Part III Utilization of Life Insurance-Linked Securities. Part III Contents:

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1 Alternative Risk Transfer: The Convergence of The Insurance and Capital Markets A Three Part Series By: Christopher Kampa, Director of Research ISI August 11th, 2010 Part III Utilization of Life Insurance-Linked Securities Insurance-linked securities, once considered to be an alternative form of risk transfer, have become a mainstream method of transferring risk from insurers to the capital markets. With greater attention being paid to risk at the institutional level and the search for portfolio diversification at the investment level, insurance-linked securities seem poised to further facilitate the convergence between the capital and insurance markets Part III Contents: 1. Utilization of Life Insurance-Linked Securities by: Life Insurers, Annuity Writers, Pension Schemes, Life Settlement Managers, Reverse Mortgage Managers, and Long-Term Care Providers 2. Life Insurers Utilize Securitization to Hedge Early Mortality Risks and to Increase Business Capital A. Embedded Value or Value-in-Force ( VIF ) Securitizations B. Reserve Funding Securitizations: Regulation XXX and AXXX C. Extreme Mortality Securitizations 3. The Need for the Securitization of Longevity and Mortality A. Longevity Risk Does not Have Access to Forward Pricing Markets B. Longevity Bonds Can be Used to Hedge Mortality and Interest Rates C. Survivor Indices and Mortality Tables Used for Securitization have Limitations D. Uncertainties Surrounding Mortality Improvement Underscore the Need to Hedge and Trade Longevity/ Mortality Risk 4. Longevity/Mortality Risks Beyond the Traditional Insurance Sectors A. Individuals are also Affected by Longevity/Mortality Risk B. Annuities, Life Settlements, Annuity Settlements, Reverse Mortgages, and Long-Term Care all Share Longevity Risk Concerns 5. Bulk Annuity Buyouts Evolve from Asset-Based Transactions A. Bulk Annuities are an Attractive, Albeit Capital Intensive, Risk Transfer Tool B. Longevity/Mortality Swaps Offer Promising New Alternative for De-Risking 6. Life Settlement Securitizations are Needed to Provide Insured with Fair Value Compensation 7. Financial Reform and Regulation will have a Significant Impact on the Longevity Market A. Financial Reform Changes Risk Management Practices and Forces Members of the Longevity Market to Adapt to New Standards B. The GAO and SEC Call for Greater Regulation of the Life Insurance Settlement Market 8. Summary Abstract This is Part Three in a three-part series on the Convergence of the Insurance and Capital Markets ( I/C Convergence Series ). Part I of the I/C Convergence Series, A Broad Overview, provides a macro-level analysis of the insurance-linked security asset class. It discusses the maturation of insurance-linked securities as an asset class and the history surrounding their emergence. Insurance-linked securities are a type of alternative risk transfer that utilizes capital market techniques other than insurance or reinsurance to provide risk-bearing entities with risk protection. Insurers turned to alternative risk transfer strategies following several catastrophic events in the 1990s, when reinsurance capacity shrunk and prices became more volatile. The first insurance-linked security was structured as a catastrophe bond, but the market has since grown to include many forms of securitization on both non-life and life insurance assets. Since their inception, issuances of insurance-linked securities have caught on at a rapid pace, growing 40-50% a year since 1997 with $50 billion in risk capital outstanding in Part II of the I/C Convergence Series, Non-Life Utilization of Insurance-Linked Securities, delves into non-life insurancelinked securities. The first non-life utilization of insurancelinked securities was in the form of a catastrophe bond, which served as the foundation for all other insurance-linked securities to follow. Catastrophe bonds serve as a check against rising reinsurance costs and have weathered the effects of the global financial crisis quite well. After the asset-based market was established, derivative and other synthetic securities soon emerged. This opened up a wide avenue of risk management techniques and allowed hedging of risks that were previously thought to be uninsurable. Part III of the I/C Convergence Series, Utilization of Life Insurance-Linked Securities, investigates securitization of longevity/mortality risks for life insurance-linked securities. Individuals, financial entities, and government agencies have exposure to longevity/mortality risk. Historically, managing such risk has been limited to a few avenues. However, the convergence between the insurance and capital markets over the last decade has produced many innovative methods for managing longevity/mortality risk. These new methods benefit individuals, life insurers, annuity writers, pension providers, life settlement managers, reverse mortgage managers, long-term care providers, and others Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III page 1

2 1 Utilization of Life Insurance-Linked Securities by: Life Insurers, Annuity Writers, Pension Schemes, Life Settlement Managers, Reverse Mortgage Managers, and Long-Term Care Providers Until recently, longevity/mortality ( L/M ) risk was one of the few remaining major risk categories that had not benefited from capital market structures for hedging and transferring risk. But many new and exciting alternative risk transfer strategies are evolving that can benefit both risk-assuming entities and investors. Traditional hedging strategies for L/M risk involved participating annuities, life insurance policies with guarantees, actuarial management of insurer surplus capital and policyholder expectations. 2 More recently, hedging strategies include cash flow risks and debt servicing risks resulting from L/M risks in life settlement portfolios. Since 2001, the market for life insurance-linked securities has grown significantly, with more than $15 billion of securities issued to capital market investors and another $20 billion of private placements between insurers and banks. 3 The convergence of the insurance and capital markets has created alternative channels for insurers to manage risks and raise capital while providing investors with new forms of investment opportunities. The fundamental risk underlying life insurance-linked securities is related to longevity or mortality. Longevity is the risk that members of a population will live longer than expected. Conversely, mortality is the risk that members of a population will die sooner than expected. Longevity/mortality can cause substantial risk where performance of large liabilities is tied to the accuracy of these projections. Reinsurance coverage for L/M has been sparse and expensive. The first operational mortality-linked bond was issued by Swiss Re in Before that, longevity risk had never been securitized. 5 In the last few years, many innovative financial instruments have been introduced, the most prominent being longevity bonds. These are securities with payments tied to the matching of actual mortality with expected mortality of an underlying reference pool or portfolio. Some life reinsurers are entering this space. The life insurance sector, which accounts for 40% of the total insurance-linked securities outstanding, has not proven to be as resilient to the financial crisis as the non-life insurance security sector. The global financial crisis revealed that many alternative asset classes, supposedly uncorrelated to the financial markets, had substantial systemic risk exposure. Specifically, insurancelinked securities were found to not be completely immune to the systemic nature of market risk, especially during times of financial distress. The collapse of the subprime CDOs caused a disruptive impact on all structured products, which included securitizations backed by life insurance risk. Substantial credit contagion and asset impairment, along with the collapse of the monoline insurance market, 6 disrupted the growth of lifeinsurance linked securities. The total amount of outstanding life securitizations stood at $22.2 billion at the end of 2009, as shown in Table 1: Life Securitization Outstanding. The bulk of securitizations were comprised of either embedded value or XXX/AXXX bonds (roughly 42% each). The remaining included extreme mortality bonds and other securitizations, such as life settlements. 7 Historically, 80% of all life insurance-linked securities have been structured with a credit-enhancement wrap provided by monoline insurers. Monoline insurers provide insurance protection in the form of guarantees on fixed-income securities. The collapse of the housing market exposed the financial weaknesses of the monoline insurance industry, as it was heavily invested in subprime assets. As losses continued to mount, many monoline insurers lacked the ability to fulfill their obligations, which lead to deep discounting of the value of the guarantees. The current disruption of credit and lack of liquidity in the financial markets should be expected to hinder the growth of life insurance-linked securities in the near future, but the long-term potential remains promising. Some experts estimate the market potential for life securitizations at $500 billion for value-in-force securitizations, and $35 billion of Regulation XXX excess reserve securitizations alone. 8 Table 1: Life Securitization Outstanding source: Swiss Re Capital Markets 2010 Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III page 2

3 2 Life Insurers Utilize Securitization to Hedge Early Mortality Risks and to Increase Business Capital Limitations of the reinsurance market plague the life insurance industry in much the same manner as it afflicts property and casualty insurance. Lack of reinsurance capacity and increasing reinsurance costs, along with concerns over credit risk, have given life insurers incentive to seek alternative solutions and sources of capital. The market for life insurance securitization is relatively immature, but is evolving rapidly. 9 In the U.S. market, the most common types of life insurer securitization include: Embedded Value (Value-in-Force) Securitizations, Reserve Funding Securitizations, and Extreme Mortality Securitizations. A. Embedded Value or Value-in-Force Securitizations Embedded Value ( EV ) or Value-in-Force ( VIF ) securitizations allow insurers to monetize future profits of an insurance portfolio. VIF transactions involve the securitization of a block of insurance or annuity policies to achieve various business objectives: to raise capital; capitalize prepaid acquisition expenses; or to support a demutualization. 10 EV/ VIF securitizations enable insurers to realize future profits in the present, and reinvest the money into business lines that have higher expected returns. Future profits are affected by longevity/mortality risk, investment risk, and policy-persistency risk. These securitizations tend to have high volatility, exposing investors to the risk that cash flows will not be sufficient to cover interest and principal obligations. Therefore, securitizations are typically structured with a series of tranches to attract a wide breadth of investors with differing risk-return profiles. The varying tranches of standardized EV/VIF securitizations provide different layers of protection and a cushion against adverse deviations of future cash flows. Most tranches have been enhanced with wrapped guarantees issued by financial guarantors, or monoline insurers. Under a wrapped structure, the monoline insurer guarantees the underlying security which removes the investment risk, but it leaves the credit risk that the monoline insurer may default. Before the credit crisis, the possibility of this happening was thought to be remote. Following the financial fallout in 2008, new issuances of embedded value securitizations fell sharply to $1 billion, down from $6 billion in When monoline insurers credit ratings were downgraded in , all of the underlying risks were also downgraded. Accounting standards, both in the U.S. and internationally, forced holders of such assets to write them down to fair value. The downgrades, along with the server market turmoil, led to large liquidations that depressed the demand for asset-backed securities across all sectors. Hedge funds were large investors in the equity tranches of structured products, and many were heavily leveraged. The downgrades of many structured products led to margin calls resulting in massive forced sales. 12 However, the common use of financial guarantees was the major force behind the declining issuances of life securitizations; which was a repercussion of the subprime collapse and not the quality of the life assets. The capital base of many insurers has been severely impacted by the financial crisis, which has increased the demand for embedded value securitizations. In the near future, securitizations may be limited without the protection of financial guarantees. Until future credit enhancement instruments are created, investors in embedded value securitizations will be exposed to longevity/mortality risk, investment risk, and policy persistency risk. The increased risk and lack of standardization will likely limit embedded value securitizations to the private placement market. The Insurance Studies Institute ISI is a non-profit research think-tank focused on: a) researching and analyzing challenges and opportunities within the many paradigms of insurance based risk management; b) publishing research findings on industry relevant topics; c) educating industry stakeholders, public policy makers and consumers in insurance based risk management, and advancing related scholarship; and, d) promoting dialogue to foster industry advancements, fair public policy and greater risk protection for consumers. Learn More B. Reserve Funding Securitization: Regulation XXX and AXXX In the year 2000, a new statutory reserve requirement, known as Regulation XXX, was passed. Regulation XXX imposes conservative valuation methodologies for determining the level of reserves insurers must hold, under statutory accounting principles, for term life insurance policies. 13 A similar guideline known as AXXX requires increased reserves for universal life policies that contained no lapse guarantees. The conservative nature of Regulation XXX resulted in significantly higher reserve levels for term and universal life insurance than was required before the regulation was enacted. Effectively, this forced life insurers to hold more capital in reserve, thus limiting their ability to invest in new lines of business. Life insurers, unwilling to be stymied by the increased capital requirements, developed XXX and AXXX securitizations. These reserve funding structures allow insurers to issue debt securities against their capital reserve requirements, and to use the securities to supplement the amount of capital required to be held in reserve Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III page 3

4 2 Continued The issuances of XXX/AXXX slowed in 2007 after the credit markets began to tighten due to pressure on asset-backed securities, and the collapse of the monoline insurers. As global financial markets recover, reserve funding securitizations are expected to return to previous growth estimates. At the end of 2009, the total amount outstanding of XXX/AXXX securitizations was valued at $11 billion, with estimates of a $35 billion total market potential. 14 C. Extreme Mortality Securitization Extreme mortality securitization is a form of alternative risk transfer designed to shift peak mortality risk to capital market investors. Extreme mortality securitizations allow life insurers to hedge against pandemics or sharp increases in longevity. These bonds are similar to catastrophe bonds in that they transfer extreme risks to the capital markets. If mortality develops as expected, investors receive the prescribed interest and a full return of principal at maturity. Conversely, if mortality increases substantially, triggering the bond, investors can suffer a loss of interest, principal, or both. Before the financial crisis, extreme mortality securitizations were structured much like catastrophe bonds. The proceeds raised from investors were deposited into an SPV, which entered into a total return swap ( TRS ) with an investment bank. These structures were thought to remove the credit risk, leaving investors exposed only to insurance risk, along with little or no correlation to the broader financial markets. However, the financial crisis demonstrated that these transactions were not free from credit risk. After the Lehman Brothers collapse in which was a large swap counterparty in many transactions -- many securities experienced severe price deterioration. 15 The collapse of Lehman Brothers demonstrated that the TRS mechanism was not sufficient to protect investors from credit risk. Following the Lehman Brothers bankruptcy, the structure of extreme mortality bonds has been improved. Newly issued extreme mortality bonds invest proceeds in treasury bills, thereby providing a return of treasuries plus the insurance spread. 16 With the collateral invested in government debt, maturities of extreme mortality bonds are shorter in order to avoid asset/liability duration mismatch. The improved structure provides investors with more security than was provided with the total return swaps. However, the newer structure exposes investors to credit risks that were previously thought to not be present. Securitization of extreme mortality risk should continue to expand as large global life insurers and reinsurers turn to the capital markets to hedge against large deviations in mortality. The combined volume of extreme mortality bonds issued thus far stands at $2.2 billion. 17 However, since insurers securitize their exposure to extreme mortality risk, and not the entirety of their mortality exposure, quantifying the size of the market is difficult. However, Swiss Re estimates that the market potential will range somewhere between $5 and $20 billion by The Need for the Securitization of Longevity and Mortality Longevity/Mortality risk exists due to uncertainties surrounding life expectancy trends. Large divergences can have severe effects on the profitability of insurers, annuity writers, pension schemes, life settlement managers, reverse mortgage managers, long-term care providers, and any other entity that has exposure to longevity/mortality risk. Securitization of this risk allows such entities to raise capital, reduce their cost of funds, reduce asset-liability mismatches, lock in profits, and transfer risks to the capital markets. Investors of insurancelinked securities benefit by adding diversity to their investment portfolios. A. Longevity Risk Does not Have Access to Forward Pricing Markets Hedging of longevity risk stems from the financial impact of developments in the long-term trend of survival probabilities. 19 Mortality improvement is typically a continual process spanning over decades, although issues such as medical advancements in the cure of diseases or health epidemics can have immediate impacts on mortality trends. Expected increases in longevity can be modeled with historical modeling and actuarial analysis. However, the pricing of longevity is not as fluid. Typically forward market contracts are used as an instrument to hedge risk and to price assets. 20 But at present time, there is no matured forward market for longevity risk. This adds to the uncertainty of future mortality improvement pricing, but some of the large investment banks are making attempts to create a liquid market. The emergence of a well-diversified forward market would allow for greater price discovery and innovation for new risk management products. A forward market would provide transparency to expected or more normal mortality improvement pricing, but would be insufficient for pricing the more extreme mortality changes, such as a cure for cancer. Swaps and reinsurance are better suited for hedging these extreme mortality changes. Even though the reinsurance markets are designed to cover these risks, to date they have been unwilling to do so. The reinsurance industry has been concerned about the amount of capital required to hedge large, extreme, and unexpected mortality changes. Therefore, securitizations and other capital market solutions stand out as the natural course of action for management of these risks Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III page 4

5 3 Continued B. Longevity Bonds Can be Used to Hedge Mortality and Interest Rates Longevity bonds offer a promising new option for managing longevity/mortality risk. Longevity bonds provide insurers, annuity writers, pension schemes, life settlement managers, reverse mortgage managers, long-term care providers, and other financial entities with a highly flexible means of hedging mortality and interest-rate risk. Longevity bonds can also be attractive to capital market investors who are looking for an asset class with low correlation to traditional financial markets. An advantage to longevity bonds, as with catastrophe bonds, is that there is little or no credit risk because the bond is completely collateralized through an SPV. However, because of the lack of a forward market, the valuation of such bonds is difficult. Further, survivor indices used to price the bonds may not completely match the reference pool of the covered asset pool. Several forms of longevity bonds exist: 22 Traditional Longevity Bonds with fixed maturities were designed to protect against longevity risk. The holder of such a bond gains if the pool of covered lives on which the bond was underwritten extends longer than expected, and the bond issuer loses. Greater than expected cash flows, resulting from the bond s extended maturity, serve as a hedge against the holder s increased liabilities and costs of the pool of covered lives. The issuer gains if the reference pool lives shorter than expected. In this scenario, the holder loses money on the bond but saves money on the decreased liabilities and costs of the underlying pool of lives. Longevity Zero Bonds are similar to conventional zero-coupon bonds or traditional longevity bonds, where the return of principal and compounded interest is paid at the maturity of the bond. Survivor Bonds payout for as long as there are survivors remaining in the reference pool. These bonds are attractive because they are open-ended, and they can provide an adequate longevity hedge for a fund or portfolio with a comparable reference population. The openended nature of these bonds allows annuity writers and pension schemes to match their own liabilities. Principal-at-risk Bonds have coupon payments fixed or tied to interest rates, but the principal repayments are based on the survivor index, meaning that the repayment of principal is dependent on the divergence between expected and actual mortality. Mortality Bonds are the opposite of traditional longevity bonds, i.e., the payout increases if the reference pool lives shorter than expected. These bonds serve as a hedge against mortality risk. Collateralized Longevity Obligations ( CLOs ) are similar to conventional collateralized debt obligations (CDOs). In the same way that a CDO tranches a pool of debt instruments a CLO tranches a pool of longevity bonds. Different tranches have different exposures to longevity risk, and therefore different return and risk and exposures. Investors in the more senior tranches would be paid before those in subordinate tranches. Payment would be based on how the actual mortality experience compares to the expected mortality experience. C. Survivor Indices and Mortality Tables Used for Securitizations have Limitations The choice of a survivor index or mortality table is critical to the success of longevity bonds. Longevity bonds expose the holder to basis risk because the bond is tied to an index and not the issuer s actual losses. The objective is to choose a survivor index that closely matches the longevity characteristics of the holder s pool of lives. If the actual longevity of the survivor index does not closely match the holder s pool of lives, the cash flows of the bond will not serve as an adequate hedge against longevity risk. Survivor indices and mortality tables are also limited by the methods used to construct them. Mortality data is published infrequently and subject to incurred-but-not-reported errors. Further, methods used to track mortality have changed with time, and tables and indices suffer when differing methodologies are used to combine historical data. If the integrity of the underlying survivor index of a longevity securitization is in question, investors may be weary of investing in such structures. Investors may also be susceptible to moral hazard risks. 23 If, for example, issuers have access to information that investors don t, or have access much sooner, they can act on this information at the expense of investors. Moral hazard can also exist where there is a possibility that data can be manipulated, thus creating an incentive for the benefiting party to misrepresent mortality statistics to influence the value of the index Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III page 5

6 3 Continued D. Uncertainties Surrounding Mortality Improvement Underscore the Need to Hedge and Trade Longevity/ Mortality Risk If future mortality improves relative to current expectations, the liabilities of life insurers decrease because death benefits will be paid out further into the future. Conversely, annuity writers, pension funds, life settlement pools, annuity settlement pools, reverse mortgage pools and long-term care providers will be adversely affected because they will have to pay benefits and costs for a longer period of time. Current mortality improvement trends suggest that global life expectancies will continue to increase, but socio-economic trends indicate that mortality improvement may be localized and less predictable. 24 For example, in the United States, some experts suggest that the nation may experience declining life expectancies for the first time in history due to excessive obesity. Uncertainties surrounding mortality improvement underscore the need for robust trading platforms to hedge and trade longevity/ mortality risk. Although improvements in mortality can adversely impact asset pools sensitive to longevity risks, the effects can be managed when they are anticipated. Annuity writers and long-term care providers could raise the premiums needed for future products, and pension funds could increase required contributions or make the pensioners work longer. Life settlement aggregators, annuity settlement aggregators, and reverse mortgage aggregators can lower the prices paid for such assets and set more capital aside for expense reserves. These implementations may not be popular, but they would improve the solvency of systems under pressure. Expected mortality improvement can be managed; it is the unexpected shocks that are problematic. Uncertainty of anticipated changes in mortality rates are the essence of longevity/mortality risk. Actuaries create mortality tables that insurers and annuity writers use to price their related products. Pension funds and government programs such as social security use mortality tables to calculate their liabilities. Mortality tables include some form of mortality improvement based on historical experience and actuarial expertise. However, mortality improvement is just an educated prediction of future mortality rates; they are not certain. Deviations from expected mortality can severely impact the bottom line of industry profits. It is for these reasons that institutions and investors in assets having longevity risk need market structures to hedge and trade longevity/mortality risks. 4 Longevity/Mortality Risks Beyond the Traditional Insurance Sectors Life insurance was established as a form of financial protection against the risk of dying too soon. But as populations around the world experience increases in life expectancies, individuals look for services to ensure sufficient funds to survive their retirement years. A. Individuals are also Affected by Longevity/Mortality Risk The major assets held by individuals in developed countries around the world are retirement savings and the family home. Retirement savings typically consist of pensions, social security, and investment savings. Individuals typically insure their own mortality/longevity risks with products such as life insurance or annuities. As life expectancies in developed countries around the world continue to lengthen, individuals are more avidly seeking products to provide financial protection during their retirement years. By providing financial protection against the major 18th and 19th century risk of dying too soon, life assurance [insurance] became the biggest financial industry providing financial protection against the new risk of not dying soon enough may well become the next century s major and most profitable industry. Peter Drucker Many longevity based products involve financial risks related to individual assets used to fund individual retirement income streams. Reverse mortgages combine housing market risk and longevity risk. Life settlements stem from arbitrages between longevity risks and mortality risks. Likewise, the more recent development of annuity settlements also stems from the arbitrage between longevity risks and mortality risks. Long-term care programs face both longevity risk and risk of increasing care costs. However, these risks currently have no active wholesale market for hedging or pricing. Financial innovation to manage longevity risk at the institutional level will require participation by the capital markets to provide protection against these risks. The Insurance Studies Institute ISI is a non-profit research think-tank focused on: a) researching and analyzing challenges and opportunities within the many paradigms of insurance based risk management; b) publishing research findings on industry relevant topics; c) educating industry stakeholders, public policy makers and consumers in insurance based risk management, and advancing related scholarship; and, d) promoting dialogue to foster industry advancements, fair public policy and greater risk protection for consumers. Learn More Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III page 6

7 5 Bulk Annuity Buyouts Evolve from Asset-Based Transactions The risk of mortality improvement has become increasingly capital intensive and challenging to manage for pension funds, annuity writers, and other financial entities.. Longevity risk has been systematically underestimated, leaving exposed firms vulnerable to unexpected increases in liabilities. 25 Large institutions are partnering with capital market investors to manage this risk. 4 Continued B. Annuities, Life Settlements, Annuity Settlements, Reverse Mortgages, and Long-Term Care All Share Longevity Risk Concerns As populations of the developed world continue to age, annuity writers, pension administrators, life settlement managers, reverse mortgage managers, and long-term care providers are under pressure to develop new products and tools to compete for capital. Like other insurance-linked securities, this asset class provides investors with the higher yields and diversification of securities that aren t correlated to economic events affecting traditional financial markets. Investors can gain exposure to these asset classes through a variety of structures, including: closed or open-ended funds or securities backed by the underlying life insurance policies; annuities; or real estate. As securitizations become more prominent for these asset classes, the resulting increases in liquidity and investor appetite will benefit seniors by raising the prices paid for their assets A. Bulk Annuities are an Attractive, Albeit Capital Intensive, Risk Transfer Tool A looming problem for many defined-benefit pension funds is that they are underfunded, and the increased legacy costs are forcing them to switch from defined-benefit to definedcontribution schemes. This costly process takes the form of a bulk annuity buy-out, where the pension fund pays an insurer to replace the pension liability with annuities to the pensioners. In these transactions, the insurer takes on both reinvestment risk and longevity risk associated with the pension assets. In Europe, one of the first methods of managing longevity risk by annuity writers and pension funds was to sell the liability via an insurance or reinsurance contract known as a bulk annuity buy-out. 26 Several dozen buyouts have taken place over the past few years. 27 However, buyouts have been limited to smaller pension fund portfolios. When combined with the shortage of liquid instruments that enable insurers to hedge against longevity risk, the capital intensive process of bulk annuities limits feasibility for large pension funds and is limiting the market. 28 Despite the attractiveness of this option, the premium required often makes buy-outs too expensive for many pension schemes. During 2005 and 2006, many new players 29 entered the market because investment banks could borrow funds cheaply to finance the buy-outs, and equity returns were high. The conventional wisdom was that returns in the equity market were more than enough to justify investing in risks associated with longevity. From 2007 onward, the buyout market enjoyed a considerable boom, writing $14.6 billion in Since then, capital has dried up and the equity markets have stagnated, and the bulk buy-out option has lost popularity. In 2009, volume dropped to $6.9 billion. The market for de-risking is evolving from the more costly assetbased transactions to less costly structures such as longevity swaps. Following the deterioration in the global economy, pension fund trustees have become more concerned about the financial health of insurance companies, leading them to search for alternative structures to transfer risk to the capital markets. 30 Another index that was recently launched by Goldman Sachs, the QxX index, tracks a representative sample of the insured 2010 Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III page 7

8 5 Continued US population over the age of 65. The index data is provided by American Viatical Services and has a reference pool of 50,000 who have participated in life settlement transactions (see the next section). The pool s mortality experience is based on the Social Security Death Index, which focuses on a narrow segment of the elderly population, and tends to be skewed towards those with more impaired health. Recently, Goldman Sachs sold its stake in the index to a Goldman Sachs partner. B. Longevity/Mortality Swaps Offer Promising New Alternative for De-Risking Longevity swaps are a form of de-risking that allows entities with L/M risk exposure to transfer the risk to capital market investors looking for diversification benefits. Asset-based transactions can be costly and capital intensive because they potentially require a large amount of upfront premiums. Longevity swaps, on the other hand, can be relatively simple. Unlike a pension or annuity buyout, longevity swaps do not require a transfer of assets and the original liabilities remain with the sponsor. Further, there is no large upfront capital requirement and other risks, such as asset risk and inflation risk, can be mitigated. There are two forms of swap transactions: indemnity swaps are customized, based on actual experiences or portfolio holdings; parametric swaps are based on an index. Indemnity swaps can be customized to the actual portfolio to remove most of the basis risk. However, it can be difficult to find counter parties for indemnity swaps and more expensive to construct the swap because of the monitoring costs. Parametric swaps based on an index are less expensive but the magnitude of basis risk is likely to be greater. Parametric index based swaps are generally more popular because they are simple, more objective and transparent, and therefore offer greater liquidity. In Europe, the de-risking market for swaps is starting to develop but has yet to reach main stream. There have only been a handful of major swap transactions, as listed below: 31 Table 2: Recent Longevity Swap Deals Sponsor Issuance Year Value ($ Millions) Canada Life 2008 $990 Lucida 2008 $195 Norwich Union 2009 $689 Babcock 2009 $755 Total $2,629 A typical longevity swap involves a party, e.g., a pension fund that has exposure to increasing mortality improvement and that wishes to hedge against adverse changes in future mortality. The pension fund receives a fixed amount from investors, as determined by the contract, and receives a variable amount based on either the pension fund s actual mortality experience or an index that tracks mortality. Thus, the pension fund locks in its future liabilities by transforming them into a stream of fixed payments, and locks in the future mortality improvement of its pensioners. As the market for longevity swaps materializes, trading indices are likely to become more developed. Investment banks such as JP Morgan and Credit Suisse have developed early versions of trading platforms built on synthetic pools of lives. The success of these platforms has been mixed. Although it is no longer available, the first attempt to develop a longevity/ mortality index was made by Credit Suisse in 2005, which was based on the US population s life expectancy statistics. J.P. Morgan s LifeMetrics Index, launched in 2007, tracks general demographic trends and provides publicly available population data. The advantage of publicly available indices is that the data is verifiable, cannot be manipulated, and is provided by reliable public sources. However, transactions based on indices may expose the issuer to basis risk because of mortality mismatch between the entire population and population of the issuer. 32 The key to success for these platforms will be their ability to match parties that (1) have opposite exposure to the underlying longevity/mortality risk and (2) have similar mortality characteristics in their underlying pools being hedged. As more capital is invested into the market and more attention is directed toward building robust actuarial tables, institutions with exposure to longevity/mortality risk will be able to hedge more of their risk exposures through standardized indices Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III page 8

9 6 5 Continued Consultant Lane Clark & Peacock predicts that $27.8 of new derisking business will be written in As of the first quarter, $7.4 of de-risking business took place, with $5.6 comprised of the automaker BMW s longevity swap the largest longevity swap to date. The consultant also predicts that prices will rise as demand for pension scheme de-risking grows. 33 The potential for de-risking instruments within the pension fund market is vast due to the unfunded liabilities facing many pension schemes (see the table across). Additionally, most pension schemes are heavily invested in equity markets, and the ongoing financial crisis has left many of the largest pension plans with record deficits and unfunded liabilities. Following the financial crisis, many sponsors are in a weakened position and can t inject the cash necessary to transfer pension risks to an insurer via a buyout. However, if the handful of transactions contracted since 2008 are any indication, 34 the potential for the market is very promising. Life Settlement Securitizations are Needed to Provide Insured with Fair Value Compensation In 2009, American International Group (AIG) became the first company to successfully obtain an investment-grade rating on a life settlement securitization. The offering yielded more than $2 billion on a pool of policies with a face value of more than $8.5 billion. AIG used the proceeds to pay off a portion of its government loan. 35 While the market in its current form has been in existence for over a decade, this is one signal that the industry is maturing, and as issuers develop more ways to securitize the life settlement asset, more investors will find this space attractive. In turn this will create capital to benefit the life insurance secondary market and benefit seniors needing funds and liquidity for retirement. In line with other insurance-linked securities, life settlements offer a wealth of attractive features that appeal to investors, including the uncorrelated nature of the returns and higher yields. An advantage of life settlements is that, unlike most other insurance-linked securities, they are available to both institutional and retail investors. This has broadened the investor base and poses a unique set of opportunities and challenges. Like traditional market assets and other insurance-linked securities, life settlements can be structured in a number of different financial securities. Notes can be issued against a pool of life settlements as a pass-through security, i.e., assetbacked security, and they can be structured with a defined rate maturity and interest payment. A pass-through will theoretically have a higher rate of return because the return is Table 3: Monthly Funding Status and Surplus/Deficit source: Milliman 2009 Pension Funding Study dependent on actual mortality as opposed to a note that offers a fixed-rate of interest. Life settlements can also be structured in closed-end or open-end funds. A synthetic market has been pursued, but has yet to find a foothold among investors. Although asset-backed securities can be issued with a wide range of assets, the overall structure is rather generic. Cash flows generated from a pool of life settlement assets are used to pay the required rate of return and the principal. A debt security is issued against the asset pool with a set maturity and defined rate of return, or actual cash flows from the pool can be passed on to the investor. In the latter case, if the underlying asset performs better than expected, the investor is rewarded, but if the performance of the underlying asset is weaker than expected, the investor s return is diminished. Thus far, most of the financial transactions involving life settlements have been structured in the form of closed-end or open-end funds based overseas. Closed-end funds lock the investor in for a defined period of time, and policies remaining at the end of the period are typically sold, or the investors are bought out. Open-end funds operate much like mutual funds with a net asset value and a unit price. Investors can buy and sell (redeem) shares as they would in a mutual fund. Some funds use leverage to increase the expected return while others are a whole asset transaction. If the portfolio manager is successful in picking and managing life insurance policies, investors will benefit with greater returns Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III page 9

10 7 Financial Reform and Regulation will have a Significant Impact on the Longevity Market A. Financial Reform Changes Risk Management Practices and Forces Members of the Longevity Market to Adapt to New Standards The Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law by President Barack Obama on July 21, Re-dubbed the Restoring American Financial Stability Act of 2010, the law is the most significant reform to the US financial system in the past 77 years. The goal of the act is to restore confidence, and will impact almost every facet of the US financial system. It creates a significant regulatory regime governing financial transactions with consumers. Although not specifically referenced, the new law will influence the life insurance settlement and longevity markets. The bill will continue enforcement of the McCarran-Ferguson Act, which exempts the business of insurance and other industry participants from most federal regulation. However, the bill creates a Federal Insurance Office (FIO) within the US Treasury Department. The FIO is directed to monitor the insurance industry and recommend to the newly created Financial Stability Oversight Council which insurance carriers should be considered to be systemically important. Within the next 18 months, the FIO is mandated to provide a report to Congress that covers the following: 1) Identify which insurance carriers are systemically important. 2) Examine if state insurance regulation is nationally uniform and analyze inconsistencies in state regulations. 3) Report on consumer protection for insurance products and practices (i.e. the recent Phoenix Life changes in the cost of insurance). 4) Analysis of any gaps in state regulation, the costs and benefits of potential federal regulation of the insurance industry, and the ability of a federal regulator to provide consumer protection to policy holders. 36 These mandates may have a positive impact on the life insurance settlement and longevity markets by helping to ensure that carriers remain financially healthy and are able to pay death benefits. However, some features of the bill could restrict risk management practices and trading in the longevity markets. The bill requires a security issuer to retain not less than 5% of any securitized asset other than certain qualified residential mortgages. While this retention standard is subject to certain exemptions, it could definitely change how longevity securitizations are structured. Further, the treatment of derivatives has been one of the most controversial portions of the new law. The bill will bring the over-the-counter (OTC) derivatives market under extensive regulation. Banks will be allowed to conduct some permitted derivative transactions on their balance sheets, while other derivative transactions will have to be managed through an affiliate. The law moves most of the OTC derivative market onto exchanges and requires them to be cleared through a clearing house. This will result in increased collateral requirements. It remains to be seen how insurers and other financial institutions will adapt to the changes in the OTC market. Financial institutions benefit from customized derivatives because it allows them to hedge the risk positions unique to their firm. The standardization of such contracts may limit the ability to successfully manage these risks. Most longevity swaps and the synthetic life insurance settlement market are customized transactions; depending on how the financial reform law is enforced, it will have serious repercussions on the life insurance settlement and longevity markets. 37 B. The GAO and SEC Call for Greater Regulation of the Life Insurance Settlement Market On July 22nd, 2010, at the request of the Senate Special Committee on Aging, the Government Accountability Office (GAO) and the Securities Exchange Commission (SEC) simultaneously released reports regarding the regulation and treatment of life insurance settlements. The reports note that there is no comprehensive data for life insurance settlements, but estimate that the market grew rapidly from 1998 until the recent financial crisis. According to the reports, the number of policies settled declined in In 2009, over 2,600 policies were settled with a total face value of $7.01 billion. This was down from over 4,500 policies worth nearly $13 billion in Over this two year period, policy sellers were paid over $3.2 billion in compensation, $3 billion of which was paid above the surrender amount offered by insurers, and thus this figure represents the value provided to policy owners that would not have occurred if not for the life insurance settlement market Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III page 10

11 7 Continued Life insurance settlements are regulated under both state and federal laws. The front-end transaction, which is the sale of a life insurance policy to a provider or investor from the policy owner, is regulated under state insurance laws. The back-end transaction, which is the sale of a life insurance policy to an investor from the provider, is regulated under state and federal securities laws. The SEC and the Financial Industry Regulatory Authority (FINRA) have regulatory authority over the sale of variable life insurance products, but they have also tried to assert themselves in the regulation of all life insurance settlements. Two federal circuit courts have reached opposing decisions, however, regarding whether a life insurance settlement is a security or not. The GAO states that inconsistencies in state-based regulation may lead to policy owners in some states receiving greater protection than those in other states while policy holders in others states may have more difficulty accessing information. Differences in state laws and court decisions may also prevent investors from gaining access to information that they need regarding their investments. The SEC concurred with the GAO s assessment and recommends that Congress clearly define life insurance settlements as securities, thus protecting investors in these transactions under U.S. securities laws. The GAO noted that they recently reported that Congress could consider the advantages and disadvantages of providing a federal charter option for insurance and creating a federal insurance regulatory entity because of the difficulties in harmonizing insurance regulation across states through the NAIC-based structure. The National Association of Insurance Commissioners (NAIC), however, disagreed with the assertion that a federal charter for insurance is an appropriate solution to the challenges highlighted in the report. Upending the existing system of state-based insurance regulation in favor of a federal charter option makes no sense given the success of the state regulatory system in the face of ongoing financial crises. 38 The NAIC asserts that state officials have effectively regulated the insurance market to keep up with the needs of the modern economy and argues that federal chartering would harm consumers. Members of the life insurance settlement industry commend the GAO on their review of the industry and pledge to work with the SEC. We are pleased that GAO recognized life settlement transactions as a viable option for policy owners, said ILMA Managing Director Jack Kelly. Only time will tell how future regulation is shaped, but greater transparency and less-ambiguous regulation may help the maturation of the life insurance settlement market. One benefit of greater regulation is that institutional investors may feel more comfortable committing capital to those that are licensed as securities intermediaries. 8 Summary Insurance-linked securities, once considered to be an alternative form of risk transfer, have become a mainstream method to transfer risk from insurers to the capital markets. With greater attention being paid to risk at the institutional level and the search for portfolio diversification at the investment level, insurance-linked securities seem poised to further facilitate the convergence between the capital and insurance markets. Life insurance-linked securities benefit entities with exposure to longevity/mortality risk by locking in mortality estimates. Investors benefit by gaining access to an asset class that is weakly correlated to the traditional financial markets and yields above average returns. As the market continues to grow, the many stakeholders facing longevity/mortality risk exposure, and the capital market investors, are gaining familiarity and sophistication with respect to the underwriting and securitization of longevity/mortality risks. Credit defaults stemming from the financial fallout in 2008 uncovered weaknesses in the way some life insurance-linked securities were structured. Investor demand has begun to return, however, indicating that previous concerns were related to the structuring of the securities, and not the underlying assets themselves. As both individuals and entities with longevity/mortality risk exposure search for greater ways to protect against adverse longevity/mortality movements, the potential for life insurance-linked securities remains strong. >>> Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III page 11

12 1 A World Economic Forum Report, Convergence of Insurance and Capital Markets, World Economic Forum, Michael Sherris and Samuel Wills, Financial Innovation and the Hedging of Longevity Risk, Australian School of Business, University of New South Wales, Sydney, Australia, Mathieu Boucher, Developments in the Insurance-Linked Securities (ILS) Life Market, Post Financial Crisis, 2009 East Asian Actuarial Conference, David Blake, Andrew Cairns, Kevin Downd, and Richard MacMinn. Longevity Bonds: Financial Engineering, Valuation and Hedging Ibid. 6 An insurance company that provides guarantees for a security to enhance the credit of the issuer. 7 The Role of Indices in Transferring Insurance Risks to the Capital Markets, Sigma, Swiss Re, Ernest Eng and Cormac Bradley, Insurance-Linked Securities Reaching Critical Mass, Emphasis, Towers Perrin, Duncan M. Briggs, Jonathan Hecht, and Charles Pickup, Life Insurance Securitizations Expanding, Emphasis, Towers Perrin, Mathieu Boucher, Developments in the Insurance-Linked Securities (ILS) Life Market, Post Financial Crisis, 2009 East Asian Actuarial Conference, Ernest Eng and Cormac Bradley, Insurance-Linked Securities Reaching Critical Mass, Emphasis, Towers Perrin, ibid 13 Jeffrey Stern, William Rosenblatt, Bernhardt Naell, and Keith M. Andruschak, Insurance Securitizations: Coping with Excess Reserve Requirements Under Regulation XXX, Journal of Taxation and Regulation of Financial Institutions, Ernest Eng and Cormac Bradley, Insurance-Linked Securities Reaching Critical Mass, Emphasis, Towers Perrin, Mathieu Boucher, Developments in the Insurance-Linked Securities (ILS) Life Market, Post Financial Crisis, 2009 East Asian Actuarial Conference, Ibid 17 The Role of Indices in Transferring Insurance Risks to the Capital Markets, Sigma, Swiss Re, Ibid. 19 Michael Sherris and Samuel Wills, Financial Innovation and the Hedging of Longevity Risk, Australian School of Business, University of New South Wales, Sydney, Australia, Robert S. Pindyck, The Dynamics of Commodity Spot and Futures Markets: A Primer, The Energy Journal, Michael Sherris and Samuel Wills, Financial Innovation and the Hedging of Longevity Risk, Australian School of Business, University of New South Wales, Sydney, Australia, David Blake, Andrew Cairns, Kevin Dowd, and Richard MacMinn, Longevity Bonds: Financial Engineering, Valuation and Hedging, Occurs when one party transfers risk to another party, and the party ceding the risk has less incentive to ensure that the risk is managed as efficiently as possible. 24 Source: Office for National Statistics Enrico Biffs and David Blake, Mortality-Linked Securities and Derivatives, Pensions Institute, David Blake, Andrew J.G. Cairns, and Kevin Dowd. The Birth of the Life Market. Pensions Institute Global Market Strategy, Longevity: A Market in the Making, JP Morgan Ibid. 29 Gill Wadsworth, Buyouts Take a Backseat, Investment and Pensions Europe, Ryan Davidson, UK Pension BPA Market to Halve in 2009, Predicts LCP, Risk.net, AON Benfield, Insurance-Linked Securities, Adapting to an Evolving Market 2009, redefining, The Role of Indices in Transferring Insurance Risks to the Capital Markets, Sigma, Swiss Re, Gill Wadsworth, Buyouts Take a Backseat, Investment and Pensions Europe, As cited in the Table 2 35 Meg Green, AIG Files First Rate Life Settlement Securitization, Trading Markets.com, Jack Kelly, What will the New Financial Reform Law Mean to the Longevity Markets?, ILMA Investor Notes, Ibid. 38 Report to the Special Committee on Aging, U.S. Senate, Life Insurance Settlements, Regulatory Inconsistencies May Pose a Number of Challenges, United States Government Accountability Office, Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III page 12