Key to the development of the longevity and life markets as a mainstream asset class is increased pricing transparency and regulation. Another important challenge is educating an uninformed investor as to the uses and strategies available in the realm of longevity structures.

By identifying and understanding the key determinants of asset value derived from a mark-to-model basis, managers have the confidence that market prices are a reasonable representation of security value. Increasingly longevity risk managers are improving their valuation methods and pricing uniformity. Underpinning the future growth of investment in the life markets as a stable, low-correlated investment opportunity is the future emergence of a uniform and transparent valuation methodology. Those asset advisors and managers that exhibit a fiduciary standard to investors aligned with the implicit fiduciary duty held by investors can offer a crucial source of asset knowledge and expertise based on the principles of transparency, consistency, and investor protection.

Greater state regulation is reinforcing the valuable utility presented by life markets to the individual. Further, growing federal recognition of the consumer utility of the secondary market, as illustrated by the Senate Bills of Oregon, Maine and Washington State, will also augment investor acceptance. Greater oversight of investment product creation by regulators will ensure that investors are aware of the relevant risks involved in longevity-linked instruments.

Longevity-linked instruments could have a profound effect on a broad range of economic factors. They may help advance annuity and pension programs in certain developing economies as well as reduce the potential for significant funding problems in the developed world. Without these tools taxpayers may be forced to bail out pensioners of bankrupt pensions and annuities. As there is currently insufficient reinsurance to deal with global longevity risk exposure, it is likely a robust market will evolve.

In this blog, I will explain some of the important issues for the market and steps being taken by regulators, service providers and investors to aid in its development.

Key to the development of the longevity and life markets as a mainstream asset class is increased pricing transparency and regulation. Another important challenge is educating an uninformed investor as to the uses and strategies available in the realm of longevity structures.

By identifying and understanding the key determinants of asset value derived from a mark-to-model basis, managers have the confidence that market prices are a reasonable representation of security value. Increasingly longevity risk managers are improving their valuation methods and pricing uniformity.

Underpinning the future growth of investment in the life markets as a stable, low-correlated investment opportunity is the future emergence of a uniform and transparent valuation methodology. Those asset advisors and managers that exhibit a fiduciary standard to investors aligned with the implicit fiduciary duty held by investors can offer a crucial source of asset knowledge and expertise based on the principles of transparency, consistency, and investor protection.

Greater state regulation is reinforcing the valuable utility presented by life markets to the individual. Further, growing federal recognition of the consumer utility of the secondary market, as illustrated by the Senate Bills of Oregon, Maine and Washington State, will also augment investor acceptance.

Greater oversight of investment product creation by regulators will ensure that investors are aware of the relevant risks involved in longevity-linked instruments.

Longevity-linked instruments could have a profound effect on a broad range of economic factors. They may help advance annuity and pension programs in certain developing economies as well as reduce the potential for significant funding problems in the developed world. Without these tools taxpayers may be forced to bail out pensioners of bankrupt pensions and annuities. As there is currently insufficient reinsurance to deal with global longevity risk exposure, it is likely a robust market will evolve.

There is more to longevity risk than simply the unexpected cost of a population or individual living longer than expected (on average). There is also its duration. As a bond manager will blend short and long term maturities in a portfolio to achieve a desired risk/return profile, a pension or annuity managers can do something similar by blending longevity duration. For instance, there is some concern by pension plan managers that taking on longevity risk externally, say through a life markets portfolio, is inappropriate because a pension portfolio already is exposed to longevity risk. However, pension longevity risk is measured in decades, whereas life markets strategies seldom move beyond ten years.  While the short term longevity risk position does not hedge, it does offer uncorrelated returns, and, because there is less volatility to short term longevity, the nature of this risk is completely different.

An alternative view to the perception that investment in the life markets would exacerbate their already pronounced longevity extension risk would suggest that such investment offers an opportunity to generate stable returns with minimal correlation to the business cycle. Also, any longevity risk of life settlements involves the careful medical- and risk-assessed mortality of US seniors, a distinctly different cohort of lives from those within UK pension funds.

Longevity/mortality risk exists due to uncertainties surrounding life expectancy trends. Large divergences can have severe effects on the profitability of insurers, pension plans, life settlement portfolios, reverse mortgage portfolios, long-term care providers, and any other entity that has exposure to longevity/mortality risk.

Two important debt instruments include longevity bonds and mortality bonds.  Longevity bonds offer no return of principal and have coupon payments that decline in line with a mortality index; mortality bonds have payments linked to a mortality index which increase with mortality experience (hedges “brevity” risk).

Securitization involves the repackaging of a pool of assets or stream of cash flows and selling the resulting securities in the capital markets while the securities are backed by the pool. This allows entities to raise capital, reduce their cost of funds, reduce asset-liability mismatches, lock in profits and transfer risks to the capital markets. Investors in these securitizations benefit by adding diversification and potential enhanced return to their portfolios. Some examples of securitizations include:

• Block of Business – capitalization of expected future profits from a block of business, recovery of imbedded values or an exit from a geographical line of business
• Regulatory Reserving (XXX & AXXX) – arrangements designed to give U.S. life insurance companies relief from stringent reserving requirements and are used to release capital that can be used to finance new business or reduce the cost of capital
• Life Settlement – life insurance policies sold for more than their surrender value but less than their face value
• Annuity Book – the packaging and selling of an insurer’s annuity business
• Reverse Mortgage – mechanism to allow homeowners to borrow from the equity in their homes while still living in them

The two primary types of derivatives are mortality and longevity swaps and forwards. In a swap, the counterparties swap a fixed series of payments in return for payments linked to the mortality of a given population at a pre-specified point. A mortality swap is based on the numbers in the cohort who die by a given year and a longevity swap on the numbers who survive. The forwards involve the exchange of a realized mortality rate relating to a specified population, or cohort, on the maturity of the contract in return for a fixed mortality rate agreed at the beginning of the contract. As yet, there are no standardized futures and options on longevity and life markets but with the development of a swap market these are likely to follow in the future.

In the next post, I’ll describe some of the big picture factors that are at play in this developing market.

There is more to longevity risk than simply the unexpected cost of a population or individual living longer than expected (on average). There is also its duration. As a bond manager will blend short and long term maturities in a portfolio to achieve a desired risk/return profile, a pension or annuity managers can do something similar by blending longevity duration. For instance, there is some concern by pension plan managers that taking on longevity risk externally, say through a life markets portfolio, is inappropriate because a pension portfolio already is exposed to longevity risk. However, pension longevity risk is measured in decades, whereas life markets strategies seldom move beyond ten years. While the short term longevity risk position does not hedge, it does offer uncorrelated returns, and, because there is less volatility to short term longevity, the nature of this risk is completely different.

An alternative view to the perception that investment in the life markets would exacerbate their already pronounced longevity extension risk would suggest that such investment offers an opportunity to generate stable returns with minimal correlation to the business cycle. Also, any longevity risk of life settlements involves the careful medical- and risk-assessed mortality of US seniors, a distinctly different cohort of lives from those within UK pension funds.

Longevity/mortality risk exists due to uncertainties surrounding life expectancy trends. Large divergences can have severe effects on the profitability of insurers, pension plans, life settlement portfolios, reverse mortgage portfolios, long-term care providers, and any other entity that has exposure to longevity/mortality risk.

Two important debt instruments include longevity bonds and mortality bonds. Longevity bonds offer no return of principal and have coupon payments that decline in line with a mortality index; mortality bonds have payments linked to a mortality index which increase with mortality experience (hedges “brevity” risk).

Securitization involves the repackaging of a pool of assets or stream of cash flows and selling the resulting securities in the capital markets while the securities are backed by the pool. This allows entities to raise capital, reduce their cost of funds, reduce asset-liability mismatches, lock in profits and transfer risks to the capital markets. Investors in these securitizations benefit by adding diversification and potential enhanced return to their portfolios. Some examples of securitizations include:

• Block of Business – capitalization of expected future profits from a block of business, recovery of imbedded values or an exit from a geographical line of business
• Regulatory Reserving (XXX & AXXX) – arrangements designed to give U.S. life insurance companies relief from stringent reserving requirements and are used to release capital that can be used to finance new business or reduce the cost of capital
• Life Settlement – life insurance policies sold for more than their surrender value but less than their face value
• Annuity Book – the packaging and selling of an insurer’s annuity business
• Reverse Mortgage – mechanism to allow homeowners to borrow from the equity in their homes while still living in them

The two primary types of derivatives are mortality and longevity swaps and forwards.  In a swap, the counterparties swap a fixed series of payments in return for payments linked to the mortality of a given population at a pre-specified point. A mortality swap is based on the numbers in the cohort who die by a given year and a longevity swap on the numbers who survive. The forwards involve the exchange of a realized mortality rate relating to a specified population, or cohort, on the maturity of the contract in return for a fixed mortality rate agreed at the beginning of the contract. As yet, there are no standardized futures and options on longevity and life markets but with the development of a swap market these are likely to follow in the future.

In the next post, I’ll describe some of the big picture factors that are at play in this developing market.

Since 1900, according to the (U.S.) National Vital Statistics System, life expectancy at birth rose from 49 to 77 years.  Over the same period, life expectancy at age 65 rose from 77 to 83 years and at age 85 from 89 to approximately 91 years.  Developed economies expect to see an average increase in life expectancy at age 65 of approximately one year for each decade in the future. At the current level this implies that an individual turning 65 now will have to accumulate sufficient capital to fund retirement for 18 years on average.  The bulk of longevity expansion occurred at the younger ages over the last century.

For investors with very long horizons, like pension plans and annuities, the longevity risk exposure is riskier because long term estimates of longevity and mortality are much harder to make.  As well, being able to account multiple decades in the future for cash flow patterns and capital market factors like interest rates and expected long run asset returns is impossible exacerbating the situation.  Cash flow matching and liability driven investing strategies have become popular mechanisms to manage these capital market risks but the longevity side has remained largely untapped.

There are a number of methods to minimize longevity risk that these “macro-scale” investors can pursue.  Purchasing longevity insurance would be the most obvious. However, this method may be costly and would be dependent on several variables, including counter-party risk.  My next blog post will discuss some of the instruments used in the longevity and life markets.

By providing financial protection against the major 18th and 19th century risk of dying too soon, life insurance became the biggest financial industry of that century…  Providing financial protection against the new risk of not dying soon enough may well become the next century’s major and most profitable financial industry. [1]

Since the onset of the liquidity squeeze in 2007, adverse market experience in the traditional asset classes of equities, fixed income and real estate has had a number of impacts on the fortunes of investors. The re-emergence of increasing correlations across major global asset classes (yet again) has encouraged the exploration of alternatives such as infrastructure, private equity and hedge fund strategies as managers seek to diversify and explore new sources of return.  In this search, longevity assets have appeared on the capital markets landscape and offer significant potential for the future providing both risk mitigation and a source of enhanced return.

Aside from excessive capital market volatility, longevity risk has created problems for pension plans and annuity providers especially. The aging global population is seeing the number of people nearing retirement explode. This growth increases the risk of underestimating mortality improvements.  According to the Pension Protection Fund, each additional year of life expectancy at age 65 increases the present value of pension liabilities by approximately 3%.

In the current environment of historically low yields and increasing investment horizons, individuals are looking to alternate sources of cash to fund retirement including like reverse mortgages, life settlements and annuities. Pension sponsors, facing massive funding deficits have turned, in some cases, to risky and/or illiquid strategies such as private equity and infrastructure investing. More recently, they have seen methods to hedge their long term longevity risk through buyouts and swaps.

The following blog entries will elaborate on these issues and provide some background as to how to participate in the longevity and life markets.

[1] Drucker, Peter: The Economist “Innovate or die”, September 25, 1999