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The Actuary The magazine of the Institute & Faculty of Actuaries
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Long term solutions

Longevity risk — the prospect that people live longer than expected — is a huge risk facing defined benefit pension plans as well as insurance companies through their annuity books. For example, if the life expectancy of 65-year-old males increases by just one year, then the cost of providing an inflation-linked pension to these individuals increases by about 5%. Historically, insurers have tended to be better at measuring and managing longevity risk, however pension plans are increasingly dealing with its impact.

Until recently, there have been several ways of managing longevity risk. Insurers have been managing the risk through prudent assumption-setting and via reinsurance arrangements. For pension plans, one method that has become increasingly popular over the last few years has been to pass the risk on to an insurer, paying a premium for the insurer to take on the liabilities. However, the most common approach has been to retain the longevity risk and try to use excess returns from growth assets to fund the cost of increasing life expectancy.

Capital market instruments have now been developed and traded to enable pension plans, insurers and reinsurers to hedge the longevity risk associated with the liabilities. These new hedging instruments transfer longevity risk to other capital market participants, bringing benefits of additional risk capacity, increased liquidity and, critically these days, mitigation of counterparty risks to the transfer of this risk.

Capital markets longevity solutions
There are two main options for hedging longevity risk in the capital markets: customised hedges and standardised index hedges. Each one has different advantages and disadvantages, but deciding between the two ultimately comes down to a tradeoff between the cost and benefit of each. A customised hedge provides a complete hedge for longevity risk. It reflects the actual longevity experience of the liabilities. It is typically structured as a cash flow hedge in that the net cash flow (liability cash flow and hedge cash flow) is fixed in respect of changes in longevity. So the pension plan might pay a fixed, pre-agreed series of cash flows and, in return, receive cash flows based on the actual payments to plan members, entirely indemnifying the liabilities against longevity risk.

In contrast, a standardised index hedge is based on the longevity experience of a broad population, such as a national population, but calibrated to match the sensitivity of the actual liabilities of changes in mortality rates. It is often structured as a hedge of value, rather than a hedge of cash flow, so that any increase in the value of liabilities from changes in mortality rates is offset by a compensating payment provided by the hedge. In other words, the net value of the liabilities and hedge at a future date is fixed with regards to longevity risk. This allows protection against the longevity risk on all cash flows but only for the maturity of the hedge, allowing a shorter term hedge to be put in place if desired.

Unlike a customised hedge, a standardised hedge does not completely eliminate longevity risk because of the differences between the pension plan’s or insurer’s longevity experience and that of the longevity index. This means the degree of risk reduction, while still significant, will be less than 100%. However, this basis risk can be minimised by calibrating the standardised hedge to match the mortality sensitivity of the liabilities — generally providing hedge effectiveness of between 85% and 90%. The hedger needs to be comfortable with this residual risk in order to put in place such a hedge.

A liquid longevity market
A liquid longevity market requires capacity driven by a pool of both buyers and sellers of longevity risk. It is obvious that there are large numbers of institutions that have longevity risk. There are approximately £1trn of occupational pension plans in the UK, with a similar amount of liabilities in government-backed pension schemes, and around £135bn of longevity-linked reserves in the insurance market.

For those looking to invest in longevity risk, this provides a huge pool from which some pension plans and insurers will be willing to pay to hedge the risk. Recent market conditions have seen significant increases in the correlation between traditional asset classes (but not with insurance risks such as longevity), highlighting the benefit of seeking returns from uncorrelated investments like longevity. Consequently, there has been interest from a wide variety of investors such as hedge funds. There is also interest in investing in longevity risk in synthetic format from insurers looking to increase their exposure to longevity risk or to diversify the sources that they hold.

The structure of transactions is important in order to create a liquid market. While hedgers may favour a bespoke customised hedge that indemnifies against all longevity risk, investors favour more standardised instruments that are easier to analyse and more conducive to the development of liquidity. This suggests that to develop a liquid market requires an objective standardised index on which to base transactions. However, this is not to say there will be no demand for non-standardised longevity transactions — in certain circumstances customised solutions meet the needs of hedgers better, although they are likely to be less liquid and therefore require the payment of an illiquidity premium by the hedger.

Currently the capital market in longevity risk transfer is still in its infancy and there have only been a handful of publicly announced transactions. Canada Life transacted a customised longevity hedge with JP Morgan on £500m of annuities, with the risk subsequently being passed onto a group of insurance-linked securities investors. The pension buyout firm Lucida also hedged some of the longevity risk in its liabilities through a standardised longevity hedge based on the LifeMetrics Index. There are a number of financial institutions, insurers, pension plans, consultants and investors looking into developing the market further.

The implications
Pension plans and insurers currently use the market prices of bonds, interest rates and inflation swaps to value their liabilities. This gives a value of their liabilities based on market observables; a mark-to-market valuation. A liquid market in longevity would provide a transparent price for buying and selling longevity risk. This would open up the possibility of using market-implied mortality assumptions to value liabilities.

So if there is a market-observable level of future longevity, how could pension plans and insurers use this to value liabilities? These levels would be based on indices of lives that would not necessarily reference the population of the liabilities that the actuary is trying to value. This problem could be overcome by backing out the longevity improvement from the market-implied mortality rates and calibrating those improvements with the reference population. This then provides a basis for the liability’s mortality improvement assumptions, allowing a mark-to-market valuation of liabilities to be made.

A liquid market in longevity has a number of implications and benefits for pension plans and insurers. It provides a means of hedging longevity risk, passing on this risk to a group of investors for whom an investment uncorrelated to wider markets appeals. However, the far-reaching implication for a liquid longevity market is that it would provide a means to value liabilities in a market-consistent manner, providing a valuation approach for mortality improvements consistent with existing market risks such as interest rates and inflation. With attention from both investors and hedgers it will be interesting to see how this market develops.

Chris Watts is a vice president and Matt Fewster is an associate in JP Morgan’s Pension Advisory Group