Built to Last
When it comes to longevity, don't forget duration.
January 27, 2011
In my last post I described the nature of increasing lifespans and how vary across age groups. This blog highlights some of the ways investors can access the market. There are a variety of ways to access the longevity and life markets. Generally, these include debt instruments, securitizations and derivatives.
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.