Multiplying investment and retirement knowledge LONGEVITY RISK

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1 Multiplying investment and retirement knowledge LONGEVITY RISK With its more prominent cousins inflation and investment risk taking center stage among pension plan sponsors and trustees, longevity risk has long lived a life in the shadows. This is about to change, as the recent longevity swap of British insurer Aviva at $8 billion, one of the biggest of its kind indicates. In a series of articles, including an exclusive interview with Akzo Nobel discussing its 2012 transaction, this special edition of PROJECT M outlines the financial risk increasing life expectancy creates. Dedicated articles explore the challenges and benefits of such seasoned tools as buy-ins or buy-outs while examining the solutions capital markets can offer. S PEC I A EDITIO L N

2 THE IMPROVEMENT THAT SHOULDN T BE Aging is far more complex than simply wearing out body tissue. Yet with rising life expectancy, we are at greater risk of using up savings, not cells.

3 Much like aging itself, the financial risk that comes with increasing life expectancy is slowly and quietly moving up on the agenda of financial experts. It did not take the stage with a sudden shock. My awareness of longevity risk has been growing since the turn of the century when pension funds investment losses, due to rising life expectancy and increasing liabilities, were no longer offset by strong equity returns, Andrew Cairns, director of the Actuarial Research Centre (ARC) and professor at Edinburgh s Heriot-Watt University, remembers. Often ridiculed for reducing life s most exciting moments to probabilities, actuaries like Cairns take a rational approach to something as emotional as ever longer human lives. With average life expectancy for both men and women in OECD countries rising from 70.5 to 80.1 over the last 40 years ( ), pension funds expanded their risk awareness (inflation, interest rate) to include longevity, the risk that a person or group of individuals will live longer than expected. While on an individual level every extra year spent in good health is an achievement, largely thanks to improved hygiene and other medical advances, this poses significant financial risk to pension funds, insurers and reinsurers as well as governments. The two questions paining them are: How can mortality rates.be more accurately forecasted? and How can the risk of associated cash flows be best managed? Ignoring longevity risk can cause substantial problems for sponsors of pension plans, above all in the long run, risklab s Bernhard Brunner warns.* In a study conducted with the department of mathematical finance at the Technical University of Munich, Brunner and colleagues analyzed DB pension plans three main risks (inflation, investment and longevity). They point to a lack of standardization in mortality assumptions on a national level, which has resulted in slow progress in establishing a longevity market. Their work also AN EXPLOSION OF MODELS The earliest model was designed by Ronald D. Lee and Lawrence R. Carter in 1992, while Natacha Brouhns (2002), Claudia Czado (2005) and Antoine Delwarde (2007) developed more formal statistical methods. Lee and Timothy Miller (2001) took a different approach to avoid a systematic bias in the last year of the data set. Arthur Renshaw and Steven Haberman (2006) proposed one of the first stochastic models to incorporate a cohort effect while Andrew Cairns, David Blake and Kevin Dowd (2006) aimed to incorporate a multi-factor age-period structure with a cohort effect. For a detailed assessment see Modelling and Management of Mortality Risk: A Review by Andrew Cairns, David Blake and Kevin Dowd. confirmed that inflation risk is reinforced by increasing longevity as first described by the OECD. MAKESHIFT IMPROVEMENTS While modeling of longevity risk has seen significant advances, understanding human life expectancies, much less projecting them accurately, has until now proven to be a flawed exercise. The explosion of new mortality models over recent years was partly prompted by the failure of existing models to identify the complexities of changing mortality rates, Andrew Hunt and David Blake (both from the Cass Business School, City University London) point out in an April 2013 paper. Yet even the new models are overloaded with ad hoc extensions of questionable demographic significance, argue Blake and Hunt. Unsurprisingly, improvements in life expectancy have been continuously * risklab is a company of Global Investors? 3

4 underestimated. From the first forecast in 1971 until 2004, UK projections of life expectancy for boys born in 2011 remained below actual life expectancy (Office of National Statistics). In the late 1990s, actuaries discovered that plan members were significantly outliving their models predictions. When put to the test of real-life events, existing mortality models often proved faulty, and demographers amended them with ad hoc fixes as they went along, David Blake told PROJECT M. Weak models may incur significant cost for plan sponsors. If liabilities increase by 3% for every year a 65-year-old pensioner outlives the modeled life expectancy, as is often assumed, funding ratios can deteriorate quickly. Aggregate pension liabilities of S&P 1500 companies would jump from $1.97 trillion (Mercer, 2013) to $2.03 trillion if the formula were applied. US public pension liabilities $3.19 trillion by a conservative estimate in June 2009 would rise by approximately $100 billion. THE DEMOGRAPHER S NEW MICROSCOPE The shift from defined benefit (DB) to defined contribution (DC), as well as the current low interestrate environment, shine another spotlight on longevity risk. In the DB world, the risk of prematurely depleting funds was largely borne by plan sponsors. While it is an ongoing debate as to who should carry what risk in a pension plan, DB schemes have economies of scale effects on their side. By sharing risk across a group of plan members, they are better positioned to mirror a population s average life expectancy than a single individual. With the risk on the individual s shoulders and life expectancy at 65 in OECD nations standing at 20.9 years for women and 17.6 years for men (OECD, 2011), savers have to prepare for up to two decades in retirement without knowing exactly if and how they will outlive their peers. Economists like David Blake now refine their mortality models to identify every significant demographic feature in a country s data. While this does not fill funding gaps, it promises to be a more powerful microscope in the demographer s lab. By allowing a more accurate glimpse at future developments of life expectancy, it may also help actuaries to better match a plan s assets to its liabilities. Yet challenges remain plentiful when it comes to longevity. The understanding of pension funds risk appetite, data quality and mortality modeling has to be improved, with the latter task likely taking up the next 15 years, Cairns estimates. Longevity risk capacity has to be increased as players with a natural longevity risk hedge, reinsurers in particular, are largely saturated. Longevity bonds have to become more attractive to capital markets. Capital market instruments such as q-forwards or S-forwards are often deliberately overlooked by pension plan advisors for fear of the residual risk they contain. 4

5 FOCUS BUY IN OR BUY OUT? HOW TO HEDGE LONGEVITY RISK Why should companies hold on to longevity risk when insurers are better positioned to handle it? Buy-in and buy-out transactions allow sponsors to pass on the risk. T he fact that we re living longer than pension assets and liabilities are transferred to the expected is good news. But for pension insurer, shifting the obligation from the pension plan sponsors with burgeoning pension plan sponsor s balance sheet to the insurer s. payments, it spells significant financial risk. A buy-in, meanwhile, is a way of reducing the Companies can transfer this risk to those better risk of dealing with a pension while the trustees able to deal with its consequences, namely remain ultimately responsible for the benefits. insurers or reinsurers, via transactions known as Under this method the insurer agrees, for a fee, to buy-ins and buy-outs. The third approach to make periodic payments that match those made by hedging longevity risk longevity swaps will be the sponsor to its members. discussed in the following article. PICKING UP THE TAB Both buy-ins and buy-outs involve pension funds buying bulk annuities from insurance One of the largest buy-outs in the UK involved Thorn, companies that then pay the pensions, taking over the lighting and electrical retailer, in The the longevity and investment risk. trustees of the Thorn Pension Fund, which covers In a buy-out, the insurance company takes over the company s former staff, purchased a bulk full responsibility for making disbursements to annuity contract from Pension Insurance pensioners. In return for an upfront payment, the Corporation (PIC) that provided an individual 5?

6 policy to each member of the pension fund. The pension fund was then wound up and sold for 1.1 billion [approximately. $1.8 bill] to PIC. The deal offered greater financial security to the trustees and a 5% improvement in members benefits. And Thorn no longer needed to worry about making extra payments if its former staff lived longer than expected. The British Airways pension scheme s buy-in with Rothesay Life in 2010, meanwhile, affected one of the two defined benefit pension schemes sponsored by the airline. In this case, the liabilities were covered by an insurance agreement issued by Rothesay, under which the trustees retained ownership of the assets backing the transaction. In return for the proceeds of those assets, Rothesay agreed to pay the trustees an amount equal to the covered pensioners benefits. TRADITIONAL BUT NOT OUTMODED While the future of buy-outs and buy-ins is debated due to limited capacity of bulk annuity markets, annuities costs and limited opportunities for diversification, buy-outs have yet to outlive their use. Pension buy-outs remain the ultimate endgame, says Guy Coughlan, chief risk and analytics officer and managing director with Pacific Global Advisors. They are the only way to completely remove risk. There is no other approach that can quite fulfill the same role. By removing the pension plan from a company s balance sheet, buy-outs free up management time and focus. A pension plan consumes the risk capacity of any company, Coughlan explains. If you eliminate it, you can free up additional risk capacity, which can be channeled into a company s core competencies. It also enables capital to be more profitably employed in its main business. A powerful tool, buy-outs nonetheless come at a cost, Bernhard Brunner, director at risklab points out. Longevity swaps may be a cheaper approach. Without the need to be funded, they can be used as stand-alone instruments to directly address longevity risk or provide custom-tailored solutions in combination with a liability-driven investment strategy. Buy-out methods tend to attract companies who want to reduce the size of a pension plan for any strategic reason, adds Amy Kessler, senior vice president and head of longevity reinsurance at Prudential Retirement. Sometimes, buy-outs may be used ahead of an acquisition or divestiture. Kessler views buy-outs as an appealing way to reduce pension obligations and address all of the asset risk and longevity risk in one go. A buy-out is the only way to have the pension obligation walk off a company s balance sheet and onto ours, she says. And buy-outs aren t necessarily costly. Plan sponsors who say buy-outs are too expensive are still thinking about earning a return on assets of 7-8%, Kessler remarks. Not only is that extraordinarily difficult to do, but it can t be done on a risk-free basis, and the cash implication in a market crisis has proven to be unacceptable. Nevertheless, the challenge of paying a premium upfront in the aftermath of the financial crisis has so far impeded buy-outs from becoming commonplace in the US. As pension funds now start to recover, US companies are better able to address their risk profile and consider buy-out as an option. Corporate boards don t want to retain the risk that their pension plans may require large cash infusions in the future to recover from market losses, Kessler explains. Instead, many companies are de-risking their pensions so their cash will be available to help survive the next business cycle or better yet, invest in business growth. BUY-IN OR LONGEVITY SWAP? At first glance, buy-ins are less attractive than the more holistic buy-out option. They offer less flexibility when compared to their more versatile and powerful capital market cousin, the longevity swap. While hedging longevity risk, buy-ins also 6

7 address interest rate and inflation risk, giving the pension fund a more comprehensive (and costly) solution than may be necessary. Swaps, which will be explored in detail in the following article, exclusively target longevity risk and thus avoid stray costs. Yet true capital market solutions are still in the making. Today, the longevity swaps being completed for pension funds may be passed through investment banks to reinsurers, Kessler remarks, but they are not yet a true capital market solution. Buy-ins also force plans to be funded up to the level of the annuity contract. Finally, the liabilities remain in the pension scheme. Nevertheless, they appeal to some companies, particularly those that are underfunded: buy-ins don t lower their funded status. Others may opt for a buy-in as they feel connected to their retirees and actively want to continue writing out their pension checks, Kessler points out. Furthermore, companies might choose a buy-in to ensure their pension plan is being taken care of and increase their attractiveness before approaching a potential buyer. longevity risk as more and more investors seek uncorrelated risks in order to diversify. A lot of traditional assets are producing low returns, he explains. Receiving slightly higher returns from new types of investments is a plus. Pension plans need a host of techniques at their disposal to manage increasing longevity risk as life expectancy increases. Buy-ins and buy-outs might be traditional instruments, but they remain valid solutions in today s market. Yet they have their shortcomings, and new options need to be explored. As Bernhard Brunner and colleagues note in a risklab study, Longevity hedges via capital markets can be a powerful tool for risk mitigation. Therefore, an efficient capital market for longevity risk seems desirable. CHOICE AND FLEXIBILITY IN THE US Today, buy-ins and buy-outs, as well as an array of other de-risking solutions, are applied freely and interchangeably in the UK following the advent several years ago of regulatory and accountancy changes encouraging good risk management techniques, according to Kessler. This choice and flexibility is now arriving in the US market, which is starting to recognize the advantages of de-risking solutions that deliver more consistent financial results which eliminate the risk that the pension fund might need a cash infusion in a down market, she says. As the market develops and grows, Coughlan expects to see interesting transactions to come from insurers reinsuring their longevity risk or packaging it up in investments in the capital markets. He predicts a growing appetite to take on 7

8 LONGEVITY SWAPS: THE DEAL OF A LIFETIME Looking to the future, longevity swaps are emerging as a powerful and attractive alternative.

9 In this world nothing can be said to be certain, The first standardized longevity swap, except death and taxes, proclaimed meanwhile, was between Pall Pension Fund (UK) Benjamin Franklin in With regards to and JPMorgan in This covered 1,800 scheme death, however, one uncertainty does remain: when one dies. This is the problem facing pension funds and annuities, which make payments to individuals as long as they are alive. With people members with a 10-year term. Pall receives money from JPMorgan if the life expectancy is higher than assumed in order to offset the additional retirement payments, says Brunner. now living longer, it means millions more in extra payouts. Faced with this dilemma, many pension funds are looking to longevity swaps for security. These serve as a type of insurance for pension funds, which pay a fixed regular premium to offload the risk of pension-scheme members living longer. The fund s partners, normally an investment bank and a reinsurer, pay a floating premium in return, which increases the longer people live. In essence, the insurance policy covers the extra payouts occasioned by the increase in life expectancy. The sponsor remains responsible for making benefit payments to its employees, and the assets remain with the seller, explains Bernhard Brunner of risklab. MORTALITY MISMATCH The one danger of standardized swaps is that the cash flow depends on the mortality index of a pension population, which can differ from the hedger s mortality experience and expectations, explains Enrico Biffis, associate professor of Actuarial Finance at the Imperial College of London. This can introduce a mismatch, or wedge, between the mortality rates of the hedger and the one in which the index is based, he says. That means that the hedger needs to carefully design the hedge and possibly rebalance it in a clever way to minimize hedging error. Overall, longevity swaps offer a number of clear advantages. Firstly, they are flexible payment can STANDARD OR TAILORED SOLUTION? Two types of longevity swaps exist: bespoke and standardized or index-based instruments. With bespoke longevity swaps, the cash flow depends on the number of survivors among the pension scheme members, so it includes a full longevity risk transfer. In the case of index-based longevity swaps, the be made monthly or quarterly, for example. In addition, they require minimal upfront capital and can be tailored to address explicitly the longevity risk of specific portions of pension liabilities. This makes them highly attractive for a pension fund that has already addressed other risks. Assets also remain with the sponsor. cashflow depends on the observed mortality rate or life expectancy of a population. One of the largest deals of this kind has been the bespoke longevity swap between BMW Operations Pension Scheme and Abbey Life (a Deutsche Bank subsidiary). This covered the liabilities of 60,000 pensioners for the rest of their lives to the value of» THE INSURANCE CAPITAL MARKET CAN PROVIDE HUGE RISK SHARING OPPORTUNITIES, BUT WE NEED SUBSTANTIAL ENGAGEMENT FROM GOVERNMENTS AND REGULATORS. «ENRICO BIFFIS 3 billion (approximately $4.8 billion). Hannover Re assumed almost half of the transaction s longevity risk. An even bigger deal was closed by Aviva in March 2014 when the British insurer transferred AN ILLIQUID MARKET Until now, all swaps have included a reinsurer. The liabilities of approximately 5 billion ($8 billion). capital markets offer additional risk-bearing? 9

10 capacity, but the market now needs to develop further. It is hard for a normal investor to invest, as longevity swaps are not standardized, the market isn t liquid yet and documentation isn t in place, Brunner explains. But the first steps are being taken towards the creation of a liquid capital market. With this in mind, a group of banks and insurers have set up the Life and Longevity Markets Association (LLMA) in a bid to speed up transactions via methods such as standardizing documentation. If more liquidity is introduced into the market, other longevity hedging solutions are likely to emerge in popularity alongside longevity swaps, such as q-forwards and S-forwards, which are currently more theoretical instruments. A q-forward is essentially a mini swap that uses a one-year death probability rate. The main difference between this and the S-forwards swap is the underlying mortality rate, which in the case of the latter is linked to the survival rate of a given population. LONGEVITY BONDS AN OPTION Longevity bonds could also be useful instruments in reducing longevity risk. There are two important types of these: principal at risk longevity bonds, which are hedges against catastrophic mortality risk; and coupon-based longevity bonds, which link payments to the survival rate of a cohort. In Biffis s opinion, longevity swaps hold the advantage over coupon-based bonds. Bonds involve huge upfront payments, plus they have the issue of how dividend payments are specified, he says. They are very capital intensive and have basis risk. Swaps, meanwhile, aren t as capital intensive, don t drain much capital, and the floating rate can be linked to different ages and cohorts of interest. On the other hand, principal at risk longevity bonds could appeal to investors familiar with Insurance-Linked Securities (ILS), such as catastrophe bonds. The challenge here is to design payments that are both beneficial to the hedgers and appealing to ILS investors. By issuing standardized longevity bonds that are index-based on the country s own population, however, governments would make prices publicly available, Brunner points out. These would then be used as reference points for other transactions and assist the growth of a longevity derivatives market, solving the problem of transparency that is also holding back the market in current over-the-counter deals. These are among the many reasons why longevity swaps are attracting interest from countries such as the US, Canada and the Netherlands as well as the UK, where all deals have taken place so far. But for longevity swaps to reach their full potential, the right regulatory environment needs to be in place. The insurance capital market can provide huge risk sharing opportunities, Biffis acknowledges, but it is clear that we need substantial engagement from governments and regulators. 10

11 TAKING THE LONG VIEW The Dutch paint and chemicals group Akzo Nobel successfully transferred pension liabilities worth 1.75 billion ($2.42 billion), but handling the contract is an onerous task. PROJECT M: Jim, Matthew Akzo Nobel opted for a swap to hedge longevity risk. What attracted you to this particular solution as opposed to others? PROJECT M: Did you consider other ways of hedging longevity risk? Are you looking at alternative hedging solutions for now or the future? KEANE: At Akzo Nobel, we have very significant pension liabilities and our policy is to try and de-risk those over time. We ve done significant work in the area of interest rates, inflation hedging and so forth. A major risk that needs to be addressed is longevity: like everyone else, we ve experienced ever-increasing liabilities due to rising life expectancy. In an ideal world, you would hedge your inflation and interest rate risks first as they tend to be the most volatile. KEANE: Yes, we looked at other solutions, such as bulk buy-ins and buy-outs, but they seemed very expensive at that time. For that sort of transaction, there would always be a premium because you re paying for the insurers reserving requirements, capital requirements and profit. There s always going to be a significant cost over and above whatever provisions we currently make. But we re always looking who knows? After that, longevity risk would be next on the agenda to achieve a solution similar to an in-house annuity, where you re not picking up all of the reserving profit lines associated with a full-blown annuity policy, at PROJECT M: What do you consider to be the highlights of the deal? And what could have been improved? least whilst the risk remains on the balance sheet. Basically, however, we saw an opportunity to hedge some of our longevity risk for an attractive price and we went for it. The provider, Swiss Re, had a UK-regulated insurance company, so we received the risk pricing directly from the end carrier instead of having an investment bank intermediate the transaction. The banks, on the other hand, relied on prices they obtained on the reinsurance market. KEANE: It was good to be able to deal with the ultimate risk carrier directly. The advisory support throughout the tendering process also went well. Some of the contractual details were challenging, however. We were conscious that we were negotiating a contract with a potential duration of 60 years and in retrospect, perhaps we over-engineered some of the contractual terms. It took about nine months to complete the TRUEBLOOD: At the time, the pricing for this type of transaction. deal looked attractive relative to our liabilities. In fact, it was sufficiently close to our estimated liabilities that no additional upfront cash funding was required from Akzo Nobel, which was appealing to the company. We had a well-funded scheme, TRUEBLOOD: We exchange and value data covered by the deal on a quarterly basis, and I am already at the point where I wish we hadn t written certain things the way we had, as they are onerous which carried out the swap. to manage.? 11

12 PROJECT M: Looking back, what would you do differently? TRUEBLOOD: If we did another swap or anything similar, like a bulk buy-out, we would run it much as we would an M&A transaction, keeping competitive tension for as long as possible with hard deadlines for completion. At times, in this transaction we found it difficult to get the key parties with appropriate authority into a room to negotiate with us. It is essential to get all parties to commit to the negotiations and agreed deadlines. KEANE: It s more the details we would change. On a high-level view, we have no question about whether longevity was a good thing to hedge. And the deal is doing what it is meant to. We weren t approaching this as a way to make a profit but were simply seeking to hedge a relatively unknown risk. If longevity improves dramatically, it provides great protection. On the flip side, we think it would take quite some time for any reverse in longevity to work its way through and give us any benefit. In our view, the downside protection is more valuable than any potential upside we are giving up by insuring it. Relative to our liabilities, we found the terms attractive, and we still think so despite some of the detailed headaches that go with it. It s quite a small market, so pure longevity hedges are quite rare. PROJECT M: Why do you think the market is so small? What are the limiting factors? KEANE: There are several reasons. Firstly, longevity swap transactions are difficult and complex. Secondly, there aren t many players in the market. Then there s the big question, which we ve been asked several times: is it a good deal and is it good value? You don t sound very professional when you say, Yes, it probably is, but we can t really point to anything for certain as it s too early to tell. Life expectancy increases slowly, so only time will tell. You also have to put it into the context of how exposed you are to pension risks, how important it is to hedge them and what proportion of the liabilities you re hedging. We have very significant liabilities, and this is only one portion of that. PROJECT M: How do you see the market developing? TRUEBLOOD: As far as we re aware, there is no direct carrier of the risk out there looking for business in the UK; it s all intermediated via insurers or banks. We considered the bankfacilitated agreements, where liabilities were capped and the length of coverage was limited, but this is against what a company naturally wants to do. If a company is going to pay a premium to get a risk off the table, it wants it completely off and not coming back when things turn bad, or after a number of years. That might be a barrier to the capital markets coming in because they don t want to hold this sort of risk indefinitely and with no caps on it. I think that s a reason why we haven t seen more players coming in at this stage. In addition, large insurers on balance probably prefer deals that involve the transfer of assets, such as bulk annuity deals rather than pure longevity deals. THE DEAL THE PEOPLE Akzo Nobel initiated the transaction of $2.42 billion of its liabilities to help protect one of its UK pension funds against the risk of its members living longer than the fund s calculations. Reinsurer Swiss Re completed the deal in 2012, which related to 17,000 pensioners, through its UK insurance subsidiary. Jim Keane is Akzo Nobel s international pensions manager; Matthew Trueblood acts as the company s UK pensions manager. Both are based in London and helped negotiate the longevity swap with Swiss Re. 12

13 FOCUS BRIDGING THE GAP What needs to be done to create a viable longevity market? By Bernhard Brunner and Mikhail Krayzler L To improve longevity risk hedging, we ongevity risk did not have its Lehmann recommend a combined approach using reinsurers moment. Awareness of retirees outliving resources as well as capital market instruments. the calculations of their pension funds has A capital market could accommodate longevity risk slowly been creeping onto the finance industry s at a lower cost compared to traditional buy-ins agenda and interest in transferring longevity risk and buy-outs. Crucially, it would also create a through buy-ins, buy-outs and swap-based distinct alternative and uncorrelated asset class solutions has increased, particularly in the UK. for investors. While the largest chunk of longevity risk has been But the development of a longevity market is absorbed by reinsurers, a true longevity market hampered by several obstacles. First, pension funds is still sorely lacking, primarily because require customized solutions that will not create reinsurers capacity is limited. additional basis risk. Potential investors, on 13?

14 the other hand, demand standardized index-based longevity instruments to make pricing comparable. This discrepancy is echoed in the area of maturities. Pension funds prefer instruments with maturities of more than 30 years, while investors are interested in asset classes with maturities hardly longer than 10 years. To bridge the gap, we recommend financial advisers cooperate with reinsurers to provide a customized longevity swap based on a pension scheme s population. Reinsurers can then pool and select the portfolio-specific longevity risk taken from a variety of pension plans and annuity providers and transfer it to capital markets using standardized, index-based longevity instruments. This allows reinsurance companies to increase their capacity for longevity risks. While problems such as insufficient standardization and a lack of transparency, liquidity and education are looming, they can be resolved. Index-based transactions, which can easily be standardized and linked to the same reference population, could be used to transfer systematic risk. It might even be possible to concentrate longevity transactions in Europe on one single index, which would not only make transactions cheaper but also increase liquidity, rendering longevity as an asset class more attractive to investors. The resulting basis risk could be taken up by reinsurance companies. Once the liquidity on this index-based market is sufficient, more specific indices, such as those based on a single country or socio-economic group, could be developed and used in further transactions. SHINING A LIGHT ON THE COSTS Transparent pricing is crucial in any capital market. This can be provided in two ways. First, pricing agents such as the Life and Longevity Markets Association (LLMA) could set up a price range for longevity risk, in order to increase liquidity and transparency. As most of its members were involved in past longevity transactions, the LLMA could provide aggregate statistics based on completed transactions. Another option would be standardized indexbased longevity government bonds. These could assist in the growth of a longevity derivatives market, while providing the transparency sought by investors in over-the-counter transactions. They could then be consulted as a pricing reference in other dealings. Ideally, governments would issue deferred longevity bonds, namely bonds with coupons linked to the survival rate of a designated cohort, with payments deferred until the cohort reaches a predefined age. This would provide more longevity exposure with less capital. If governments were to issue bonds annually at a face value of 5-10 billion ($7-14 billion) with short maturities of years, this would boost the longevity market. Once investors start flowing in, governments could gradually reduce their participation, eventually exiting the market once it is liquid. This tactic worked successfully in the past, when inflation-linked bonds issued by the national governments essentially converted inflation into a tradable instrument. ONE MORE JOB FOR THE REGULATOR Finally, regulatory requirements and accounting rules need to be adjusted to kick-start supply and demand in a future longevity risk market. The application of realistic mortality assumptions and the introduction of risk-based capital requirements made pension funds in the UK very aware of their longevity risk exposure. This was one of the main drivers for companies to start securitizing this risk. In order to develop a longevity market outside the UK, similar regulatory changes need to be made. Realistic assessment of longevity risk will also help reduce the catch-up premium: the net difference in 14

15 the perceived cost and the actual cost of longevity hedging. Ensuring realistic values for pension liabilities would require changes in accounting rules. Accounting and regulatory rules are crucial for the attractiveness of longevity hedges. A pension fund or annuity provider will only hedge its longevity risk if the risk capital relief is sufficient. Otherwise, it might be cheaper for the pension fund to keep the risk without securitization. Introduction of risk-based levies in the UK is often named as one of the main incentives for the increased number of longevity transactions. Initial steps towards a longevity risk market have been made in the Netherlands, the US, Canada and particularly in the UK where several transactions driven by regulatory and accounting incentives were completed. Still, the market cannot evolve on its own. Governments, regulators and international institutions need to play their role, too. BIOGRAPHIES As head of hedging with risklab, a company of Global Investors, Bernhard works to mitigate pension plans longevity risk. Mikhail is a PhD student at Technical University Munich, currently examining hedging opportunities for variable annuities. 15

16 SOURCES Antolin, Pablo (2007); Longevity Risk and Private Pensions in OECD Working Papers on Insurance and PrivatePensions Hunt, Andrew and David Blake (2014); Discussion Paper: A General Procedure for constructing Mortality Models Novy-Marx, Robert and Joshua D. Rauh (2010); Public Pension Promises: How Big are They and What are They Worth? in Journal of Finance Scheuenstuhl, Gerhard and Sandra Blome, Bernhard Brunner, Matthias Börger, Mikhail Krayzier, Helmut Artinger (2012); Longevity Risk within Pension Systems Related articles outliving-our-bodies-warranty MASTHEAD Publisher and Editorial Office SE International Pensions Königinstrasse Munich, Germany [email protected] Authors: Bernhard Brunner, Christian Gressner, Lois Hoyal, Mikhail Krayzler Closing date: March 2014 Notice The opinions expressed in the articles in this magazine do not necessarily reflect the views of the publisher or the PROJECT M editorial team. Photo Credits: Plainpicture, Getty Images, Shutterstock; Important Information Investing in the markets involves risk. The principal value and return of an investment will fluctuate over time, and an investment may be worth more or less than its original cost when redeemed. Past performance does not guarantee future results. Diversification and asset allocation do not assure a profit or protect against loss in declining markets. PROJECT M is issued in the U.S. by Global Investors Distributors LLC, 1633 Broadway, New York, N.Y , member SIPC. The materials in this publication are based on publicly available sources verified at the time of release. However, SE does not warrant the accuracy, reliability or completeness of any information contained in this publication. Neither SE nor its employees and deputies will take legal responsibility for any errors or omissions. The magazine is intended for general information purposes only. None of the information should be interpreted as a solicitation, offer or recommendation of any kind. Certain of the statements contained herein may be statements of future expectations and involve known and unknown risks, and uncertainties that may cause actual results, performance or events to differ materially from those expressed or implied in such statements. No duty to update The company assumes no obligation to update any information contained herein. Copyright: The contents of this magazine are protected by copyright law. All rights reserved by SE. To subscribe to PROJECT M or provide feedback, contact: [email protected]