Survivor Products: Managing longevity risk & mortality improvements Professor David Blake Director Pensions Institute Cass Business School email@example.com
The problem • Nothing is certain in life except death and taxes (B Franklin). • Over last 20 years, it has become clear that, while death is no less inevitable than before: • it is getting later • and its timing has become increasingly uncertain.
The problem • When British welfare state began in 1948, men could draw their state pension at 65 and expect to live until 67 and only a few lived beyond 70. • At beginning of 21st Century, British men can still draw their pension from age 65 but now live into their early 80s. • Significant proportion of women living into their late 80s.
What is longevity risk?(Broken limits to life expectancy – Oeppen & Vaupel)
Stochastic nature of mortality improvements • Evident for many years that mortality rates have been evolving in apparently stochastic fashion. • Sequences do exhibit general trend, but changes have an unpredictable element: • not only from one period to next • but also over the long run.
Longevity risk • Large number of products in life insurance and pensions have mortality as key source of risk. • Products exposed to unanticipated changes over time in mortality rates of relevant reference populations. • Eg annuity providers exposed to risk that mortality rates of pensioners will fall at faster rate than accounted for in pricing and reserving calculations: • Current pool of annuitants living 2 years longer than anticipated
Longevity risk • Annuities are commoditised products selling on basis of price, profit margins have to be kept low in order to gain market share. • If mortality assumption built into price of annuities turn out to be gross overestimate, cuts straight into profit margins of annuity providers. • Most life companies claim to lose money on annuity business.
Longevity risk • Yet life annuities are mainstay of pension plans throughout the world: • they are the only instrument ever devised capable of hedging longevity risk. • Without them, pension plans will be unable to perform their fundamental task of protecting retirees from outliving their resources for however long they live. • Real danger that they might disappear from financial scene.
Longevity risk • Equitable Life: • Embedded options in annuity contracts became very valuable in 1990's due to combination of falling interest rates and improvements in mortality. • Problems avoided if EL could hedge exposures to: • interest-rate risk • mortality improvement risk.
Longevity risk in UK pension provision, £billion of total liabilities- broad estimates: end 2003 Figure 5.17 p181
Significant concern! Reinsurers (eg Swiss Re) have stopped reinsuring longevity risk of life offices!
Survivor Products • Long-dated survivor bonds: • Life annuity bond: coupon payments decline in line with mortality index: • Eg based on population of 65-year olds on issue date. • As population cohort dies out, coupon payments decline, but continue in payment until the entire cohort dies. • Eg, if after one year 1.5% of population has died out, 2nd year’s coupon payment is 98.5% of 1st year’s etc
Survivor Products • Bond holder, eg life office writing annuities, protected from aggregate mortality risk it faces. • Based on Tontine Bonds issued by European governments in 17th and 18th centuries • Recently revived by Blake and Burrows (2001) and Lin and Cox (2004).
BNP Paribas Longevity Bond • November 2004 • Issuer: European Investment Bank (AAA) • Issue: £540m, 25 year • Mortality index: 65 year-old males from England & Wales (ONS) • Structurer/manager: BNP Paribas (assumes longevity risk) • Reinsurer of lengevity risk: PartnerRe, Bermuda • Investors: UK pension funds
Advantages of longevity bond • Provides better match for liabilities of pension funds and life insurers than other available investments: • other than purchasing (re)insurance to cover the longevity risk (i.e annuities) • Bond also provides long term interest rate hedge. • Longevity index transparent • EIB has AAA credit rating. • Life insurers holding longevity bond as hedge may be able to hold lower prudential margins.
Survivor Products • Short-dated, mortality-linked securities: • Market-traded securities whose payments are linked to mortality index • Similar to catastrophe bonds (Schmock, 1999, Lane, 2000, Wang, 2002, and Muermann, 2004)
Swiss Re Bond 2003 • Designed to securitise Swiss Re’s own holding of mortality risk! • 3-year contract (matures 1 Jan 2007) which allows issuer to reduce exposure to catastrophic mortality events: • severe outbreak of influenza • major terrorist attack (WMD) • natural catastrophe. • Mortality index (MI): • US (70%), UK (15%), France (7.5%), Italy (5%), Switzerland (2.5%). • Male (65%), Female (35%) • Also age bands
Influenza pandemics • All resulted from avian flu virus mutating with human flu virus • 11 outbreaks in 300 years • 1580 • First confirmed flu pandemic • 1782 • Summer Flu • Started in China • Hit young adults • 1889 • Russian Flu • Over 20% of world population infected • 1m deaths
Influenza pandemics • 1918-19 • Spanish Flu • Started in Kansas • Killed 50m people worldwide: • 250,000 in UK • More than died in WW1, in shorter period • 20% of world’s population infected and 1% killed • Spread along trade routes and shipping lines
Influenza pandemics • 1957-58 • Asian Flu • 2m deaths • Hit teenagers hardest • Spread around world in 6 months • 1968-69 • Hong Kong Flu • Started in China • 1m deaths • Spread slowly with moderate symptons
Influenza pandemics • 2005-06 • Started in SE Asia • H5N1 virus • Closely related to 1918 Spanish virus
Swiss Re Bond 2003 • $400m, principal at risk ‘if, during any single calendar year, combined mortality index exceeds 130% of baseline 2002 level’. • Principal exhausted if index exceeds 150% • Equivalent to a call option spread on the index with: • Lower strike price of 130% • Upper strike price of 150% • Investors get quarterly coupons of 3-mo USD Libor + 135bp
Swiss Re Bond 2003 • Bond valued using Extreme Value Theory (Beelders & Colarossi (2004)) • Assume Generalised Pareto Distribution • Probability of attachment: • P[MI(t)>1.3MI(2002)] = 0.33% • Probability of exhaustion: • P[MI(t)>1.5MI(2002)] = 0.15% • Expected loss = 22bp < 135bp • A good deal for investors! • Bond trading at Libor + 100bp in June 2004
Survivor Products • Survivor swaps: • Counterparties swap fixed series of payments in return for series of payments linked to number of survivors in given cohort: • UK annuity provider could swap cash flows based on UK mortality index for cash flows based on US mortality index from a US annuity provider counterparty • Would enable both counterparties to diversify their longevity risks internationally. • Dowd et al (2004)
Survivor Products • Annuity futures: • Prices linked to specified future market annuity rate • Mortality options: • Payout depends on underlying mortality table at payment date. • Eg, EL guaranteed annuity contract
Demand side of market • Reference population underlying calculation of mortality rates central to both: • Viability • Liquidity of contracts. • Hedging demand from investors (eg life offices) wishing to hedge mortality exposures. • If reference population v different from investor’s specific population, then investor will be exposed to significant basis risk: • Might conclude that mortality derivative is not worth holding.
Demand side of market • Speculative demand: • depends on liquidity. • Adequate liquidity will require small number of reference populations: • Need to be chosen carefully to ensure that level of basis risk is small for investors with hedging demands. • Demand from hedge funds: • seeking instruments that have low correlation with existing financial instruments
Supply side of market • Government: • Securitising social security budget • Corporates long longevity risk: • Pharamceuticals
Barriers to development in cash market • After more than year, BNP Paribas longevity bond had not generated sufficient demand to be launched: • Has been withdrawn for redesign • Suggests significant barriers need to be overcome before sustainable market in survivor products and derivatives emerges.
Barriers to development in cash market • Reasons why BNP bond did not launch: • design issues • which make bond an imperfect hedge for longevity risk • pricing issues • institutional issues
Design issues • Small scheme will find it difficult to use bond to match its liabilities: • as variance between actual and expected mortality will be quite large. • Mortality experience of individual pension funds and life insurers may be different from reference UK population. • Bond only provides hedge for longevity of males: • pension funds and life insurers also exposed to significant longevity risk from females.
Design issues • Liabilities for pension funds and life insurers give greater weight to the lives receiving larger pensions. • Further, significant differences in mortality of those receiving larger pensions compared to those receiving lower pensions. • As payments under bond effectively give equal weight to all the lives in the UK population, the already imperfect hedge provided by the longevity bond is worsened.
Design issues • Bond only matches cashflow under level pension • while large portion of pensions paid by pension funds and life insurers will be increasing at RPI/LPI. • Bond is progressively worse hedge for pension liabilities related to younger or older cohorts.
Pricing issues • Need to forecast mortality index MI’s • Need to estimate r’s • Correlation between MI and r: • Anticipated to be low
Pricing issues • Above model valid only in complete market • In incomplete market, need to convert projected deterministic mortality rates into risk-neutral probabilities • E.g using Wang transform • Lin & Cox (2005)
Pricing issues • Longevity risk premium built into initial price of bond set at 20 basis points. • Given that this is first ever bond brought to market, markets have no real feeling as to how fair this figure is. • However, concern that up-front capital was too large compared with risks being hedged by bond: • longevity and interest rate risks • leaving no capital for other risks to be hedged • e.g. inflation
Institutional issues • Issue size too small to create liquid market. • Consultants reluctant to recommend it to trustees. • Fund managers do not currently have mandate to manage longevity risk. • Fund managers have not welcomed bond: • since believe it would be closely held and they would not make money from it being traded. • Partner Re is unlikely to be perceived as being a natural holder of UK longevity risk.
Institutional issues • Last point highly significant • Reflects view that key determinant of future issue of longevity bonds is availability of sufficient reinsurance capacity. • Neither UK-based nor EU-based reinsurer willing to provide cover for BNP bond • Partner Re not prepared to offer cover above issue size of £540m. • Has been questioned whether EU’s solvency requirements render reinsurance cover within EU prohibitively expensive.
Barriers to development in futures market • Following factors key to success of particular futures contract: • defined as having consistently high volume of trade and open interest: • Must be large, active and liquid spot market for underlying with good price transparency: • by far the most important factor: • indeed no futures contract has ever survived without a spot market satisfying these conditions.
Barriers to development in futures market • Spot prices must be sufficiently volatile to create hedging needs and speculative interest. • Relative hedging demand can be measured by level of open interest relative to volume: • since former excludes the many speculators who do not hold overnight positions. • Low open interest to volume ratio is an indication of high liquidity : • another sign of successful futures contract.
Barriers to development in futures market • Underlying must be homogeneous and/or have well-defined grading system. • Market in underlying must not be heavily concentrated on either buy or sell side: • since this can lead to price manipulation. • Futures contract must be effective in reducing risk.
Barriers to development in futures market • Liquidity costs: • bid-ask spreads • execution risk: • risk of adverse price movements before trade execution • Liquidity costs in the futures contract must not be significantly higher than those operating in any existing cross-hedge futures contract.
Failure of futures contracts • CPI futures contract listed on US Coffee, Sugar and Cocoa Exchange in June 1985 • Delisted in April 1987 with only 10,000 contracts traded. • Reasons for failure: • no inflation-linked securities market at the time. • underlying was infrequently published index. • no stable pricing relationship with other instruments.