Keeping Some Skin in the Game: How to Start a Capital Market in Longevity Risk Transfers

Abstract

The recent activity in pension buyouts and bespoke longevity swaps suggests that a significant process of aggregation of longevity exposures is under way, led by major insurers, investment banks, and buyout firms with the support of leading reinsurers. As regulatory capital charges and limited reinsurance capacity constrain the scope for market growth, there is now an opportunity for institutions that are pooling longevity exposures to issue securities that appeal to capital market investors, thereby broadening the sharing of longevity risk and increasing market capacity. For this to happen, longevity exposures need to be suitably pooled and tranched to maximize diversification benefits offered to investors and to address asymmetric information issues. We argue that a natural way for longevity risk to be transferred is through suitably designed principal-at-risk bonds.

Notes

The Life and Longevity Markets Association.

The market was started by newly established monoline insurers known as buyout companies. Later, larger traditional insurance companies and reinsurance companies and investment banks entered the market. See LCP (2012) for an overview of market participants and recent transactions.

A “lemon” is something, such as a second-hand car, that is revealed to be faulty only after it has been purchased (e.g., Akerlof 1970).

The typical longevity exposure of a pension plan spans different cohorts of active and retired members, not to mention the fact that a large portion of pensions paid by pension funds and annuity providers are indexed to inflation.

See Blake et al. (2006), Biffis and Blake (2010b), and Blake et al. (2013) for further details.

In the case of a plan deficit, a company borrows the amount necessary to pay an insurer to buy out its pension liabilities in full.

See Biffis et al. (2012) for details on the structuring of longevity swaps, including collateral arrangements.

Longevity risk management in LDI is discussed, for example, in Aro and Pennanen (2013).

See Cowley and Cummins (2005) for an overview of insurance securitization.

This situation is formalized in the model of DeMarzo and Duffie (1999), for example.

In the model of Biffis and Blake (2010b), this premium is zero because both supply and demand are risk-neutral.

The bond would typically be collateralized and issued via a special purpose vehicle, a procedure that would influence the size of the credit risk premium.

Should the holder of the exposure wish to do so, this responsibility could be transferred to a third party administrator who would make the pension payments.

See Grace et al. (2001) and Lakdawalla and Zanjani (2012), for example.

In the baseline model of Biffis and Blake (2010a), for example, one unit of collateral is used to collateralize a representative survival probability S. The resulting payoff from the instrument is therefore a death rate D=1−S.

It is a central tenet of corporate finance that debt-like instruments can minimize the adverse effects of information asymmetry when raising capital through the issuance of securities (e.g., Tirole 2005).

Buyout and other insurance and reinsurance companies have already been acting as aggregators and may find themselves as naturally positioned to take on this intermediary role.

See Subrahmanyam (1991) and Gorton and Pennacchi (1993), for example.

See DeMarzo (2005), for example.

We note that Figures 1 and 4 encompass both cases of informed and uninformed sellers of longevity exposures. In the first case, the investors face the “buyer’s curse” (the risk of ending up with a “lemon”) when buying from more informed counterparties. In the second case, the uninformed holders of exposures face the “seller’s curse” (of being exposed to “cherry picking”) when selling to more informed counterparties.

For a more formal analysis together with proofs of the propositions discussed in this article, see Biffis and Blake (2010b, 2013).

See “Swiss Re Transfers 180 Million of Extreme Mortality Risk” (www.swissre.com/media/news_releases/Swiss_Re_transfers_USD_180_million_of_extreme_mortality_risk_to_the_capital_markets_through_the_Vita_securitization_programme.html; accessed January 18, 2014).