Who wants to pay forever? Hedging longevity risk

A picture shows the hands of Chinese 104-year-old twins Cao Xiaoqiao (R) and her elder sister Cao Daqiao on the outskirts of Shiqiaozi town in Zhucheng, Shandong province June 18, 2009.

LONDON (Reuters) - The ageing of Europe may open opportunities to sell savings products, but it also spells a real threat to parts of the financial services industry. Pensions experts call it the "toxic tail".

Like the subprime crisis faced by by banks in 2008, the risk of people living for up to 20 years after retirement seems to have crept up on an industry based on using historical data to calculate people's chances of an early death.

Now, pension funds and insurers say the mounting burden of protracted pensions payments is increasingly concentrated on a small group of providers: them.

Trying to spread this longevity risk to include capital markets and governments, they highlight concerns about corporate solvency and argue that fundamentally, provision for retired people who outlive expectations is a sovereign role.

"We don't want to see the equivalent of a banking crisis in the pension market," David Blake, professor of Pension Economics at Cass Business School, and director of the Pensions Institute told Reuters.

Nowhere better can the process be seen than in Britain, which is facing a crisis resulting from a combination of pension reforms and increased life expectancy.

As home to the world's second largest pension fund industry and one of the most sophisticated markets for private pensions, Britain's experience is worth exploring: other European countries are moving in a broadly similar direction, shifting the burden of old-age provision towards funded, private schemes.

Global pension private-sector liabilities are of the order of $25 trillion (16 trillion pounds), according to OECD data in a January Pensions Institute report, which cited estimates that every additional year of life expectancy at age 65 adds around 3 percent to the present value of some UK pension liabilities.

Several factors -- the market crash brought on by subprime lending, new solvency rules for insurers due in 2012 and the stampede of baby-boomers to retirement age -- are adding urgency to providers' efforts to spread their exposure.

The UK has seen a flurry of over-the-counter longevity swaps deals, the biggest of which so far involved German car maker BMW (BMWG.DE) in February offloading 3 billion pounds of risk from its UK pension scheme to Deutsche Bank's (DBKGn.DE) insurance subsidiary Abbey Life.

Abbey Life insured the longevity risk on the BMW pension scheme, taking responsibility for the payments and transferring a proportion of that risk to a panel of reinsurers.

Building on these deals, pension providers are working to construct capital markets instruments to slice and dice longevity risk into tradeable portions.

But the pensions industry says such markets should be underpinned by a roster of government bonds that are structured to help maintain payments to people who are tending to outlive even current expectations -- for example, those aged over 90.

If that seems like a small group, the evidence is it's the population segment most likely to grow. There are around 450,000 centenarians in the world today and experts estimate that thanks to ageing baby-boomers, there could be a million across the world by 2030.

There's also mounting uncertainty about how many people will have died by age 90, and the Pensions Institute cites mortality projections which show some men at that age will live beyond 110 -- a long "tail risk" which may boost liabilities significantly.

"Longevity risk is a size that it should also go out to the capital markets," said John Fitzpatrick, a partner at Pension Corporation, which buys out liabilities and sponsors some pension funds. He is also a director of a fledgling venture to make such a market happen.

So far, neither capital markets nor the British government have been enthusiastic about the plan, although investment banks are behind the latest efforts to build a tradeable longevity swaps market.

Proponents of a longevity bond say they are receiving a more receptive response from the Conservatives, but the party declined comment.

WHO WILL BUY?

In a longevity swap like the BMW deal, the automaker reduced its exposure to its longer-lived pensioners by passing this liability to Abbey Life for 3 billion pounds. Typically, that premium is based on agreed mortality risks in the portfolio.

Abbey Life transferred a proportion of the risk to a consortium of reinsurers. The idea is that this risk is then passed onto investors such as Insurance-Linked Securities (ILS) investors, hedge funds and sovereign wealth funds.

They are attracted by the new asset class as an investment which would trade out of synch with traditional assets such as equities, bonds and real estate.

At the fundamental level, longevity risk is a good thing to own if you believe for any reason that more people will die sooner than currently forecast, if you have a portfolio that would lose money should such a catastrophe happen, or if you anticipate returns on the asset.

"Investors ... who own the risk of hurricanes, typhoons, earthquakes and lethal epidemics are ideally suited to take on longevity risk," said Fitzpatrick.

"There is no known correlation between the wind blowing and the earth shaking and how long UK pensioners live -- longevity offers a good diversifying risk for their portfolios," he said.

Capital markets players have already been involved in longevity transactions to a small degree: of the eight publicly announced swaps, the longevity risk was passed through to investors through reinsurers and investment banks.

But these have been bespoke deals. A key to developing such a market would be standardised indices. The Life and Longevity Markets Association (LLMA), of which Fitzpatrick is a director, was set up in February by a consortium of banks, insurers and pension experts to do just this.

HOT POTATO

Pricing the risk is complex. For a longevity transaction to happen, the investor, pension fund and investment bank have to agree on a forward projection of the cash flows related to either a population index or to a specific pension block.

And markets' resistance at current prices is palpable.

"Pension funds are marketing liabilities at unreasonable levels," said Andrea Cavalleri, head of Life at Securis Investments Partners, a fund dedicated to transferring insurance-linked risk to the capital markets.

"We often disagree with the mortality improvement assumptions provided by the pension funds in what can be outdated models," he said, underlining the basic problem -- people are living longer than previously expected.

"In reality, the capital markets should not be picking up the bill for unreasonable assumptions that the pension funds have on their books," he added, referring to liabilities the pension providers already hold.

Enter the government?

The many arguments in favour of a sovereign bond linked to longevity rest on one fundamental expectation: if pension providers can't pay, or become insolvent, governments will have to.

Longevity bonds could make the process neater, and more politically palatable, than the collapse of a pension provider.

"We will develop collateral mechanisms so investors can trade the risk themselves," said Fitzpatrick of the LLMA.

"But it would be helpful if the government did issue a longevity-linked bond, because such a system would reduce the amount of longevity risk that the government is likely to have in the future."

UNINTENDED CONSEQUENCES

A paradox in all this is that waves of pension reforms have been designed to shift the risk of providing for old age away from the state or corporates and onto the individual, and people have been encouraged to turn to capital markets to provide.

In principle, pension providers' liabilities have been reduced by moves away from the guarantees in Defined Benefit pension schemes towards less-secure Defined Contribution models, which are more like the U.S. 401(k) plans.

But in practice insurers say that even with the reforms, because people are living longer than expected, the risk of funding new schemes is becoming concentrated with them, especially in Britain.

"Insurance companies are beginning to play a big role in aggregating longevity risk in the economy," said the Pensions Institute paper, co-authored by Blake and Tom Boardman, director of retirement strategy and innovation at Prudential UK (PRU.L).

When they retire, Defined Contribution plan members usually use capital accumulated in the schemes to buy an annuity -- commonly sold by insurers -- to provide their future income.

So sellers of annuities are the ones now exposed to the risk that holders will typically live longer than expected in pricing the product. This "aggregate longevity risk" cannot be hedged, Boardman says.

"The situation is particularly acute for insurance companies operating in the European Union," said the paper. The insurance industry's equivalent of Basel II for banks, Solvency II, is due to be introduced in 2012 and currently proposes that insurers be required to hold significant extra capital to back their annuity liabilities if longevity risk cannot be hedged.

As a result, affordable annuities are becoming harder to find.

"If the private sector is unable to hedge aggregate longevity risk, it increases the likelihood that insurance companies stop selling annuities or increase annuity prices, which would reduce pensioner income in retirement," said Boardman.

LONGEVITY FLOATERS

The pensions industry wants the government to issue bonds whose coupon payments, made to pension plans and annuity providers, depend on survivorship: if more people survive at each age than was expected, the government pays higher coupons.

If, on the other hand, survivorship is lower than expected, the bond pays out lower coupons. Pension plans and annuity providers would see their payments also fall.

Boardman argues that the private sector can hedge risks at an individual level, but the government needs to provide the hedge against the trend. The industry says the bond could be similar to inflation-linked gilts first issued for pension funds in 1981.

"The government helped the development of the inflation swap market by issuing an index-linked bond because it gave a pure price for inflation risk to the market," said the Pension Corporation's Fitzpatrick.

"Likewise, it would be helpful for investors to be able to see a pure price for longevity. A large traded market in longevity would develop as you have today around inflation swaps."

The government has so far been averse to the implication that by issuing a longevity bond, it would be assuming the risk of the old getting older that no-one foresaw when pension reforms were implemented.

But the pensions industry points that the government is already exposed to longevity risk: private-sector pension liabilities and public sector funded pension plans both exceed 1 trillion pounds each, according to Boardman's paper.

"Nobody wants to take on the tail risk," said Blake. "The government bonds are necessary because the investors who have recently become interested in taking the other side of the longevity swaps market have no appetite for hedging long-duration tail longevity risk."

Securis Investments Partners' Cavalleri thinks it's simpler than that.

Unless the starting assumptions are appropriate, the need for pension and annuity players to hedge is misleading, he said.

"It is about getting rid of unwanted and unattractive risks. Frankly, we don't see who would want to be on the receiving side of that -- at least on current terms."

(Editing by Sara Ledwith and Nigel Stephenson)