February 5, 2010
UK: Live longer and prosper
. LONDON, England / The Economist / Business & Finance / February 4, 2010 Longevity swaps Live long and prosper Plans are afoot to create a new capital market in longevity risk DEATH comes to everyone. The timing is much less certain. Longevity risk, the risk that people will live longer than expected, weighs heavily on those who run pension schemes and on insurers that provide annuities. Actuaries have a track record of systematically underestimating gains in life expectancy, and more old people means a bigger bill for benefits providers. Every additional year of life expectancy at age 65 is reckoned to bump up the present value of pension liabilities in British defined-benefit schemes by 3%, or £30 billion ($48 billion). Spry and retiring. Getty Images Demand for ways to offload longevity risk is increasing, particularly in Britain, which has lots of annuities and defined-benefit pensions. Solvency 2, a pending set of rules governing European insurers, is one source of pressure: it will force annuity providers to hold more capital against unhedged longevity risk. Pension schemes, fed up with filling in deficits only to see them widen again, are desperate to manage away as much risk as they can. Many schemes have now hedged against interest-rate movements and inflation; longevity is the next thing on the list. Simply offloading liabilities onto pension buy-out firms, which take on responsibility for schemes in return for a premium, is one option. But higher pension deficits in the wake of the financial crisis have made buy-outs more expensive. It is much cheaper to try to break off longevity risk and manage it separately. An army of bankers, insurers and consultants is at work figuring out ways to do just that. Longevity swaps, in which investors take on the risk of paying for longer-living pensioners in return for an agreed stream of payments from the seller, are emerging as a favoured answer. Last year Babcock International became the first company to complete a longevity swap, with Credit Suisse, for three of its schemes. Others have followed. Nick Horsfall of Towers Watson, a consultancy, thinks the pipeline of potential deals could push the British swaps market to £10 billion this year, up from around £3 billion-4 billion in 2009. Some are thinking further ahead. On February 1st a group of banks and insurers launched the Life and Longevity Markets Association (LLMA), a trade body based in London, to try to spur the development of a liquid longevity market. To date the end-buyers of longevity risk have mainly been insurers and reinsurers. They have the expertise to price the risk, but they do not have anything like the financial clout to cope with potential demand. In Britain alone, the total exposure to longevity risk is estimated by the LLMA to exceed £2 trillion. Soaking up that amount of business would require the capital markets to become interested in longevity risk, just as a market for catastrophe bonds has developed to hedge issuers against the risk of natural disasters. Some steps toward the goal of a longevity market are easier to take than others. The LLMA wants to speed up swaps transactions (which can currently take as long as a year) by standardising documentation, for instance. It should be possible to disseminate better data on past mortality experience. But other problems are much less tractable. Predicting life expectancy accurately is the biggest obstacle to pricing longevity risk. The risk of big jumps in life expectancy may be pretty low for people who have already retired, but underwriting longevity risk for young people in defined-benefit schemes or with deferred annuities is a shot in the dark. Nor is the scale of demand from mainstream investors clear. According to Christian Mumenthaler of Swiss Re, one of the LLMA’s founder members, reinsurers have an incentive to take on longevity risk, because they are already exposed to mortality risk (the risk of people dying too soon) through life-insurance policies. So if people live longer than expected, these businesses will see offsetting benefits elsewhere. High levels of interest from these natural buyers are thought to be suppressing prices at the moment. But they will run out of capacity eventually. What premium other investors will demand for taking on longevity risk is the question that will decide the success of this nascent market. [rc] Copyright © The Economist Newspaper Limited 2010.