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Longevity: A New Asset Class

Longevity: A New Asset Class. Professor David Blake Director Pensions Institute Cass Business School d.blake@city.ac.uk March 2018. Agenda. Longevity: A new class of asset Longevity risk: The key risk to quantify The birth of a new capital market: The Life Market

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Longevity: A New Asset Class

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  1. Longevity: A New Asset Class Professor David Blake Director Pensions Institute Cass Business School d.blake@city.ac.uk March 2018

  2. Agenda • Longevity: A new class of asset • Longevity risk: The key risk to quantify • The birth of a new capital market: The Life Market • Successful insurance-based solutions • Successful capital markets solutions • Re-insurance sidecars: Introducing new investors • A role for government? • Longevity assets in a diversified portfolio • Conclusion

  3. Longevity: A new class of asset

  4. Longevity: A new class of asset • New global capital market is emerging that trades longevity-linked assets and liabilities • Longevity-linked assets are to a first-order uncorrelated with financial assets • eg equities and bonds

  5. But really how new? • Tontine Bonds issued by European governments in 17th and 18th Centuries • Secondary market in life insurance policies began in mid-19th Century: • In 1844, Foster & Cranfield auctioned an endowment life insurance policy in UK

  6. Longevity risk:The key risk to quantify

  7. What is longevity risk? • We systematically underestimate how long people are going to live: • Longevity is a slowly-developing trend risk • Danger of: • Individuals outliving their savings • Pension plans must provide retirement income security for however long people live: • Plan sponsors risk having to divert resources away from dividend and investment programmes • Annuity providers inadequately reserving

  8. Decomposition of longevity risk Total longevity risk = Systematic longevity risk [Trend risk] + Specific longevity risk [Idiosyncratic and modelling risks]

  9. Getting the trend right(Broken limits to life expectancy – Oeppen & Vaupel)

  10. Variability in life expectancy Expected distribution of deaths: male 65 Expected distribution of deaths: male 85 Most likely ageat death = 86 Most likely ageat death = 90 Life expectancy = 86.6 10 5 Life expectancy = 91.6 9 8 4 7 6 3 % deaths at each age % deaths at each age 1 in 3 will reach 93 and 5% will reach 100 5 25% 4 2 25% 3 Idiosyncratic risk 1 2 Random Variation Risk Random Variation Risk Idiosyncratic risk 1 0 0 65 70 75 80 85 90 95 100 105 110 85 90 95 100 105 Age Age 1 in 1000 chance of living twice life expectancy at age 65 1 in 10 chance of living twice life expectancy at age 85 Source: 100% PNMA00 medium cohort 2007

  11. The future • Will longevity continue to improve? • Recent improvements have been underestimated • Mortality now recognised as being a stochastic process

  12. Alternative expert views • ‘Pessimists’ suggest that life expectancy might level off or decline (Olshansky) • Impact of obesity, poor diet, global warming etc. • ‘Optimists’ suggest no natural limit to human life (Vaupel et alia) • Supported by extrapolative methods • Future scientific advances?

  13. Poor accuracy of official projections:Actual and projected period life expectancy at birth, UK males, 1966-2031 Source: Office for National Statistics (2007)

  14. Stochastic nature of mortality improvements • Mortality clearly declining • But declines are volatile

  15. The birth of a new capital market:The Life Market

  16. Stakeholders in bearing longevity risk • Individuals • Company pension funds • Annuity providers: • Insurance companies • Government: • Public pension systems • Insurer of last resort • Investors in longevity-linked products

  17. Range of responses • Accept longevity risk as legitimate business risk • Only makes sense if earn suitable longevity risk premium • Share longevity risk, e.g.: • Participating annuities with survival credits • Conditional indexation • Caps • Reinsurance: • Buy-outs and buy-ins • Manage risk with longevity-linked products • Securitisation Life Market

  18. Supply and demand in the longevity market

  19. Demand-side segmentation:Equity in insurers vs pure longevity Both forms of capital provision are occurring

  20. Supply side of market • Potential long-term investors: • ILS investors • Hedge funds • Endowments • Seeking instruments that have low correlation with existing financial instruments • Institutions naturally long longevity: • Pharmaceuticals • Long-term care homes • Life insurers • Could consider selling longevity protection • Government: • Providing longevity protection for private sector?

  21. Quantifying the potential size of the longevity risk market • Potential size of the global longevity risk market for (state and private sector) pension liabilities at between $60trn and $80trn • Main countries (private sector): • US ($14.460trn) • UK ($2.685trn) • Australia ($1.639trn) • Canada ($1.298trn) • Holland ($1.282trn) • Japan ($1.221trn) • Switzerland ($0.788trn)

  22. Market requirements

  23. Market requirements • Understanding causal factors underlying longevity • Quantifying longevity risk using mortality forecasting models

  24. Causal factors underlying longevity • Gender • Geographical location • Social class • Income/wealth • Year of birth (cohort)

  25. Life expectancy at age 65 in the UK

  26. Male life expectancy at birth: by local authority, 2004-6

  27. Social class Source: Longitudinal Study, Office for National Statistics

  28. Income/wealth Modelling Socio-Economic Differences in the Mortality of Danish Males Using a New Affluence Index - Andrew J.G. Cairns, Malene Kallestrup-Lamb, Carsten P.T. Rosenskjold, David Blake and Kevin Dowd

  29. Cohort effect:1930 cohort

  30. Longevity volatility is driven by three underlying risks … Outcome Probability, % Modelling Risk: Risk that A Expected Alternative probability distribution is incorrectly Outcome Outcome modelled due to a limited data set. A Modelling Risk Trend Risk: Risk that large B unanticipated changes in socio - economic environment or health care significantly improve longevity. B Trend Risk C Idiosyncratic Risk: Risk C Idiosyncratic Risk that mortality rates still vary from the expected outcome as a result of random chance. Life Expectancy Longevity risk is driven by three underlying risks Modelling Risk and Idiosyncratic (Random Variation) Risk are greater the smaller the number of scheme members and the greater the distribution of scheme benefits.

  31. Mortality forecasting models • ‘Process-based’ models • Model process of dying or mortality improvement • E.g., Risk Management Solutions (RMS) Longevity Risk Model uses ‘vitagion categories’ or individual sources of mortality improvement: • lifestyle trends including smoking prevalence • health environment • medical intervention • regenerative medicine, such as stem cell research, gene therapy and nanomedicine • retardation of ageing, including telomere shortening and caloric restriction

  32. Mortality forecasting models • ‘Causal’ or ‘explanatory’ models • Model causes of death using exogenous explanatory variables • e.g. macro-economic variables or socio-economic indicators • ‘Extrapolative’ projection models • Purely data-driven • Will only be reliable if the past trends continue: • medical advances can invalidate extrapolative projections by changing the trend

  33. Main extrapolative models • Lee-Carter model: • No smoothness across ages or years • P-spline model: • Smoothness across years and ages • Cairns-Blake-Dowd (CBD) model: • Smoothness across ages in same year

  34. Longevity fan chart for 65-year old male(CBD model)

  35. Survivor fan chart for 65-year old male (CBD model) Age 75 Shows where longevity risk is concentrated Age 90 0.995 Note: Derived from the Cairns-Blake-Dowd stochastic mortality model, estimated on English and Welsh male mortality data for 65 year olds over the period 1991-2006 0.95 90% confidence 99% confidence Expected income value 0.05 0.005 30

  36. Successful insurance-based solutions

  37. Successful insurance-based solutions • Classified as ‘customized indemnification solutions’ • since the insurer fully indemnifies the hedger against its specific risk exposure • These solutions can also be thought of as ‘at-the-money’ hedges • since the hedge provider is responsible for any increase in the liability above the current best estimate assumption on a pound-for-pound basis • Buy-out • Buy-in • Longevity insurance contract / insurance-based longevity swap

  38. Successful capital markets solutions

  39. Successful capital markets solutions • Small number of capital market securities have been successfully launched since 2006: • longevity-spread bond • longevity swap • q-forward • tail-risk protection (or longevity bull call spreads) • Key feature of these is that most are index rather than customized solutions

  40. Swiss Re Kortis Bond • Longevity-spread bond, December 2010 • Issuer: Swiss Re • Issue: $50m, 8 years • Purpose: to hedge Swiss Re's own exposure to longevity risk • Bond holders: exposed to risk of increase in spread between annualized mortality improvements in English & Welsh males aged 75-85 v US males aged 55-65

  41. Swiss Re – Friends’ Provident Longevity swap • World’s first publicly announced swap in April 2007 • a pure longevity risk transfer • but insurance contract not capital market instrument • Friends Provident’s £1.7bn book of 78,000 of pension annuity contracts written between July 2001 – December 2006 • Swiss Re makes payments and assumes longevity risk • in exchange for undisclosed premium

  42. JPMorgan – Canada Life longevity swap • World’s first capital market longevity swap in July 2008 • Canada Life hedged £500m of its annuity book: • 125,000 lives • 40-year swap customized to insurer’s longevity exposure • Longevity risk fully transferred to investors: • Hedge funds and ILS funds • JPM acts as intermediary and assumes counter-party credit risk

  43. realized mortality rate q-forward or mortality forward Pension Hedge Plan Provider Amount fixed mortality rate The first capital markets transaction involving a q-forward took place in January 2008 between buy-out company Lucida and J.P. Morgan

  44. Tail-risk protection (or longevity bull call spread) • Five publicly announced deals involving tail risk protection: • Aegon with Deutsche Bank in 2012 • Aegon with Société Générale in 2013 • Delta Lloyd with RGA Re in 2014 and 2015 • NN Life with Hannover Re in 2017 • Deep ‘out-of-the-money’ hedge

  45. Distribution of Final Index Value and Potential for Capital Reduction Michaelson and Mulholland (2015, Exhibit 3)

  46. Bull call spread payoff to hedger Exhaustion point

  47. Cumulative Pension Risk Transfers by Product and Country, 2007-16 $17bn Canada All Transactions $88bn UK Longevity Swaps $102bn UK Buy-outs and Buy-ins $79bn US All Transactions

  48. Re-insurance sidecars:Introducing new investors

  49. Sidecar structure RGA Re and RenaissanceRe set up Langhorne Re in 2018 to target in-force life and annuity business with pension funds and other life companies as third-party sidecar investors

  50. A role for government?

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