Longevity Risk: Old Age is Getting Even Older

What happens when people are living longer than expected? It is certainly fantastic news for everyone, as we look forward to live longer alongside continual medical and quality of life improvements. That is, unless you are a pensions fund or life insurer. In 1980, females at age 65 were expected to live for another 17 years. By 2009, this figure rose to 22 years. For males, life expectancy of 65-year-olds has increased from 14 years to 18 years over the same time period. With global life expectancies continuing to increase year on year, the providers of annuities and pension plans are faced with the risk of paying out greater amounts of money than they accounted for. This can be referred to as longevity risk, a buzzword amongst the insurance and financial industry for more than two decades. Longevity risk can be interpreted as uncertainty in the long-term trend in survival rates of individuals, although we typically are interested in survival rates being higher than expected.

What approaches have been taken for pensions funds and life insurers to manage their longevity risk? Reinsurance is a practical approach; however, most reinsurers are averse to taking on longevity risk. The second is for life insurers to sell more life insurance relative to annuities as a natural hedge. One emerging solution is building a life market, a market where standardised or over the counter longevity-linked securities are traded. This life market will allow the involved entities to spread their risks among each other and other investors who benefit from diversifying their portfolio with assets arguably uncorrelated with traditional financial markets. The contracts for trading these assets are robustly based on a suitable mortality or survivor index.

Although it sounds similar to a stock market index, a mortality index is based on the mortality of lives from an entire population rather than selected shares of biggest sizes. Similarly, the survivor index portrays the survival of a population over time. Shares can fluctuate by a multitude of ways, for example, news, trading, investor sentiments, and it can be very volatile daily. On the other hand, longevity improves over time but at a gradual pace, with the exception of catastrophes like wars and natural disasters. Volatility is typically less pertinent in the short term, rather being more significant in the long term trend. Hence, the fundamental volatility drivers are very different. A measure of longevity risk is to compare the difference between the expected and observed paths of the index.

Based on the mortality or survivor index, mortality- or longevity-linked securities can be created, for example longevity bonds or swaps. In December 2000, the world’s oldest life office Equitable Life Assurance Society (ELAS) was forced to close business due to losses arising from exposure to longevity risk, in the form of with-profits annuities. A year later, in 2001, the idea of a longevity bond (or survivor bond) was conceived. These bonds had annual coupon payments that were tied to a survivor index of a reference population, for example US males aged 65 in 2000. As members of this population cohort died off, the coupon payment amounts would decrease. The motivation behind the bond was to provide a useful hedge for the annuity position of a life insurer.

The first issue of these types of securities was a mortality bond in December 2003 by Swiss Re. The offer was a three-year maturity with face value tied to an international mortality index however in the event of catastrophic mortality, such as the Spanish influenza pandemic of 1918, the face value was significantly reduced. In return, investors were provided with generous floating coupon payments. This bond issue was successful, as it was well received by investors and allowed Swiss Re to transfer some of its extreme mortality risk.

A second longevity bond was soon announced by BNP Paribas, in conjunction with the European Investment Bank (EIB), in November 2004. The longevity bond had maturity of 25 years and an initial market value of around £540m. It featured coupon payments that were tied to a survivor index of English and Welsh males aged 65 in 2002. In a similar vein to the concept of bonds proposed in 2001, these longevity bonds were targeted at life insurers and pensions funds looking to hedge their annuity position. However, this second bond was poorly received by investors and subsequently withdrawn the next year.

This has led to a deeper look at the issues surrounding the pricing of these securities and the product design. Most current longevity securities are OTC; custom-made and provided by insurers themselves. This is attributed to the absence of a mortality or survivor index. Standardised longevity securities, based on indices, can attract more capital outside the insurance world and are more transparent with higher liquidity. However, this is subject to the reliability of the underlying indices.

Currently, the Life & Longevity Mortality Association seek to develop a working life market in the UK. Formed in 2010, LLMA is the longstanding not-for-profit venture whose current members are AVIVA, AXA, Deutsche Bank, J.P. Morgan, Morgan Stanley, Prudential PLC and Swiss Re. The LLMA plans to set standards for the new trading market of longevity securities by launching the first mortality trading index. Since May 2016, this index is being developed by a research team led by Macquarie University’s Associate Professor Jackie Li, Professor Leonie Tickle, and Dr Chong It Tan along with the support of Mercer Australia. The government also plays an important role in facing supply and demand issues for the life market. This is largely due to the influence of a country’s retirement system, for example, the UK has compulsory annuitisation and hence more developed annuity markets, especially in comparison to Australia which has middling demand for annuities.

The management of longevity risk is still very much in its infancy. Active discussion, research and engagement from industry professionals and academics is needed to develop solid solutions to the looming challenge. Hopefully in the future, the rise of old age and longer lives will be an all around pleasant event, even for the life insurers.

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