Hedging the longevity inherent in risk

Like the subprime crisis faced by banks in 2008, the risk of people living for up to 20 years after retirement seems to have crept up on an industry based on using historical data to calculate people’s chances of an early death.

Now, pension funds and insurers say the mounting burden of protracted pensions payments is increasingly concentrated on a small group of providers: them.

Trying to spread this longevity risk to include capital markets and governments, they highlight concerns about corporate solvency and argue that fundamentally, provision for retired people who outlive expectations is a sovereign role.

“We don’t want to see the equivalent of a banking crisis in the pension market,” David Blake, professor of Pension Economics at Cass Business School, and director of the Pensions Institute said.

Nowhere better can the process be seen than in Britain, which is facing a crisis resulting from a combination of pension reforms and increased life expectancy.

As home to the world’s second largest pension fund industry and one of the most sophisticated markets for private pensions, Britain’s experience is worth exploring: other European countries are moving in a broadly similar direction, shifting the burden of old-age provision towards funded, private schemes.

Global pension private-sector liabilities are of the order of $25trn, according to OECD data in a January Pensions Institute report, which cited estimates that every additional year of life expectancy at age 65 adds around three percent to the present value of some UK pension liabilities.

Several factors – the market crash brought on by subprime lending, new solvency rules for insurers due in 2012 and the stampede of baby-boomers to retirement age – are adding urgency to providers’ efforts to spread their exposure.

The UK has seen a flurry of over-the-counter longevity swaps deals, the biggest of which so far involved German car maker BMW in February offloading £3bn of risk from its UK pension scheme to Deutsche Bank’s insurance subsidiary Abbey Life.

Abbey Life insured the longevity risk on the BMW pension scheme, taking responsibility for the payments and transferring a proportion of that risk to a panel of reinsurers.

Building on these deals, pension providers are working to construct capital markets instruments to slice and dice longevity risk into tradeable portions.

But the pensions industry says such markets should be underpinned by a roster of government bonds that are structured to help maintain payments to people who are tending to outlive even current expectations – for example, those aged over 90.

If that seems like a small group, the evidence is it’s the population segment most likely to grow. There are around 450,000 centenarians in the world today and experts estimate that thanks to ageing baby-boomers, there could be a million across the world by 2030.

There’s also mounting uncertainty about how many people will have died by age 90, and the Pensions Institute cites mortality projections which show some men at that age will live beyond 110 – a long “tail risk” which may boost liabilities significantly.

“Longevity risk is a size that it should also go out to the capital markets,” said John Fitzpatrick, a partner at Pension Corporation, which buys out liabilities and sponsors some pension funds. He is also a director of a fledgling venture to make such a market happen.

So far, neither capital markets nor the British government have been enthusiastic about the plan, although investment banks are behind the latest efforts to build a tradeable longevity swaps market.

Proponents of a longevity bond say they are receiving a more receptive response from the Conservatives, the party challenging Labour for government in elections due this spring, but the party declined comment.

Who will buy?
In a longevity swap like the BMW deal, the automaker reduced its exposure to its longer-lived pensioners by passing this liability to Abbey Life for £3bn ($4.6bn). Typically, that premium is based on agreed mortality risks in the portfolio.

Abbey Life transferred a proportion of the risk to a consortium of reinsurers. The idea is that this risk is then passed onto investors such as Insurance-Linked Securities (ILS) investors, hedge funds and sovereign wealth funds.

They are attracted by the new asset class as an investment which would trade out of synch with traditional assets such as equities, bonds and real estate.

At the fundamental level, longevity risk is a good thing to own if you believe for any reason that more people will die sooner than currently forecast, if you have a portfolio that would lose money should such a catastrophe happen, or if you anticipate returns on the asset.

“Investors … who own the risk of hurricanes, typhoons, earthquakes and lethal epidemics are ideally suited to take on longevity risk,” said Fitzpatrick.

“There is no known correlation between the wind blowing and the earth shaking and how long UK pensioners live – longevity offers a good diversifying risk for their portfolios,” he said.

Capital markets players have already been involved in longevity transactions to a small degree: of the eight publicly announced swaps, the longevity risk was passed through to investors through reinsurers and investment banks.

But these have been bespoke deals. A key to developing such a market would be standardised indices. The Life and Longevity Markets Association (LLMA), of which Fitzpatrick is a director, was set up in February by a consortium of banks, insurers and pension experts to do just this.

Hot potato
Pricing the risk is complex. For a longevity transaction to happen, the investor, pension fund and investment bank have to agree on a forward projection of the cash flows related to either a population index or to a specific pension block.

And markets’ resistance at current prices is palpable.

“Pension funds are marketing liabilities at unreasonable levels,” said Andrea Cavalleri, head of Life at Securis Investments Partners, a fund dedicated to transferring insurance-linked risk to the capital markets.

“We often disagree with the mortality improvement assumptions provided by the pension funds in what can be outdated models,” he said, underlining the basic problem – people are living longer than previously expected.

“In reality, the capital markets should not be picking up the bill for unreasonable assumptions that the pension funds have on their books,” he added, referring to liabilities the pension providers already hold.

Enter the government?

The many arguments in favour of a sovereign bond linked to longevity rest on one fundamental expectation: if pension providers can’t pay, or become insolvent, governments will have to.

Longevity bonds could make the process neater, and more politically palatable, than the collapse of a pension provider.

“We will develop collateral mechanisms so investors can trade the risk themselves,” said Fitzpatrick of the LLMA.

“But it would be helpful if the government did issue a longevity-linked bond, because such a system would reduce the amount of longevity risk that the government is likely to have in the future.”