All the recent activity in longevity risk transfers has been of the over-the-counter variety, from pension schemes to insurers and reinsurers, and sometimes via investment banks.
Broadly speaking, the way longevity risks are transferred can be broken down into two types. There are buy-outs that transfer all of the scheme’s assets and liabilities to an insurer (or reinsurer) in return for an upfront premium. Then there are buy-ins and insurance-style contracts, such as longevity swaps, in which the sponsor retains the scheme’s assets and liabilities on its balance sheet, plus full responsibility for making benefit payments to its employees.
In a buy-in, for an upfront premium the (re)insurer makes periodic payments to the pension scheme sponsor equal to those made by the sponsor to its members. In a longevity swap, there is no upfront payment. Instead the premium is spread over the life of the contract and the (re)insurer and scheme sponsor exchange periodic payments based on the difference between the actual and expected benefit payments.
For pension schemes whose actuarial liabilities exceed the value of their assets, buy-ins and swaps may be preferable to buy-outs because the former do not involve any requirement for the asset-liability gap to be recognised immediately as a loss.
Another advantage of buy-ins and swaps is that they can be used to hedge the longevity risk associated with specific subsets of the underlying population. Longevity swaps are particularly ‘surgical’ in that they can transfer just longevity risk, whereas buy-in and buy-out transactions typically also transfer the investment risk of the assets. Longevity swaps can also be combined with other types of derivative contracts, such as inflation, interest rate and total return swaps, to create so-called ‘synthetic’ buy-ins that do transfer all of the risks.
In terms of the volume of transactions, the United Kingdom is by far the leader, but activity is picking up in the Netherlands and the United States.
Ultimately, these markets are driven by the private sector’s exposure to longevity risk. So we are unlikely to see many of these transactions taking place in countries such as France, where the private-sector role in pension provision is minimal. The United Kingdom, on the other hand, has all the ingredients for a healthy demand for pension scheme longevity de-risking, as does the Netherlands.
In both countries, there are still many defined benefit pension schemes, and accounting rules and prudential regulations compel scheme sponsors to accurately measure and report their pension obligations. In addition, the actuarial communities are actively seeking to disseminate more frequent and up-to-date longevity data and forward-looking models.
Although US pension schemes are now predominantly based on defined contributions, firms such as General Motors are recognising and acting on the risk reduction benefits of working to mitigate longevity risk.
So far, life (re)insurers have dominated the risk-taking sides of these transactions, although investment banks have been playing active intermediation roles. For life
(re)insurers, longevity risk can provide a partial hedge for their insurance exposures, because the two risks largely offset each other – life annuity liabilities increase when annuitants live longer, whereas life insurance liabilities decrease. Partial is the key word here, because the underlying annuitant populations are likely to be older than those of life insurance policyholders.
Appetite for risk
(Re)insurer appetite for longevity risk clearly has its limits. Some market participants estimate that life (re)insurers can take on about $15bn (£9.3bn) of new longevity risk per year. However, even if they could handle double that amount, and the recent transactions by Aegon (€12bn) (£9.6bn) and General Motors ($26bn) (£16.1bn) suggests that it is possible, they are still dwarfed by the potential demand for longevity risk mitigation.
Global longevity risk exposure as measured by total assets backing future pension and annuity guarantees has been estimated to be over €15trn (£12trn). In order to tap into this demand, new market players are needed, and there are developments that bode well for this possibility.
A relatively untapped pool of potential longevity risk-takers may consist of asset managers, sovereign wealth funds and hedge funds. Several projects are under way to bring much-needed pricing transparency and liquidity to these markets. The Life & Longevity Markets Association (LLMA) is working on the development of standardised index-based longevity swap curves and pricing models risk. Also promising are the Deutsche Börse’s exchange-traded longevity swaps based on their Xpect® family of longevity indices.
Concerns about products designed to transfer longevity risk revolve around regulatory arbitrage and concentration and basis risk. Cross-border regulatory arbitrage is particularly worth looking out for given divergences in European and US insurance regulations. Also, concentration risk is a real possibility, with a handful of (re)insurers dominating longevity risk transfer markets. Basis risk is a potential downside of standardising transactions for enhanced liquidity, for example by basing them on generic (sub)population mortality data.
The downside to standardised indices and products is that the mortality experiences may not match that of the pension scheme being hedged. It is important that this basis risk be properly accounted and reserved for.
Prudent longevity risk transfer should provide benefits all around. Firms that hedge their longevity risk will reduce a source of potential profit and loss volatility. They will also find that they are free to focus their efforts on core business activities. Employees of such firms can benefit from reduced ‘counter-party’ risk on their future pensions.
Better managed longevity risk also benefits taxpayers, because aside from their own considerable longevity risk, governments are likely to be liable for the ‘tail’ of longevity risk, whether it be their own or the private sector’s (for example, via pension fund guarantee schemes).
The potential numbers are not trivial. Each year of life extension adds between 3% and 5% to the discounted present value of future pension liabilities. A year of unexpected life extension every 10 years has been the norm for decades.
Some commentators have speculated that the first person who will live for more than 150 years has been born already, and there is no question that the human lifespan is on an upward trajectory. But the question of whether there is a biological limit to our lifespan remains unanswered.
Keep in mind that most longevity advances to date have been driven largely by life expectancy improvements at younger ages. Although important advances are being made in the prevention and treatment of cancer and cardiovascular disease, there has been less progress in eliminating the chronic degenerative diseases usually associated with ageing.
Nevertheless, there is always the possibility of a major development in bio-medical technology that breaks what seems to be a natural limit to life expectancy – currently it stands somewhere between 110 and 120 years.
With thanks to Marty Bonus for providing the interview with John Kiff