Research shows path to de-risking longevity

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29/01/2018

ACADEMIA | Longevity risk has become a serious concern for insurers, pension plan sponsors and governments in terms of ongoing mortality improvement and population ageing.

A recently proposed idea in the UK and Europe is to use index-based capital market solutions, such as longevity bonds, longevity swaps and other mortality derivatives, to hedge longevity risk.

The key feature of these index-based securities is that their cash flows are linked to a selected reference or index population, instead of being customised to the population underlying the portfolio being hedged.

A notable example is the €12 billion longevity swap offered by Deutsche Bank to Dutch insurer Aegon in 2012, in which the index was set as the Dutch population, and the entire trade was targeted specifically at capital market investors.

On the demand side, index-based mortality, or longevity-linked, securities have great potential in providing effective risk management at lower costs and capital savings.

With more ability to reduce longevity risk, and therefore the capital requirements, insurers can provide better and more affordable retirement products that would be greatly beneficial to the general public.

On the supply side, market investors may take on longevity risk from insurers and pension plans in exchange for appropriate risk-adjusted returns.

Some investors may diversify their portfolios over a new market sector based on longevity, which is arguably uncorrelated with conventional asset classes. Those financial institutions having life insurance on their books may also accept longevity exposures to offset their own risks.

Despite these promising aspects, there is some mismatch between the hedging instrument and the portfolio to be hedged.

First, there are certain demographic differences between the hedging instrument and the portfolio.

Second, a small portfolio often has a high sampling variability, making its experience more likely to deviate from that of the reference population. Moreover, the pay-off amounts and timing are usually different between the two sides.

These discrepancies give rise to longevity basis risk, which has drawn attention from both practitioners and academics in recent years. This is perceived to be one major reason underlying the rather sluggish growth of the index-based market.

To address this issue, the Institute and Faculty of Actuaries (IFoA) and the Life & Longevity Markets Association (LLMA) have jointly sponsored a research project on assessing basis risk for longevity transactions.

The first phase of the research project was a practical guide for how to select a suitable mortality model. It was completed by Cass Business School and Hymans Robertson LLP in 2014.

The second phase focuses on measuring longevity basis risk in realistic scenarios under practical circumstances. This research project, titled “Assessing basic risk for longevity transactions” was completed by Macquarie University in 2017.

The key findings in this research are that about 50 per cent to 80 per cent of longevity risk can be reduced via index-based hedging for a large portfolio, whereas the risk reduction is usually less than 50 per cent for a small portfolio. (These findings came from applying the mortality models in the first phase of the research project, and using UK and Australian industry datasets.)

The precise level of risk reduction depends on the particular hedging scenario under consideration.

An extensive sensitivity analysis on the hedging results has also been conducted, by changing the initial model settings and assumptions.

The “Assessing basic risk for longevity transactions” research reflects the huge potential in what the longevity risk transfer market can finally offer.

The longevity de-risking market will have every opportunity to flourish when global economic conditions improve, hedging instruments become more widely affordable, financial institutions offer more innovative products, and pension plans sponsors and capital market investors have a better understanding of longevity risk transfer.

Jackie Li is an associate professor in Macquarie University’s business and economics faculty in the Department of Applied Finance and Actuarial Studies. A copy of the research report mentioned in this article can be downloaded here.

 

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