 billion - a figure that would more than double liability levels, which stand at £47 billion. British Airways and the metals company Corus alone are facing pension liabilities of 294% and 396% of their current market values, respectively, and the thinking is that corporates will be willing to pay large risk premiums to be rid of such risks.

"We are beginning to see a driving force for change," says Bob Tyley, managing director of the insurance and pensions solutions group at Merrill Lynch in London. "Risk officers at corporates are beginning to re-examine their longevity calculations, and there's growing pressure from equity analysts, regulators and rating agencies to sort things out. They're slowly realising that pensions are a non-business risk that need to be resolved."

Dealers have begun to notice a renewed appetite for taking on longevity risk. And many are keen to get a piece of the action. The belief is that the bulk-purchase buy-out option could prove too expensive for some corporates because of the premiums involved. Until now, dealers have mainly been offering asset and liability management solutions to pension funds. But some are now looking seriously at structuring longevity hedges for clients. "The financial markets can provide a value-added way to transfer longevity risk," says Tyley. "And whoever can provide a scalable execution process first will be on to a winner."

But before dealers get carried away, they should remember that this isn't the first time investment banks have looked at the longevity market. Back in November 2004, BNP Paribas structured a £540 million longevity bond for the European Investment Bank that paid out an annual coupon linked to a survivor index referenced to government data for English and Welsh males aged 65 in 2002. The thinking was that this would provide a hedge for pension funds' exposure to longevity - the greater the number of people living on each year, the greater the payout would be from the bond.

However, the bond was withdrawn before it even got to market. Pension funds criticised the inherent basis risk in the structure. For one, the bond referenced the entire male population, which bore little resemblance to the actual liabilities faced by many pension funds, whose members are specific to a region or job type. In addition, the risk premium - around 20 basis points - was considered too high, making the hedge relatively capital-intensive compared with the potential liabilities according to value-at-risk calculations.

"The other way of managing this risk could be by using financial instruments tied to mortality," says one London-based head of pensions at a leading investment bank. "But that market really is in its infancy, and to date they haven't taken off in a big way. We feel that here the publicity is probably ahead of the reality, and that the markets still haven't dealt with some of the basic problems inherent to vanilla structures."

Certainly, most of the dealers contacted by Risk said only a handful of clients had actually used derivatives solutions to hedge longevity risk.

That was all meant to be so very different. A year ago, Credit Suisse launched its own set of indexes linked to US population mortality - including detailed sub-indexes for different subsets of attained ages (Risk January 2006, page 12). The thinking was that investment banks could use the indexes as a reference for structuring swaps, with payouts linked to the difference between a pension fund's own mortality estimations and the index at expiry of the contract. The bank had plans to launch indexes in Europe and Asia. However, one year on, dealers say the index is little-used, and that insurance and buy-outs far outnumber swaps as solutions to the problem of lengthening life spans.

Basis risk is central to the swaps market's failure to take off. National longevity statistics may show a trend, say critics, but within those lie vast variations. Indeed, a joint survey by the universities of Sheffield and Bristol last year found vast longevity inequalities between areas in a country as small as the UK. In some inner-city areas of Glasgow, life expectancy is 72.9 years, compared with 82.4 years in some of London's wealthier districts. Naturally, such variation shows how a national index might deviate widely from the life spans of a specific company's scheme members.

But dealers now predict a revolution in longevity risk management. Talk at half a dozen investment banks is brewing of using collateralised debt obligation (CDO) technology to provide tailored solutions to pension and insurance schemes in a way that makes distribution of that risk quick, cheap and easy.

"Mortality and mortality improvements have never been so well understood," says Bob Howe, London-based chief risk officer for Swiss Re's life business. "With that, some people in the annuity business have become quite active in segmenting the market, some offering enhanced terms for lifetime smokers, while others are using postcodes as a proxy for occupation or wealth." And with such a pin-pointing and stratification of risk, dealers believe the most natural way to sell this out to the market is through securitisation.

Already, the Zurich-based reinsurance company has used tranching and securitisation technology in two transactions over the past three years: Vita and Vita II. The issues transferred $400 million and $362 million of mortality risk (the risk that people might die early, forcing Swiss Re to pay out to life assurance companies it had provided reinsurance to), with the second introducing tranches that were hit when mortality exceeded 110%, 115% and 120% of a population index. Both issues were oversubscribed, with more than 80% of the paper going to traditional money managers and hedge fund investors.

"We're going to see attempts to move this kind of risk on to the market in more efficient ways over the next two or three years," says Ed Giera, head of the pensions advisory group at JP Morgan in London. "Structured finance techniques for risk tranching are well established across a variety of asset classes. These kinds of solutions are under development by JP Morgan, as well as a number of other investment banks, of course."

An investment bank could tranche the longevity risk of a certain pension fund in a CDO format, says Guy Coughlan, asset/liability management strategist at JP Morgan. Longevity risk from each obligor would first be categorised by how much life spans would have to move before the obligor suffered a loss, before being stratified synthetically into equity, mezzanine, senior and super-senior tranches, much in the same way as debt.

Investors in each tranche would receive a payout provided that longevity rates didn't rise too much - after all, if people lived longer they would prove more costly to a pension fund. A similar structure could be used for life assurance companies, where obligors lost their capital if mortality were to increase beyond a certain limit. "A super-senior tranche would be a piece where mortality would have to fall by a tremendous amount before you started suffering losses," says Coughlan.

Structures are still at the drawing-board stage, but one potential sticking point could be finding investors to take on the equity tranche. Instead, the investment bank or pension fund may have to retain the first-loss piece.

"The equity tranche simply means the piece where the first losses occur, so with relatively small improvements in mortality, you stand to lose a significant fraction of your capital," adds Coughlin. The bank is starting to engage with pension and life assurance clients with regards to a possible structure, and that a deal could come as early as 2007.

Appetite for longevity risk among institutional investors is strong because of the seeming lack of correlation with other asset classes and the potentially large premiums some pension funds and life assurance companies will be willing to pay. However, some fear hedge funds could be biting off more than they can chew, and that correlations between mortality and other asset classes - equity and debt, for example - could increase were a bird flu pandemic to hit the globe.

"Correlation does exist in the extreme," says Howe. "So if there were a pandemic causing a number of deaths there would be an impact on economic activity. There are areas of negative correlation - obviously equities would be badly hurt, but the value of fixed-interest assets would benefit from the fall-off in economic activity as governments cut interest rates."

Needless to say, pension funds and insurance companies are taking heed of these developments. It could offer them a vital way to take longevity risk off their balance sheets.

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