Canadian Investment Review

Can the Longevity Levee Be Breached?

Written by Scot Blythe on Tuesday, January 25th, 2011 at 9:46 am

aground boatInsurance markets are interesting, for two reasons. On the one hand, they are the ultimate risk arena, with legions of actuaries and underwriters evaluating and pricing risk so it can be laid off to another party. On they other hand, they are incomplete. Some risks get priced and securitized; others don’t.

This latter is particularly a problem for retail investors, who might want to buy an annuity that includes partial cash-out options for, say, a medical emergency. While it’s a real need, it requires a great deal of tailoring  to create a pool of potential annuitants that is large enough.

However, incompleteness affects even large pools of potential annuitants – namely members of pension plans. With imperfect information as to the match between a pension plan’s member mortality profile and that of the general population, plan sponsors are more or less whistling past the graveyard. More perfect information, or at least better risk pricing, requires more transparent markets with more participants. Price discovery, in other words.

Certainly, in Europe, there is a longevity market. But it’s not really a market where the owners of longevity risk – namely pension funds – can hedge it. Instead, they sell it, through over-the-counter swaps. Then they face counterparty risk, not something to look askance at, given the failure of Lehman Brothers, which fouled up operations for many hedge funds, but also led to a capital loss for retail investors who bought structured notes based on the bank’s (now-defunct) capacity to pay.

In a bid, of a kind, for transparency, and certainly one to increase capital market participation. Swiss Re has issued a longevity trend bond. It’s modelled on a catastrophe bond, i.e., it pays steady interest to the bondholder unless the levee, inspected, shored up and possibly re-engineered, breaks – as would happen with a hurricane or some other force majeure.

So far the levees are somewhat crude. Says Swiss Re: “This transaction marks an innovative transfer of longevity trend risk to the capital markets. Kortis Capital Ltd. provides cover to Swiss Re against a divergence in mortality improvements experienced between two selected populations. The bond is based on population data and would trigger in the event there is a large divergence in the mortality improvements experienced between male lives aged 75-85 in England & Wales and male lives aged 55-65 in the US. The single tranche Series 2010-I Class E Notes are rated BB+ (sf) by Standard & Poor’s.”

Kortis Capital Ltd. is a special purpose vehicle domiciled in the Cayman Islands.

“Noteholders who invest in this transaction will be bearing the risk of an increase in the ‘difference between the annualized mortality improvement in a U.K. age group and the annualized mortality improvement in a U.S. age group, over eight years of mortality improvements from Jan. 1, 2009, to Dec. 31, 2016.’ The two geographical age-groups are U.S. males age 55 to 65 and UK males age 75 to 85,” says the Artemis blog site, which tracks alternative risk transfer vehicles in the capital markets.

In this instance, Swiss Re is laying off its risks through a $50 million offering.

“The trigger is defined at the start of the transaction and based on the eight year total risk period for the deal. Probability of loss and magnitude of loss depend on how large the divergence in mortality improvements is between the geographical age-groups and how much it exceeds the set attachment point.”

Simply said, if the longevity profiles diverge significantly, the noteholders will face a capital loss.

At $50 million, it’s hardly a drop in the swelling bucket of longevity risk. But let a few more drops rain in …

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