Longevity & Mortality Risk Transfer via the Capital Markets Guy Coughlan, Managing Director PENSION ADVISORY GROUP S T R I C T L Y P R I V A T E A N D.

Longevity & Mortality Risk Transfer via the Capital Markets

Guy Coughlan, Managing DirectorPENSION ADVISORY GROUP

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N O V E M B E R 2 9 , 2 0 0 7Challenges in Quantitative Risk Management for Insurance,International Centre for Mathematical Sciences,Edinburgh

L I F E M E T R I C S

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Overview

A new market for longevity risk is emerging Investors are showing increasing interest in longevity-linked investments Pension plans and insurance companies are evaluating hedging

Longevity hedging via the capital markets is now possible Hedges are available

Obstacles to market development are being addressed Standardization Education

Hedgers (pension plans + annuity providers) need to better understand: Longevity risk should be measured and this can be done quite easily You don’t have to transfer 100% of the longevity risk to add value Basis risk can be managed

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Derivatives for transferring longevity risk

Issues in hedging longevity risk

Longevity – a new market

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This is because longevity exposure: Is transferable in principal Is economically significant: >£10 trillion globally Cannot be hedged in existing markets

But market development also requires:

Standardization to create liquidity

Standardized Index

Standardized instruments

The two sides of the market are hedgers and investors

Investors are prepared to invest in longevity

Longevity appears to be a good candidate to become a new market

Education

Longevity is an unfamiliar risk

Perceived as more complex than it is

A market for longevity risk is emerging

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Pension plans have by far the biggest exposure to longevity/mortality risks

Large imbalance between long and short exposures Short exposure is 30-40 times larger than long exposure

Hedging demand from pension plans will drive market

Longevity US UK Exposure

Defined Benefit Pensions Short £3 trillion £800 billion

Life Insurance Industry

Annuity Reserves* Short <£50 billion £135 billion

Life Insurance Reserves*Long £75 billion £38 billion

* These are only the portion of reserves linked to mortality/longevity riskSources: 2006 data from: OECD, UK Pensions Regulator, US Council of Insurers, Moody’s, JPMorgan

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Pension Plans

Annuity Providers

Life Insurers

Life Settlement / Premium Finance

InvestorsPension Buyout

Funds

ILS InvestorsOther Hedge

FundsEndowments

Pharma

Others (reverse mortgage, etc.)

Partial offset of risk in life business

Earn risk premium

Issue longevity-linked debt

Add synthetic exposure

Buy longevity protection

Buy longevity protection

Sell longevity protection

Sell longevity protection

Add synthetic exposure

Earn risk premium

Hedge longevitytrend risk

Earn risk premium

Earn risk premium

Hedge

Hedge

Hedge

Potential players in the longevity risk marketplace

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Pension plans & annuity providers Several are already looking to

hedge at least some part of their longevity exposure

Investors see longevity as a new asset class enabling them to: Earn a risk premium Gain exposure to an

uncorrelated asset class

Hedgers: Longevity risk sellers

Hedgers: Longevity risk sellers

Investors: Longevity risk buyers

Investors: Longevity risk buyers

Risk transfer products need to balance these opposing needs

Want customized hedges to

maximize effectiveness

Want standardized investments

to maximize liquidity

There is capital seeking to be deployed on both sides of the market

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Intermediaries will play a crucial role in this market

Repackaging to meet both the needs of buyers and sellers

Providing credit intermediation

Providing liquidity through market making in standardized contracts

Pensionplan /

Annuitybook

Banks

Insurance Co.

Hedge funds

Endowments

Asset managers

Longevity Risk

Longevity Risk

Hedges Investments

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“LifeMetrics” is a toolkit developed to catalyse the market by providing standardisation and education

What is LifeMetrics?

Launched by JPMorgan in March 2007 and freely available from the website

Longevity IndexLongevity & mortality indices based on national

populationUS, England & Wales and the Netherlands

FrameworkMethods and analytics for risk measurement &

management

SoftwareTools for modelling and forecasting mortality

Features

Transparent, non-proprietary, open-source and freely-available

International

Key Advisors: Watson Wyatt and The Pensions Institute

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Current and historic data available on website and Bloomberg

www.lifemetrics.com

Designed to: Increase visibility of

longevity risk Provide a standardized

reference for longevity hedges

Data on crude and graduated mortality rates, and period life expectancy

Broken down by Gender, Age, Country, Period

Full documentation also available from the website

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Standardised Longevity Hedge: Standardised Longevity Hedge:

Hedge Provider

Pension Plan

Payment reflects growth in liability

value from changes in longevity

Standardised to reflect national population longevity experience But calibrated to match mortality

sensitivity of liabilities

Structured as a value hedge

Maturity of Hedge: Finite: E.g. 10 years or 20 years

Financial risk management paradigm

There two broad categories of longevity risk hedges, both of which will transact

Tailored to reflect actual longevity experience of the pension/annuitants

Structured as a cash flow hedge

Maturity of Hedge: When last member/annuitant dies

Indemnification paradigm

Customised Longevity Hedge: Customised Longevity Hedge:

Fixed longevityHedge

ProviderPension Plan

Actual longevity

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Advantages and disadvantages of customised vs. standardised longevity hedges

DisadvantagesDisadvantagesAdvantagesAdvantagesC

usto

mis

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Hed

ge

Cu

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Hed

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Sta

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Hed

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Sta

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Hed

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Standardised has advantages of simplicity, cost & liquidity

Exact hedge, no residual basis risk

More expensive than standardised

High set-up & operational costs

Poor liquidity

Longer maturity so larger counterparty credit exposure

Less attractive to investors

Cheaper than customised hedge

Lower set-up / operational costs

More liquid

Shorter maturity so lower counterparty credit exposure

Not a perfect hedge Basis risk Roll risk

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Hedge effectiveness is an important risk management concept… But in the context of longevity it is poorly understood

A hedge can be less than 100% effective and still add value The “indemnification paradigm”

means that this is not widely acknowledged. Insurance risk transfer is generally 100% effective

Most hedges of financial risk are not 100% effective

Hedge effectiveness is about risk reduction Quantifying how a hedge reduces

potential for monetary loss Need to measure residual risk

Standardised hedges can still be highly effective

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0% 20% 40% 60% 80% 100%

Amount of hedge

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Risk (£mm)

Source: “HEAT: Hedge Effectiveness” (2003)www.jpmorgan.com/heat

Risk Reduction (%)

Hedge effectivenessHedge effectiveness

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One key aspect of hedge effectiveness is the population basis risk associated with standardised hedges Correlations in mortality

improvementsShort-term correlations E&W males aged 65

Correlations in mortality improvementsShort-term correlations E&W males aged 65

Basis risk by age can be managed Since mortality

improvements are highly correlated across age

Pension value males aged 65CMI demographics vs LifeMetrics hedge

Pension value males aged 65CMI demographics vs LifeMetrics hedge

Basis risk by socio-economic group can be managed Short term correlations in

mortality improvements have a low correlations

But mortality movements are correlated over the long term

456789

1011

1991 1993 1995 1997 1999 2001

Pension (CMI population)

LifeMetrics hedge (Nationalpopulation)

100%98% 95% 92% 91% 90%94%88% 98%82%83%

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100%

60 61 62 63 64 65 66 67 68 69 70Age

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Successful products will best meet needs of all economic agents

Mortality rates are most likely to form the basis of liquid products Simple building bocks Allows creation of smallest number of instruments Can be combined in a portfolio to replicate survivorship and life expectancy Can be used by all hedgers: pensions, annuity provides, life insurers, etc.

Hedgers: Want efficient hedging vehicle

Bespoke instruments

Investors: Want attractive investments

Finite maturity

Standardised indices

Market makers:

Want liquidity Lowest number of instruments

Standardised instruments

Longevity risk transfer products could be based on survivorship, life expectancy and/or mortality rates

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LifeMetrics longevity hedges can be tailored to individual pension plans and annuity books

“Building-block” approach Standardised hedging building-

blocks called “q-forwards” Building-blocks are carefully

combined to provide an effective hedge for a specific portfolio

What are these building-blocks? Simple capital market

instruments Based on LifeMetrics Index Involve exchange of realised

mortality rate in a future period for a fixed mortality rate

Paym

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Pen

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Pla

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Realised mortalit

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Fixed rate

1.20%

PensionPlan

Hedge Provider

Amountx realised mortality rate

Amount

x fixed mortality rate

Payout from q-forwardPayout from q-forward

q-Forward: Hedge building-blockq-Forward: Hedge building-block

Lower realised mortality results in a payout to offset the increase in

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Pension/annuity hedge: Receive fixed q

Pension/annuity hedge: Receive fixed q

q-Forwards can hedge pension, annuity and life insurance liabilities

q-Forwards are building blocksCan be combined to hedge: Pension liabilities Annuity liabilities Life insurance liabilities

A small set of standardised contracts can provide effective hedges A specific maturity (e.g. 10

yrs) Split by gender (males &

females) Age groups (40-49, 50-59, 60-

69, 70-79, 80-89)

Pension Plan /Annuity Book

Hedge provider

Amountx realised mortality

rate

Amount x fixed mortality rate

Amountx fixed mortality rate

Life InsurerHedge

providerAmount

x realised mortality rate

Life portfolio hedge: Pay fixed qLife portfolio hedge: Pay fixed q

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Portfolio of LifeMetricsHedge Building Blocks

Age 50-59Males

Age 60-69Males

Age 70-79Males

Age 80-89Males

Age 50-59Females

Age 60-69Females

Age 70-79Females

Age 80-89Females

Portfolio of building-blocks can provide an effective hedge of longevity risk for a pension plan

10%

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12%

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14%

15%

Payoff for hedgein 2017

Increase inliability in 2017due to mortalityimprovements

Liab

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val

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hang

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Impact of increase in trend of mortality improvements

Impact of increase in trend of mortality improvements

Hedge

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100

150

2007 2017 2027 2037 2047 2057 2067

+2% Unexpectedmortality improvementBest Estimate

Pension liability

13.3%

13.2%

Hedges are liquid, cost effective and effective

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0.60%

0.80%

1.00%

1.20%

1.40%

1.60%

2005 2009 2013 2017 2021 2025

Mortality rates for XX-year-old males (illustrative only)

Mortality rates for XX-year-old males (illustrative only)

How much does it cost?

The market is net short longevity

There are more economic agents with short longevity positions than with long positions

So to transfer longevity risk investors will require compensation

Mortality forward rate should be settled below the expected mortality rate

Best Estimate or Expected Mortality Curve

Forward Mortality Curve

Risk Premiu

m

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Longevity hedging via the capital markets is now a reality Hedges are now available

The development of liquidity requires Standardisation Education

Hedgers (pension plans + annuity providers) need to better understand: Concepts of hedge effectiveness You don’t have to transfer 100% of the risk to add value Basis risk can be managed

A liquid market requires standardised instruments Concentrate liquidity in a small number of contracts initially q-Forwards are a good candidate for developing a liquid market

Conclusions

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Longevity & Mortality Risk Transfer via the Capital Markets Guy Coughlan, Managing Director PENSION ADVISORY GROUP S T R I C T L Y P R I V A T E A N D.

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