01 Dec 2007, Risk magazine
Longevity derivatives have been the source of fevered market speculation for some time. The concept of trading longevity - or the risk that people might live longer than expected - is of particular excitement to some. The ability to lay off this risk seems like a silver bullet to pension funds and annuity providers in particular, which are smarting from exposure to steadily increasing life expectancies in the US and western Europe.
A report released in April by Pension Capital Strategies, the pension advisory division of insurance broker Jardine Lloyd Thompson, claimed the deficits of companies in the UK's FTSE 100 share index amounted to £20 billion ($41 billion). While this was an improvement of £20 billion on the same figure in 2006, the survey added that FTSE 100 companies continue to underestimate longevity by between two and four years. Despite their £20 billion admission, this would mean those companies were understating their liabilities by around £60 billion and that total deficits should be closer to £80 million, the report said.
Dealers already implicitly trade longevity in transactions as diverse as life insurance securitisations, bulk annuity purchases and even reverse mortgages. Some traders think the accumulation of these exposures on bank balance sheets, along with greater familiarity with actuarial and insurance businesses, will help drive the development of a tradable market. Indeed, some dealers are already putting together bespoke longevity trades to cater for a few investors with a taste for novelty investments. But a multi-billion-dollar market involving liquid over-the-counter swaps, options and even longevity-linked collateralised debt obligations has yet to be realised.
"At the moment, if trades are being done it's on a trade-by-trade basis for particular clients," says Evan Guppy, London-based manager in inflation structuring at HSBC. "To do the kind of size of trades the pension industry is looking to do, there would have to be a standardised market."
One key prerequisite for getting such a standardised market up and running is developing a suitable index. In 2005, Credit Suisse published a series of benchmarks based on male and female US life expectancies. But despite declaring it would follow this up with further indexes for the UK and Asia, it has yet to expand into these new areas.
More recently, JP Morgan announced the launch of its LifeMetrics indexes in March. These track historical and current statistics on mortality rates and life expectancy across different genders, ages and nationalities. On their initial release, the bank launched indexes covering males and females in England and Wales (see figure 1) and the US. In October, the bank added the Netherlands to the LifeMetrics range. Consultants Watson Wyatt and the Pensions Institute at Cass Business School in London helped develop the suite of indexes, which the bank hopes will become a reference for longevity-based derivatives and structured products.
Guy Coughlan, JP Morgan's global head of pension asset-liability management in London, says this sort of standardisation is crucial to getting a liquid market up and running: "The building blocks should be completely fungible - that's the only way you're going to come up with a liquid market." But while Coughlan claims JP Morgan is in discussions with potential counterparties in the US, the Netherlands and the UK, it has yet to close an actual trade on the LifeMetrics indexes.
One of the reasons for the slow rate of growth is the unease many pension funds feel with derivatives. A survey by Mercer Human Resource Consulting and the Association of Corporate Treasurers, released in July, found that only 16.5% of UK funds questioned had made use of inflation swaps over the previous year. Given this, the prospect of swaths of trustees signing master confirmation agreements and issuing mandates to trade on the JP Morgan indexes seems remote in the immediate future.
More generally, the idea of trading an index engineered by a single bank could deter potential participants. Coughlan says the LifeMetrics indexes have an independent calculation agent and are compiled using data collected from various government agencies. But while this might allay the anxieties of pension funds and insurers, comments made to Risk by JP Morgan's competitors indicate it would probably not be enough for other dealers.
However, by far the biggest issue for all potential longevity counterparties is basis risk. Life expectancy is not uniform, varying widely across countries, cities and even within finely delimited demographic groups. While indexes such as JP Morgan's LifeMetrics track the life expectancies of the male or female population as a whole, the liabilities contained within a specific insurer or pension fund's portfolio are likely to be very different. This means the index could prove an ineffective hedge - unless either the dealer or client actively manages the basis risk.
This hitch was blamed for killing off a prospective longevity bond structured by BNP Paribas in 2004. The 25-year £540 million bond issue was marketed on behalf of the European Investment Bank, with a coupon linked to the survivorship of 65-year-old males in England and Wales. Designed to meet the needs of pension funds, the bond ultimately didn't meet with enough interest to be issued. It is thought many investors were worried about the mismatch between the demographic scope of the bonds and their exact requirements.
The problem of basis risk is perceived to be so acute that some dealers even doubt a standardised market is really the way forward. "It's very difficult getting an index up and running that mirrors the risks faced by clients. The one-size-fits-all approach is not the way forward with this product," argues Chris Murphy, London-based head of European interest rates at Morgan Stanley.
Some firms intent on developing a market are therefore focusing on particular client segments. Société Générale Corporate and Investment Banking (SG CIB), for instance, is looking for partners in an endeavour aimed at addressing longevity risk faced specifically by insurers. Instead of collecting data from the general populace, it plans to gain information on mortality and life expectancy among these counterparties' actual pools of business.
"We're basically looking at acting as a market-maker," says Ian Carey, director of insurance structuring at the bank in London. SG CIB wants to aggregate the information received from insurers for particular demographic groups contained in their portfolios. It would then ask them to submit bid and offer prices on financial contracts linked to these longevity assumptions, which could form the building blocks of hedges for their life insurance or annuity businesses. Carey suggests that from the outset, the bank's approach may be to provide a market in a small amount of longevity, perhaps packaging it in fund format in order to make investors feel more comfortable. With greater education and a popular readiness to consider uncorrelated assets, he thinks investors might then become more confident about trading it.
Meanwhile, a new UK-based firm called PensionsFirst, which launched in November, is pledging to offer bonds tailored to match the liabilities held by defined benefit pension schemes. Many schemes are keen to match assets and liabilities under FRS 17 accounting rules, which require funds to discount their liabilities using bond yields and to use market prices for valuing assets, with any deficits reported on their balance sheets. The products offered by PensionsFirst would deal with a range of risks these schemes face, one of the most significant of which is longevity.
"We will create bonds and derivatives that are pension scheme-specific and precisely match their liabilities," says Timothy Lyons, a founding partner at the firm in London, who has 25 years' experience in the capital markets. He says the company has been working on a new method to assess and value longevity risk over the past two years, which it is now trying to patent. Once it has taken this risk from its pension scheme clients, the firm would then seek to lay it off with investors via capital notes, with PensionsFirst taking any basis risk.
Lyons says the company is setting up an international distribution network for its proposed offerings: "We're confident we can generate strong interest in this asset class."
But others are not quite so sure. Generating enough enthusiasm from investors is seen as a challenge. Although pension funds are naturally exposed to improvements in life expectancy, dealers say it is hard to find an equivalent constituency to take the other side of trades. While life insurers' exposures to mortality makes them seem like a reasonable fit, many of these companies also have annuity businesses - which put them in a similar position to pension funds. Other hopeful suggestions include pharmaceutical companies or even residential care homes - which could stand to benefit from a rise in sales and revenues thanks to an ageing population. But critics point out that unpicking the longevity exposure in the balance sheets of individual drug or care companies is extremely complicated. For them, it may simply not be worth the hassle.
Nicolas Tabardel, vice-president of inflation trading at Citi, suggests this difficulty isn't unique to longevity. "There's a precedent for that in the inflation market," he says. As with longevity, he contends, the most avid potential buyers for inflation were pension funds, and building interest among those who were naturally long inflation took time. "We need to be creative and find people to source the longevity risk," he adds.
In the immediate future, dealers concede those willing to take the other side of longevity trades will probably only comprise institutional investors, such as hedge funds. Their relative unfamiliarity with longevity risk, combined with a lopsided market, means they may demand a high premium for their initial involvement.
For all these pitfalls, the banks and other firms harbouring plans on longevity sound an upbeat note - JP Morgan's Coughlan is adamant that the development of a true longevity market can be achieved in the near term. The pessimism of others suggests it could be a lifetime away.