Coverage for longevity risk

This article discusses the challenges associated with longevity risk for certain economic actors and presents the main ways of hedging this risk. In particular, it outlines the market instruments that have recently been introduced to address longevity risk.

Abstract:

• The evolution of longevity is uncertain;
• The aging of the population means that more and more players have an interest in hedging against longevity risk;
• In addition to traditional insurance solutions, market-tradable hedging products have been introduced;
• These still represent a limited market but could increase the capacity to hedge this risk;
• This article presents the main instruments for hedging longevity risk: longevity risk bonds, longevity swaps, and q-forwards.

Life expectancy projections are uncertain, and the organizations that produce them generally provide, in addition to central scenarios, alternative scenarios based on different assumptions to reflect this uncertainty (see, for example, Bloom and Luca, 2016). Due to the aging of the population and increased longevity, the financial challenges associated with changes in life expectancy, at the aggregate level, are becoming increasingly significant and may affect various types of players, such as pension funds and life insurance companies.

There are now several ways to hedge against longevity risk. Until now, the main ones have been based on insurance contracts. However, market solutions have recently been introduced, although they have not always been as successful as hoped when they were first launched.

Ultimately, despite the potential benefits, the longevity risk market is still in its infancy and remains relatively small. This article is intended as an introduction to the issues surrounding longevity risk coverage and the various instruments available to address it.

Who has an interest in hedging against longevity risk?

Those who have an interest in hedging against longevity risk are those whose liabilities are likely to increase if actual longevity is higher or lower than anticipated. For example, an insurer with a large life insurance portfolio (more specifically, death insurance) will see its liabilities increase if actual mortality is higher than anticipated (see Table 1 for an example). Conversely, an insurer holding mainly life annuities or a defined benefit pension fund will see its liabilities increase if actual longevity is higher than anticipated (see Table 1).

One way for these types of players to hedge their bets is to diversify their portfolios. For example, an insurer with a short position in longevity risk, i.e., an insurer whose liabilities increase if longevity increases, can hedge by offering products for which its payments will be reduced if longevity increases. This would be the case for an insurer offering life annuities that decides to offer life insurance products to offset its short position in longevity risk. However, this strategy may have its limitations in that the two positions do not necessarily cancel each other out. In fact, the net position of life insurance companies and pension funds with regard to longevity risk is short (Blake et al., 2016). In 2011, Swiss Re estimated global exposure to longevity risk at USD 20.7 trillion (Burne, 2011).

Table 1: Effect of increased longevity on different types of contracts

Another means of coverage is to opt for buy-out and buy-in reinsurance solutions. In a buy-outcontract, a pension fund transfers, in exchange for a single premium, part of its assets and liabilities to an insurer who will be responsible for paying the annuities of the client portfolio it has acquired. In a buy-in contract, the pension fund pays a single premium to the insurer, which then pays out annuities based on the actual mortality of the pension fund’s clients (Latourrette, 2016).

Market-tradable longevity risk hedging products

Although reinsurance solutions are the most common today, insurers’ capacity to cover all longevity risk needs is limited. As a result, market-based solutions have been devised and are beginning to be introduced. However, this market is still in its infancy. We will present two types of products or contracts:

1. Longevity risk bonds (which are traded on regulated markets);
2. 
   Longevity swaps and q-forward products.

1. Longevity risk bonds

The principle behind longevity risk bonds is relatively simple and can take two forms. In the first case, a bank, government, or other entity issues a bond whose coupon depends negatively on a mortality index. Potential buyers of the bond are, for example, pension funds that want to protect themselves against the risk of higher-than-expected longevity. The issuer receives a sum of money at the start of the contract and the buyer generally receives in exchange a coupon (and possibly part of the principal repayment) whose amount increases (decreases) when the mortality index decreases (increases). This type of bond is similar to the one issued by the European Investment Bank and BNP Paribas in 2004, which was something of a failure.

The quality of this type of hedge obviously depends on the index chosen and its correlation with the longevity risk faced by the buyer. For example, if the mortality index used is that of the general population of a country P and a cohort C, but the buyer wishes to hedge against the risks associated with a product sold mainly to men in the high socio-professional category of this cohort, they will be imperfectly covered if the evolution of longevity among men in the high socio-professional category does not perfectly mirror that of the general population. The residual risk is known as the basis risk.

It is also possible for a company wishing to hedge a long position against longevity risk, for example if it has a large life insurance segment, to issue a bond whose payments depend positively on a mortality index. In this case, it can invest the amount it receives at the time of issue and has less to pay to bondholders if mortality is high, i.e., when it has to increase payments to its life insurance customers. Swiss Re issued a bond of this type in 2003, which was very successful.

However, the market for this type of product is still young and relatively limited. But given the growing need for coverage, this market could grow in the future. For it to be attractive to speculators, it is particularly important that the perceived liquidity of the product be high. For example, the underlying mortality indices must be transparent, not susceptible to information asymmetry issues, and there must be sufficient historical data on these indices for the markets to be able to value these bonds at their fair value. One attraction of longevity bonds for these investors is that the correlation between longevity and financial market returns appears to be low, which can allow for better diversification.

2. Longevity swaps and q-forward contracts

Finally, longevity swaps and q-forward contracts are very similar. In a longevity swap, the party seeking to hedge against longevity risk (e.g., a defined benefit pension fund or a company selling life annuities) owes a fixed amount to the other party each period, while the other party owes an amount that depends positively on changes in longevity.

A q-forward contract is similar, but payments are made only once, at the end of the contract. These contracts can be pure insurance contracts, but they can also be securitized and traded on markets. The advantage of the latter solution is that it spreads the risk among a larger number of players, thereby potentially increasing the proportion of risks covered. As with the previous products, trading in securities based on q-forwards and longevity swaps is recent and still limited.

Conclusion

Due to the aging population, longevity risks are significant for many economic players. Insurance solutions exist to address these risks. While traditional insurance solutions have prevailed for the time being, the introduction of new products indexed to longevity risk could ultimately increase the capacity to insure this risk. To be continued.

Sources

The above text is intended as a brief introduction to ways of hedging against longevity risk. For readers who would like more details on the market for financial products linked to longevity risk and the related issues, we particularly recommend reading the article by Blake et al. (2016).

Blake D., Cairns A., Coughlan G., Dowd K., Macminn R., « The New Market for Longevity Risk, » Revue d’Économie Financière, Issue 122, June 2016

Bloom D.E., Luca D.L., « The Global Demography of Aging: Facts, Explanations, Future, » Handbook of the Economics of Aging, 2016

Burne K., « Swiss-Re Longevity-Risk Deal Opens Door to More, » The Wall Street Journal, 2011, https://www.wsj.com/articles/SB10001424052748703730704576065871937194158

Latourrette B., « Longevity Risk for Pension Funds, » Revue d’Économie Financière, Issue 122, June 2016