The burden of paying for the retirement of the baby boomer generation by those still working is at a critical stage. “If this problem isn’t sorted out, we are facing intergenerational conflict,” says Professor David Blake, director of the Pensions Institute at London’s Cass Business School.
Such a phrase brings to mind the plot of US satirist Chris Buckley’s 2007 novel, Boomsday. In the book, the lead character, Cassandra Devine, suggests “voluntary transitioning” – suicide at the age of 65 in return for tax breaks – as the solution to this problem. But Blake has a more serious and less bloodthirsty answer – use the capital markets to transmute longevity into an investment product that institutions and even retail investors can make a return on.
According to Blake, there is the potential to disperse longevity risk around the capital markets by creating a new global life market, similar to the global bond market. Furthermore, if it were possible to structure this risk into a retail product, then it could be marketed as an investment. This would enable young people to potentially make financial returns from longevity, rather than simply pick up the tab through higher taxation.
“That way, if the product is priced correctly, it benefits both generations – the older people get certainty over their retirement income and the young can make a return. And if the longevity predictions turn out to be underestimated, the young still have the option of working longer to fund their retirement – that simply isn’t possible for those in their 70s. In other words, it would be a brilliant example of intergenerational risk sharing,” he says.
At this early stage, it is difficult to make a definitive view on whether the aim of sending the UK’s £1 trillion-worth of occupational pension longevity risk to institutional, or even retail investors, globally is realisable. But what is incontestable is that for longevity swaps to become a mainstream financial instrument, there must be a liquid primary market before the secondary or even tertiary markets that Blake envisages can emerge.
This appears to be happening. The £3 billion longevity swap – technically a longevity insurance between carmaker BMW and Deutsche Bank in February was the fourth such pension plan deal since the second quarter last year, bringing the sector’s total value to £7.1 billion. This figure is almost exactly double the amount of traditional buyouts – £3.6 billion – completed in the whole of 2009.
It is clear that the savage hits pension funds took to their asset portfolios in 2008, and a drying up of capital in the buyout sector, have provided a major spur to longevity swaps as risk managers look at ways to de-risk pension schemes that are not prohibitively expensive.
One only needs to look at Paternoster’s role as structurer in the BMW deal to see the transient nature of the longevity risk transfer sector. Less than two years ago the monoline was the biggest writer of buyout business, but the drying up of its capital resources have reduced it to merely a pricing advisory role to its major shareholder Deutsche Bank. Are longevity swaps going to also be the mayflies of the pension de-risking world, or does the market have a longer term potential?
Costas Yiasoumi, managing director of Swiss Re’s pension advisory group, is confident the longevity swap sector has a serious life expectancy. “This is no flash in the pan,” he says, sat in the firm’s London offices. “Pension funds are effectively a monoline with only one insurance risk – and if you only have one insurance risk it makes sense to offload it.”
And Swiss Re is not the only company that is optimistic about the potential of the longevity swap market. In January, it joined several other high-profile names in launching the Life & Longevity Markets Association (LLMA) – a London-based organisation, initially comprising insurers Axa, Legal & General, Pension Corporation, Prudential and Swiss Re, and banks Deutsche Bank, JP Morgan and the Royal Bank of Scotland (RBS).
The LLMA’s aim is to “build a liquid trading market” that will transfer longevity liabilities from pension schemes to insurers, and then onto the capital markets. Eugene Dimitriou, London-based managing director at RBS, which structured a longevity swap by Aviva’s York-based UK subsidiary last year (see Life & Pension Risk, April 2008), says this liquidity is on its way – he suggests £10 billion is an achievable aim for longevity swap dealflow for 2010.
Crucial to getting the number of deals moving is convincing pension fund trustees that longevity swaps are a good concept. Anecdotal comments from providers suggest this is the case and John Chilman, pension manager for the £3 billion pension scheme of transport company First Group, agrees.
He says First Group has preliminarily looked at the issue of longevity swaps and would consider transacting if “the opportunity and price was right”. Other trustees, who declined to be named for this article, expressed similar views.
Aberdeen-based Chilman argues that in some respects the recent interest in longevity swaps marks the natural extension of the wholesale move to liability-driven investment (LDI) strategies over the past five years.
“LDI sees schemes immunise themselves against interest rate and inflation risk – which leaves longevity as the major risk outstanding. So a scheme fully hedged against both those risks is effectively just left with longevity risk. If there is a way to hedge this as well then a scheme will have effectively created a synthetic buyout, which is potentially cheaper than the option of offloading all the liabilities to an insurer,” he says.
Taking out longevity swaps with third parties clearly carries a degree of counterparty risk – a risk that trustees are very aware of in the post-Lehman Brothers world.
And one leading figure from the life reinsurance sector says this is a major issue for the longevity swap sector. He puts it bluntly: “A pension fund with the choice of Goldman Sachs, Credit Suisse or a motley start-up that needs to exit the market at some point in the near future and has no access to additional capital has got to make a brave decision. A trustee gets no reward for good decisions and will be hammered for a bad one, so why would they place a longevity swap with a small name?”
Chilman, however, takes a more sanguine approach in offloading longevity liabilities to less established names. Indeed, he argues that the need for a start-up to find an exit strategy means that it is likely to sell up to an established insurer long before a longevity swap has come to the end – meaning any counterparty risk in this case is a short-term problem.
Legal & General is the longest continuous player in the buyout market and it officially declared its longevity swap offering in February. Its managing director of annuities, Simon Gadd, however, looks unconvinced when Chilman’s comments are put to him, but drily concedes, “at least pension schemes are thinking about this issue”.
Gadd’s point is that obtaining a longevity swap from an unrated counterparty will act as a barrier to future buyouts from mainstream firms. He cites the recent experience of several funds holding exotic derivatives, such as total return swaps which subsequently found buyouts difficult, or in one case impossible, because providers were unwilling to take these assets on, and the holders were unable to renegotiate the swaps.
Clearly this is an area of concern for trustees, but the recent expansion of the buyout sector has been driven mainly by interlopers rather than established names. For example, Prudential, one of only two buyout players prior to 2006, did not write any buyout business last year. It seems unlikely a lack of history will prove too much of a barrier to new entrants to the longevity swap market.
However, John Fitzpatrick, director at UK monoline buyout firm Pension Corporation, which entered the market in 2006, argues that rather than counterparty risk, the major roadblock is a lack of data – or at least, a lack of the right sort of data.
The UK’s venerable Continuous Mortality Investigation (CMI), run by the Institute of Actuaries, has been publishing life tables based on the population of England and Wales at 10 yearly intervals since 1843, with the first ones based on actuarial data collected by 17 different life offices between 1762 and 1840.
For any other part of the financial markets, a stream of verifiable data heading back nearly two-and-a-half centuries would be worth its weight in gold. But the specific nature of the longevity risk contained within pension funds differs both from the insured data that forms the heart of the CMI approach and the Office of National Statistics’ general population-based numbers. And while pension schemes want a hedge based on their specific mortality profile, according to Fitzpatrick, capital markets want transparency and comparability.
Gadd says this is where the insurance sector comes in. It can aggregate the individual schemes until there is a sufficient amount of identifiable risk, which can then be packaged onto the capital markets with the ceding insurer holding the basis risk. Indeed, with Legal & General holding a large amount of longevity risk through individual and bulk annuities, the aggregating model is the only way it can enter the market in a prudent and meaningful way.
But it is not just those players whose portfolios are already weighted to longevity that believe the aggregation approach is the right one. According to Swiss Re’s Yiasoumi, the company’s willingness to warehouse longevity denotes “a real difference between us and the other market participants”. He points out that of the three public transactions completed in 2009, only its £1 billion deal with Royal Berkshire did not see the majority of the risks sent to third parties.
Despite this, Swiss Re also believes the way forward for the development of the longevity market is for players such as itself to aggregate longevity and pass on some of the risks to the capital markets. And, according to Alison McKie, head of life and health risk transfer at the insurer, it expects to start this process well before it has reached its self-imposed longevity risk limits.
McKie cites Swiss Re’s role in longevity risk transfer as an example of its approach to harvesting – and potentially distributing – longevity risk. The four Vita catastrophe risk transactions (‘cat bonds’) have seen Swiss Re offload £1.4 billion of its tail risk – or peak – mortality exposure from a number of advanced economies onto the capital markets since 2003.
“Swiss Re looks to hedge the peak risk on its books – and I can certainly see a scenario where we start to transfer longevity risk to the capital markets. This could be done in a manner not dissimilar to Vita – that is, we bring in a piece of risk, and then we assess how this diversifies risk within the overall portfolio. Once the peak risk is identified, Swiss Re may want to keep it or send it to the market,” she says.
One of LLMA’s aims is to establish a series of indices so that when insurers look to offload longevity onto the capital markets it is done in a transparent and easily understandable form, most crucially with regard to pricing. One short cut to establishing a pricing benchmark would come from the government issuing a small number of longevity bonds to facilitate this.
The theory is that this would provide a risk-free pricing structure in the same way as issuance of index-linked government bonds in the 1980s acted as catalyst for the development of the interest rate swap market. Pre-crash, the UK’s interest rate swap market was four times the size of the outstanding index-linked bond market.
“Having a government-based longevity bond which works in a certain way that can be structured into a swap would certainly accelerate the emergence of a traded market in longevity. The question is whether the government would want to do this because, clearly, it already holds a lot of longevity risk,” says Gadd.
With UK public sector pension debt rocketing, persuading the government to issue a series of longevity bonds will be a difficult task – however Blake points out that this is an argument in favour of state-issued longevity bonds: “Thirty-billion pounds is nothing when the government is already issuing £700 billion of other bonds,” he says.
And the concept appears to be gaining ground. At the latest meeting of the UK’s Debt Management Office – which issues all government paper – with market-makers on 11 January, the issue of the government kick-starting a longevity bond programme was discussed, the first time it has even been talked about at this level.
If so, it would be the first successful attempt to get a longevity bond to market. In 2009, the World Bank’s treasury department tried to launch a longevity bond to underpin the expansion of the annuity market in Chile. So far this has not been successful, but a spokesman says, “this does not mean the idea is dead”. And in 2005, French investment bank BNP Paribas was unable to sell any of its European Investment Bank-backed E550 million longevity bond.
The reason that longevity is such an issue for pension schemes is not that life expectancy is increasing – but that it is increasing at a greater rate than is predicted. And for the last 20 years this has been the case as actuarial projections for life expectancy increases have been superseded by the actual experience.
And the risk that this could occur again is one that all potential investors in longevity swaps will need to bear in mind – a cure for cancer, or heart disease, could wipe out those holding the floating leg of a longevity swap overnight.
So does this make the market uninvestable? RBS’s Dimitriou thinks not. Instead he argues that by packaging the risk through the capital markets it can be diversified, enabling the impact of seismic shifts in longevity to be moved around the world, as is already the case with catastrophe risk.
The key issue is the sheer unpredictability of medical advancement – Viagra was originally tested as a cure for angina before its more headline-friendly use was discovered, and Dimitriou agrees that modelling the likely impact of medical advancements on life expectancy is a difficult, if not impossible, task. “It is difficult to see someone come up with a Black-Scholes model that will predict the likelihood of finding a cure for cancer,” he says.
But this should not preclude the transference of longevity onto the capital markets.
“Regardless of whether longevity risk is diversified across a wide range of players, or if it simply sits on the balance sheet of the corporate that holds it, the probability of a tail-risk event is the same,” he says.
But does the longevity swap have to be the only option for pension schemes? Given that peak mortality risk has successfully been transferred to the capital markets in various issues, such as French insurer Axa’s $445 million Osiris bond and Scottish Re’s $155 million Tartan issue in addition to the previously mentioned Vita, why not reverse this and provide some form of peak insurance risk to pension funds?
For Swiss Re’s McKie, the issue is not whether this is possible, but if it is in the interests of pension funds. “Fundamentally, we can reverse-engineer Vita to protect against a longevity shock. But would this protect a pension plan from the type of risk it actually faces? A shock structure would only provide cover for events such as a cure for cancer, or a breakthrough in heart disease, where the impact is felt in a relatively short period of time.
“The real danger for pension plans is not a shock event, but that the scheme’s assumptions with respect to predicted increases in life expectancy end up being wrong. If the assumptions are out by 1%, it could add as much 5% on to a scheme’s liabilities.”
The structure of cat bonds may be unlikely to provide a template for longevity de-risking structures, but what of Blake’s assertion that it could ultimately end up in the investment portfolios of young workers providing a healthy return in addition to a generational risk transfer?
Gadd argues that the long-term nature of longevity investment means a retail product holds similar – if uncorrelated – characteristics to equities. Characteristics that could – in theory – make an attractive investment product.
“Anything is possible. If you get to the stage where an investment can be structured in a relatively simple form and it has a reasonable expected yield then in principle it can be packed up into an investment product. The challenge would be can it be made transparent enough for a retail investor.”
Box text - When is a swap not a swap?
Deutsche Bank made a point of describing its deal with BMW as longevity insurance, rather than a longevity swap, and indeed, all contracts that have been entered into so far by pension schemes have been insurance contracts. But because this structure looks very similar to a swap in terms of the cashflows being traded, the term longevity swap has gained acceptance.
For this article the term longevity swap is used to refer to both, but it is important for pension schemes to check that the actual contract is an insurance contract, not a derivative, to ensure
they get the protection of insurance reserving and capital framework and Financial Services Compensation Scheme Protection. An additional difference is that insurance contracts are
‘whole of life’, while derivatives contracts are often limited term.
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