Over the last year there has been a lot of attention paid to risk transfer instruments available to pension schemes to directly manage their longevity exposures. Swaps — whereby the protection buyer pays the expected annuity payments and receives actual annuity payments — are increasingly popular for a small number of transactions completed in both (re)insurance and derivative formats. Similar transactions based on indices have been discussed but have not materialised. Although such structures are useful for some pension schemes, they are not without problems for the protection buyer. Bespoke instruments introduce long-term counterparty credit risk, while shorter-dated index products offer limited protection against a scheme’s specific risk profile. In both cases, an oversupply of protection buyers and limited supply of available risk capital is likely to mean that the cost of protection is high.
Many insurers have longevity exposures, and while direct risk transfer is one risk management technique, diversification of insurance risk can be equally powerful. Pension schemes may consider the use of insurance risk as a low correlation diversifying asset in their portfolio that can help fund the potential costs of increasing life expectancy.
Large insurance conglomerates have a diversity of risk exposures across life and nonlife lines. By deploying capital to a variety of business lines, they increase and diversify their income and reduce the impact of any one risk on the performance of the company. Pension schemes can diversify their insurance exposure by investing in non-life insurance-linked securities. These securities act in a similar way to reinsurance, whereby the bond principal is reduced when insured losses exceed a threshold due to natural perils.
The coupons on such instruments are many multiples of the losses predicted by expert modelling firms. Unlike credit and equity investments, which are correlated to each other and to longevity through exposure to corporations and their pension schemes, insurance losses from natural catastrophes have a low correlation to both financial markets and longevity. Despite some structural weaknesses in these instruments, highlighted by the bankruptcy of Lehman Brothers, the asset class has continued to demonstrate its low correlation to other assets (see Figure 1).
Life insurers write a diverse range of business where gains or losses from mortality can offset gains or losses from longevity. If longevity systemically improves, fewer people in a mortality portfolio die, which improves profitability to help offset losses in the longevity business. Conversely, in a pandemic, the mortality portfolio suffers an increase in deaths and there should be an offsetting profit from deaths in the annuity book.
Pension schemes can access mortality risk and create a similar hedge by using life insurance-linked securities. Over the last few years, life securitisation became reliant on guarantees from monoline bond insurers to transform mortality risk into credit risk. As a result, the securities became highly correlated to credit markets and have not proven as resilient to the financial turmoil as their nonlife counterparts. There is still demand for these instruments to protect large life insurers from spikes in mortality and to relieve redundant reserves under US regulation triple-X. New life transactions will isolate mortality risk and maintain the natural low correlation of mortality to financial markets.
Pension insurers only write longevity-related insurance business. They aggregate and diversify this risk across many industry segments, socio-economic groups and geographic locations. This creates a large pool with stable performance where the risk transfer premium received is sufficient to cover plausible adverse deviations.
Pension schemes could take the same approach and invest in longevity-linked instruments, which will diversify their exposures. High demand for longevity protection is likely to cause exceptional risk-adjusted returns on these illiquid and long-dated investments, causing them to generate income in most plausible longevity scenarios. Pension schemes need not consider that risk transfer is the only method to manage longevity. Schemes should assess their appetite for and comfort with longevity risk and manage their exposure accordingly.
Dan Knipe is a portfolio management actuary at Leadenhall Capital Partners