(October 29, 2013) — After several false starts, the creation of a capital market where longevity risk can be traded may be about to happen—and other options might be coming online too.
Until now, all swaps that have been carried out by investors hedging this risk have included a reinsurer, but Allianz Global Investors thinks this may be about to change.
“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,” Bernhard Brunner of risklab, a subsidiary of Allianz Global Investors, wrote in a recent paper issued by the financial institution. “But the first steps are being taken towards the creation of a liquid capital market.”
Brunner highlighted the 2010 creation of the Life and Longevity Markets Association by several banks and insurers in a bid to speed up transactions via methods such as standardizing documentation.
In anticipation of a properly functioning longevity market, Allianz Global Investors set out a range of possibilities for investors.
“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.”
However, the company said investors themselves might be interested in taking the other side of the bet through longevity bonds.
It detailed “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 Brunner’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 wrote. “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.”
Principal at risk longevity bonds could appeal to investors familiar with Insurance-Linked Securities (ILS), such as catastrophe bonds. The challenge, Allianz Global Investors said, would be 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, governments would make prices publicly available,” Brunner said. “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.”
The amount by which longevity shocks can blow a pension fund off course has been outlined by consulting firm Redington.
“Even for schemes with an achievable set of investment objectives and deficit recovery contribution schedule, the magnitude of the moves in longevity assumptions experienced over the last decade can substantially damage the chances of the scheme meeting its investment objectives, “ said Wenyu Bai, a member of the ALM team at Redington.
“Moving from a popular mortality assumption back in 2006 to the most frequently used assumption in 2013, a typical UK pension scheme could see their liability present value increased by 7.2%, and interest rate and inflation hedge ratio reduced by 9%. This means that the scheme will have to increase their required return on assets by 88 basis points, or increase their annual deficit reduction contribution by £6.9 million.”
All investors need now, is to engage governments and regulators.
To read the full Allianz Global Investors paper, click here. For the Redington research, click here.
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