An age-old problem. Longevity roundtable. 16 July/August 2011 Reactions

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1 An age-old problem Reactions in association with Scor held a roundtable in Paris to discuss the growing issue of longevity and what the industry should be doing now in response. Hugh Fasken, Reactions: Why is longevity risk getting increasing attention? Daria Kachakhidze, Scor: There are several reasons this is a very interesting question. First is the demographic change that developed countries are facing today and that developing countries will face in a few years. We all know that the age pyramid has completely changed its form. It doesn t look like a pyramid any more: the society is aging, there are fewer children and longevity is increasing constantly. This leads to a smaller proportion of the working age population today compared to what we used to have in the past. The dependency ratio, which is the ratio of people aged over 65 to the working-age population between 18 and 65, is increasing and is projected to double by This is a very important phenomenon and a strain on the social security system, which is mostly based on the pay-as-you-go system. So this is going to strengthen the demand for establishing or developing private pension solutions. The second reason is the longevity risk that is increasing. Life expectancy in the world has been increasing linearly since the 1840s nearly by two-and-a-half years per decade. That is a very strong increase. In the past 30 years most of it was due to the mortality decline at ages above 60. Thirdly, the interest rate environment has changed lately. If in the past it was possible to compensate the longevity risk by higher financial return, it has become much harder to do so in the recent years and especially after the financial crisis. The last point is the change in the regulation, especially the approach of Solvency II or IFRS. This regulation is helping to increase the awareness of the longevity risk. Risk transfer will lead to significant capital relief, in particular a risk transfer with a well-rated and well diversified reinsurer. More generally, Solvency II leads to better transparency of risk management and therefore it will have a positive impact on the development of other longevity risk transfer solutions, whether through reinsurers or through the capital markets. The transfer of the excess risk would help to balance portfolios and thus to benefit from the optimal diversification and smaller capital charge. Chris Madsen, Aegon: But is longevity risk actually increasing? Or is it just the perception of the risk that s increasing? Daria Kachakhidze, Scor: Actually, both. The steady trend since 1840s I was talking about was on the life expectancy at birth. We are here more to talk about the residual life expectancy of people at the retirement age and this has been rising much faster in the most recent years. Mortality rates are decreasing at a higher and higher rate just now. So the longevity of people over 60 has been increasing a lot recently. Chris Madsen, Aegon: It depends on how you quantify risk, of course. Most of us would agree that virtually every actuarial table in the past 40 years has missed the trend that we ve seen. It seems that there was an implicit assumption made that the trend in 16 July/August 2011 Reactions fact would not continue. But a trend for longevity improvement has actually been in place for over a century. If you look at any other industry, where else do you have something in place for 100 years and then assume that it will probably change in a couple of years and flatten off? This seems to be the implicit assumption that has been made, and that s interesting. I wonder if it isn t the fact that we are just adjusting those assumptions so the new actuarial tables, and the market for that matter, is more in line with historical evidence and that is in fact the change rather than the risk increasing? James Vaupel, Max Planck Institute for Demographic Research: I think both points are very well taken. Daria s point that not only life expectancy at birth but life expectancy at 65 is now increasing and has been particularly increasing since 1970 is a relatively new development. But there was also an extremely deep-seated belief that life expectancy was close to a looming limit. This belief was almost universally accepted by actuaries, by demographers, by gerontologists and others, and this belief was almost universally accepted despite the absence of any evidence. That is truly remarkable collective blindness. There s been a whole series of ultimate limits to life expectancy that have been published and each of these limits has been exceeded within a few years. The first limit was in the early 1920s by Louis Dublin, who was chief actuary of the Metropolitan Life Insurance Company in New York. He said life expectancy would never exceed 62 never, ever exceed 62! It s amazing. In the year he published his example life expectancy in New Zealand was 62-anda-half, so even when he published the ultimate limit he was wrong. There s been a whole series of limits that have been published that have been exceeded, and we now know that there s no empirical evidence for a looming limit and there s no biological evolutionary theory for why there should be a looming limit. There may be some limit some place but there s no evidence that we re close to any such limit. That has led the profession to be more worried about what s going to happen if life expectancy keeps on going up. Life expectancy at birth has been going up by about two-and-ahalf years per decade since That s three months per year or six hours per day. So if it s two-and-a-half years per decade then in a century it s 25 years longer. If life expectancy today is 85, then in a century it might be 110. The most judicious way to think about it is that there s no evidence of a looming limit in the foreseeable future. It looks as if life expectancy will probably continue to rise in the foreseeable future. It may be the case that most new-born children in Europe today will celebrate their 100th birthdays 100 years from now. Andreas Muschik, Scor: It s not only longevity itself. If you compare the graphs of the life expectancy in various European countries they are more or less parallel, but then in addition the demographics are changing. For example, in Germany nowadays 70% of households are one person or two person households. I d guess 70 or 80 years ago it was more than five persons in one

2 Participants (left to right): Jean-Marie Nessi, founding partner, Nessi Consulting Daria Kachakhidze, head R&D longevity-mortality, Scor Global Life Andreas Muschik,managing director, Scor Global Life Deutschland Dan Knipe, life portfolio manager, Leadenhall Capital Partners Dr James Vaupel, founding director, Max Planck Institute for Demographic Research Chris Madsen, head of risk structuring and transfer at Aegon Moderator (not pictured): Hugh Fasken, Reactions household, so you would still have a social environment that everyone has a lot of kids and you shouldn t worry about longevity because there are enough people looking after you. This is the change that makes longevity more a risk that we have to talk about than it was in the past. Chris Madsen, Aegon: The dependency ratio is much more of a funding issue brought to the forefront since many public schemes are unfunded pay-as-you-go schemes. Pay-as-you-go is a bad funding policy, but it doesn t actually have anything to do with the underlying risk per se. It just means that we feel the pain a lot more if we look at society as a whole. Clearly this fact amplifies the point but not really because the trend risk is increasing. Dan Knipe, Leadenhall: Fundamentally, for insurers particularly, it s the financial impact of longevity that s the worry. If you go back 10 years, the fact that people would live an extra year in 25 years time really had no financial impact because it was so far in the future that once it was discounted the financial liability was negligible. The problem we face today, as Daria rightly said, is that with interest rates being so low and with the fact that we ve rolled on 10 years most of those liabilities have a higher financial impact because they are much less distant and are discounted at lower rates. For me, the question is whether our concern about longevity reduces again if we move to a higher interest rate environment as the financial impact of differences in life expectancy becomes small again. Chris Madsen, Aegon: That s a really good point. If you look at pension plans today they are in a perfect storm. They re getting hit from all sides and that is definitely one of the reasons that it s a key topic at the moment. Jean-Marie Nessi, Nessi Consulting: We all refer to the life expectancy, at birth or at 65, of the whole population. But my question is: are we concerned by the same population in terms of insurance and what is the evolution of the longevity of the insured population? Is it more or is it less than the general population? There are countries where it s very difficult to know. France is an example, because all the information is known by the social security but it s not really shared. We were referring to the dependency ratio but when we talk of dependency annuities we are running after information because we have no tables of probability of where you fall in dependency. So as long as we talk of annuities the problem is whether we have access to reliable information allowing us to work with a table, allowing us to price adequately the products of life or pensions. Is there a big gap between the insured or the beneficiary of annuities, life expectancy and overall population? Daria Kachakhidze, Scor: It is a very interesting point and unfortunately I haven t seen any data set for the insured population big enough to allow the performance of a proper analysis of the difference in the improvements Reactions July/August

3 The insurance industry has come to realise that there s not a looming limit to life expectancy. There is likely to be continued increases, but many of the forecasts that I see are still to my mind conservative. Dr James Vaupel, founding director, Max Planck Institute for Demographic Research in these two populations. But my point of view would be that we could probably use the comparative analysis between different countries and translate it into our view on different subpopulations of a given country. The insured population would definitely benefit first from the advances in medical research, which is just to say that there is a difference between social classes and not everybody, unfortunately, is getting the best treatment at the same time. There are countries that make advances faster than others. A lot depends on the social policy of a country and on the degree of social class heterogeneity: I have seen studies that say that the countries that have lower social class differences make advances in mortality decrease faster than the others. James Vaupel, Max Planck Institute for Demographic Research: The frontier of life expectancy seems to be going up at two-and-a-half years per decade at birth, and about two years per decade at age 65. The countries that are the world s leaders in life expectancy currently Japan but previously Sweden and The Netherlands and other egalitarian societies are the countries with the least life span disparity, the smallest differences among people in when they die. The reason is that the best-off part of the population is increasing its life expectancy by about two-and-a-half year per decade and the people who are less well educated and have less income are lagging behind. If there s a lot of people lagging behind then life expectancy can t go up so much because you have all these people who are not doing as well. The countries that are doing best are the countries with the least life span disparity. That suggests that, as Daria said, by looking at the countries that are doing best you might get an idea of what the insured population s life expectancy in the future could be. There have been careful studies by demographers where we have put ourselves back in time, we ve pretended for example it s 1960 and we want to project what s going to be true in 2010, and we ve used different methods and tried to see which method works best. You put yourself back in 1960 and read what the experts were saying in 1960 and project the historical trends. The experts do much worse than the historical trends. It s very, very difficult to know what s going to happen in the future, to predict the changes that are going to happen. The record of the past includes all sorts of breakthroughs and all sorts of events that have happened. The epidemic of cigarette smoking provides some precedent for this. Chris Madsen, Aegon: I would second that. The thing is we don t know what s going to be driving mortality 20, 30, 40 years from now but we can be absolutely sure that whatever is driving mortality at that point in time somebody will be focused on solving that problem. So I liken this to Moore s law in information technology. We cannot foresee what will continue to drive the rate of improvement, but there is no particular reason to expect it to stop. Over the long term, whatever is driving mortality will 18 July/August 2011 Reactions be the primary focus of pharmaceutical companies and various social studies and this will continue to lead to a continuation of mortality rate improvement even if current technology would suggest that there is a finite limit to growth. In reality, I think we at least have to acknowledge the possibility that there may not be a finite limit to life expectancy. Hugh Fasken: How well has the insurance and the financial community dealt with this issue of increasing longevity? James Vaupel, Max Planck Institute for Demographic Research: The insurance industry has come to realise that there s not a looming limit to life expectancy. There is likely to be continued increases, but many of the forecasts that I see are still to my mind conservative. These forecasts don t take into account the longterm trends adequately and these forecasts implicitly assume some slowing down of improvements in the future. Again, I think this is a legacy of this very long tradition that it s going to be impossible to do much better than we re doing now and therefore progress has to slow down in the future. The situation has improved but there s still a bias towards somewhat conservative estimates of future life expectancy. What has to be taken into account is the range of uncertainty about the future, not just simply what the best guess forecast is but how much higher it could be and how much lower it could be than that best guess. That s really what you need to figure out what the risk is, some notion of the uncertainty around your forecast. To my mind there s been much too little research done on trying to estimate the range of uncertainty about future mortality trends. Given the enormous amount of money that s at stake in terms of annuities, pension plans and so on, the amount of money being spent on systematic research to try to estimate what the range of uncertainty is miniscule. I don t think we need more data but we need more analysis of the existing data. Hugh Fasken: If life expectancy is expected to continue, both in developing and developed economies, will longevity transfers become much more commonplace? Dan Knipe, Leadenhall: Probably yes. Where you ve got somebody who wants to transfer the risk and also someone who s prepared to accept that risk and the two parties come to an agreement on a price then there will be trades to be done and things will march forward. What I see as potentially the biggest stumbling block is if that matching doesn t occur. If the people who are able and willing to take longevity risk, given the uncertainty in life expectancy estimates and the variability around those estimates, are not prepared to accept the price that is being offered from the longevity seller then I think that the people who hold the risk, like pension schemes, will be more than happy to keep it. In the UK for example the future longevity assumptions used by some pension schemes for the valuation of their liabilities can sometimes be so far from the market price of risk transfer that they would have to crystallise large losses from risk transfer and so have no financial incentive to do so. But that brings us to the next point, which is the other thing that could cause the market to grow a financial incentive to transfer longevity risk. For example, if pension schemes in the UK come into a regulatory regime like Solvency II then there would be a big incentive for them to transfer risk. This could lead to the ballooning of a market like this because they would have to hold capital against their risks, including longevity, and then they would start to think about where the capital is best used, and that could spur what people tend to call the securitisation market. Securitisation was a big buzz word five years ago, securitisation of anything. The hype around securitisation as a format has in

4 some part subsided, and it was never particularly applicable to the characteristics of longevity risk in any case. But in terms of transferring risk there are other options, derivatives would be a big one, which broaden the risk transfer universe away from just securitisation. Jean-Marie Nessi, Nessi Consulting: I d like to make two comments about the securitisation. One is that when we refer to securitisation we have to be very careful to identify what risk can be transferred, meaning that when you have a portfolio, an insurance portfolio or a pension scheme, you have two types of risk. You have the risk of annuities being served today and annuities for which you are collecting money and you will serve in the future. Securitisation cannot be implemented or cannot be attractive to the financial market mixing these two blocks of business. So there is a possibility of the securitisation market but as long as you strictly refer to the closed book of annuities and existing served annuities because that population can be more statistically analysed. Then you can deliver a more predictable flow of cash flow, and then to sell that through securitisation. That s the first criterion to have a securitisation market. My second point is the fact that it s very difficult to come to a market and say: I will deliver commitment for the next 40 years. The insurer or pension fund has a signed commitment to deliver something for the next 45 years and that was possible at the time where the economy was growing and we were all expecting population to be growing. Today it s not a reality, so we have a situation where we have to recognise that the long-term commitment was underpriced and there is a cost to be paid. Can it be paid in one year or in 20 years? I don t know, but it has to be paid. So, what securitisation or reinsurance can do is to spread the cost of that loss over 20 years by layering this 25 or 40 years commitment and spreading the cost of that loss over several years. That s one possibility. We have to recognise that the world is changing and so the cost, the price to be paid to establish a pension scheme or a pension fund, a retirement product or a life product, has to be changed, and even more today because of change of regulation. If longevity risk is a risk under Solvency II, there is a cost of solvency margin and that solvency margin will have to be paid for. Therefore the price has to change. Now the question is: is the population able or ready to pay the technical price of even just a break-even product or social scheme for retirement? We have to separate the past and the future, we have to be professional, have a technical approach for the future, and find the smartest possible way to spread the loss or the cost of the past because we have to cope with that cost. Dan Knipe, Leadenhall: You make a good point, and in terms of technical pricing I think that s where the reinsurance market and the capital markets may differ. In a reinsurance environment you do have a technical price, you can add your profit load, and you can add the cost of solvency capital. If you then look at the capital markets where supply and demand are the big drivers, a larger supply of a product than there is people that want to buy it will cause the price to shift and potentially for longevity risk a long, long way away from any technical price. So the transfer of risk into the capital markets in that way can almost be a two-edged sword. On the one hand it s great because you re able to retrocede, you re able to get access to a wider variety of counterparties, you share your risk and reduce the peak risk within the book. But by the same token if you get to the stage where the market is truly liquid then as an insurance company, at least in theory under Solvency II, you should be marking your liabilities to that market. Now, if that market, because of supply and demand factors, goes a long Regulation is definitely going to help to move the risk transfer market forward, initially to the reinsurers and then to the capital market, when reinsurers capacity is complete. Daria Kachakhidze, head R&D longevity-mortality, Scor Global Life way away from the technical market and the reinsurance capacity is full and unable to bring it back to technical pricing, then we could see a lot more volatility on insurance balance sheets. But the market getting to the stage of being mature enough and liquid enough to be used for marking insurance liabilities to market is a long way away. Hugh Fasken, Reactions: How important is Solvency II in this debate today and how influential will it be the next few years on how the market evolves? Daria Kachakhidze, Scor: In terms of longevity risk Solvency II standard capital approach is not perfect at the moment and it s not equal for all portfolios. For example if you have a very old portfolio then Solvency II standard capital is overestimating the capital you need to put aside, but this makes people work on the risk and try to optimise their risk management, either through better diversification by rebalancing their portfolio or by transferring the risk. So in this sense regulation is definitely going to help to move the risk transfer market forward, initially to the reinsurers and then to the capital market, when reinsurers capacity is complete. But it s not something that s going to happen immediately because there are lots of differences in perception, in particular with regard to the duration, as investors are not eager to take such long-term risk as 10, 20 or 50 years. Hugh Fasken: Is there a need then to further educate the wider market and is there an information gap do you think currently? Daria Kachakhidze, Scor: Yes, and it s relevant to mention here the Life and Longevity Market Association, which is an association that includes certain reinsurers, insurers and investment banks. It is doing the education work and publishing educational notes explaining longevity risk and how it could be packaged and transferred to the capital market, but there is a long way to go still in terms of common understanding and common vocabulary. Dan Knipe, Leadenhall: They are very focused on trying to standardise the market, which is a great goal. As well as creating a framework and tools and information there is a need to just get out there and do something. We saw Swiss Re at the end of last year come out and actually securitise some longevity risk. It was packaged up with mortality risk but nonetheless it was done. It was small but it was bought. So one of the ways to get around the concern about the very long-term nature of this risk is to put it into a format that is tradable. As an investor I am much less concerned about the term of the risk if, should I change my mind tomorrow, I can sell it to somebody else. So the real problem is liquidity. The LLMA is trying to develop liquidity in its own way through setting standards and frameworks but a large part of any market won t believe there is liquidity there until they actually see an instrument that can be traded and that does trade. So the Swiss Re bond, called Kortis, is a good example of traded longevity Reactions July/August

5 risk we see it in the market today, it has a price, it trades, you can buy it, you can sell it, irrespective of the fact that it s a longer dated transaction. Until we get more transparency on the other trades that are being done, both sides the buyer and the seller are going to be wary of entering into these transactions that are intermediated by investment banks. Hugh Fasken, Reactions: How long do you think it will take to get that transparency then? Dan Knipe, Leadenhall: It might develop once we get through the first round of people that have a particular need to do a deal. If you start to think about incentives, merger and acquisition can be a big one. So you could see a lot of the smaller deals that come to market, for example funded buy-out deals, that are driven through merger acquisition activity because the pension problem has to be solved prior to any transaction. Once those are cleared out of the way then I think more and more people will start to look at it. Some pension schemes will be interested to see some consistency in the pricing environment or at least some trend in the pricing environment, then they can be more comfortable about executing a longevity deal without it being off market, but this may take three or four years for some. For others as more of their peers do it, then they may be more prepared to consider it. The same considerations apply to investors. So, it s going to be years rather than months but people continue to live longer and it s a very long-term problem. Chris Madsen, Aegon: The development of the market is a very interesting topic. The fact is that there are existing longevity markets everywhere they re just in different stages of development and transacted on different bases. In terms of stages of development, you could almost start with buy-outs and insurance at the bottom, then consider the over-the-counter transactions that Dan just referred to, then at some point you move into securitisation-type structures where you actually have investors stepping in and taking a share of the risk purely for profit taking purposes. Even in that market you have the indemnity type structures where you re actually buying into a specific risk, but you also have synthetic portfolios and then ultimately you have the index based structures. The LLMA is at the index-based level and it s all very interesting, but I think that the market needs to go through all the initial stages before it actually gets there. The LLMA is helping to further the understanding and the discussion, but I think it s difficult to see that during the next few years there s going to be a significant index-based market. So I don t see the market skyrocketing. I see it more as a gradual development with a clear saturation point, but if you have a 20 July/August 2011 Reactions For me, the question is whether our concern about longevity reduces again if we move to a higher interest rate environment as the financial impact of differences in life expectancy becomes small again. Dan Knipe, life portfolio manager, Leadenhall Capital Partners saturation point say of the total market in Europe of E20bn to E30bn ($29bn to $43bn) per annum, I think that s still sufficient that there is enough of a market where people can lay off the risk and hopefully it is large enough that significant investors would also take an interest also in the secondary market. Dan Knipe, Leadenhall: The other side of our business at Leadenhall is on the non-life side, cat bonds and catastrophe derivatives. If you look back to the inception of that market a lot of the risk passed to the market was taken by the reinsurance community, so the involvement of the reinsurance community in the nascent longevity market is no bad thing. From my perspective as an investor if I knew that two or three reinsurers had lined up and had taken the risk alongside me that should give me some comfort. Now, they haven t always priced the risk in the best way, but it should give me comfort that I m not being arbitraged because I don t know enough about the market. Somebody who s very sophisticated and should know a lot has looked at the risk and is happy at the price that s being paid. But the other thing is that their participation gives me an element of liquidity. If I know that three other reinsurers in the world have taken this exact same risk as me then I could phone one of them up and say, Right, would you like to take a little bit more because I need to exit. Chances are that for a price they would do that. So there is a market but it s not got to the stage yet where it s really a capital markets product. Andreas Muschik, Scor: From a UK perspective there is a market. From a global perspective it s still in development, let s put it that way. Hugh Fasken, Reactions: What role is the reinsurance industry playing in this market then? Daria Kachakhidze, Scor: Reinsurance plays a very important role in this nascent market. As Dan just said, it s very comforting for investors to know that there are other players who are ready to take up the risk, and that these other players are considered to be the experts in the field. Reinsurers should know more about the biometrical risks because this is their area of expertise and the traditional form of the longevity risk transfer is of course via reinsurance. But reinsurance capacity is limited. Capital markets would bring additional risk bearing capacity as well as potential for greater liquidity. Andreas Muschik, Scor: In Scor s Strong Momentum plan one of our initiatives is being active in this market. Daria Kachakhidze, Scor: We have an active team in the UK now who are planning to write one or two deals per year, and we are gradually looking at other markets. l >> For the panellists views on how longevity risk differs across European markets, read the full length version of this story on