Finance 432: Managing
Financial Risk for Insurers
Longevity Risk
Overview
• Longevity risk defined
• How insurers are exposed to longevity risk
• How organizations could manage this risk
– Life insurers
– Pension funds
• Longevity derivatives
Reading: “Living with Mortality: Longevity
Bonds and Other Mortality-Linked Securities”
by Blake, Cairns and Dowd
Longevity Risk
• Longevity risk is the risk of mortality rates
deviating from expected levels
• Over last century, mortality rates have steadily
declined, leading to longer life expectancies
• Significant improvement for most recent
period has been noted
• Primary concern for insurers and pension
funds is improvement for those age 60 and
older
Exposure to Longevity Risk
• Life insurance
– Risk is if mortality rates increase
– Coverage concentrated on particular ages (30-70)
– Recent concerns
• Catastrophic losses
• Pandemics
• Annuities and pension funds
– Risk is if mortality rates decline more than expected
– Annuities are concentrated on particular ages (60+)
Managing Longevity Risk
• Life insurers
– Could balance life insurance and annuity exposure
• Difficult to accomplish
– Reinsurance for sudden increased mortality
• Concentration of reinsurers
• Cost of coverage
• Pension funds
– Spreading losses forward under pension accounting
– Use of asset returns as discount rate
Longevity Derivatives
• First life insurance securitizations involved
offsetting premium loadings or reducing
reserve requirements
• Current securitizations involve securitizing
mortality risk
– Swiss Re (2003)
• Life insurance catastrophe bond
– EIB/BNP (announced 2004, on hold)
• Long term longevity bond
Swiss Re Mortality Index Bond
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Issued December, 2003
$400 million in 3 year notes, quarterly coupons
Bond paid LIBOR + 135 basis points
Mortality rate was based on the weighted
average mortality of US, UK, France, Italy and
Switzerland
• Option to reduce repayment on bond if
mortality exceeds 130% of 2002 mortality rate
• Principal is reduced 5% for every 0.01 increase
in mortality over threshold
• Vita Capital was the Special Purpose Vehicle
Swiss Re Bond
• Ratings: A3/A+
• Fully subscribed
• Investors included pension funds
– High coupon
– Natural hedge
Swiss Re– Second Mortality Bond
• Second bond announced in April 2005
• $362 million, maturity date of 2010
• Three tranches:
– Class B: 120% trigger, LIBOR + 90 bp, A- rating
– Class C: 115% trigger, LIBOR + 140 bp, BBB+
– Class D: 110% trigger, LIBOR + 190 bp, BBB-
EIB/BPN Longevity Bond
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Announced in November 2004
Issued by the European Investment Bank (EIB)
BNP Paribas was the originator
Partner Re was the longevity risk reinsurer
₤540 million, 25 year maturity
Amortizing bond
Floating coupon payments tied to cohourt
survivor index (English and Welsh males age 65)
EIB/BNP Bond Problems
• Required upfront payment by hedgers
• Cost to hedge ~20 basis points
• Credit risk
– EIB (AAA rating)
– BNP (AA)
– Partner Re (AA)
• Cross-currency swap involved (euros/sterling)
• 25 year maturity may be too short
New Mortality-Linked Securities
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Longevity Bonds
Mortality swaps
Mortality futures
Mortality options
Characteristics of Securities
• Exchange traded or Over-the-Counter (OTC)
– Basis risk
– Liquidity
• Credit risk
Longevity Bonds
• Principal at risk
• Coupon based
• Classical longevity bond
– Payments linked to survivorship
– Stochastic maturity
• Zero-coupon longevity bonds
• Deferred longevity bonds
Mortality Swaps
• Exchanging future cash flows based on
mortality index
• Current market developing
– Published mortality and counterparty mortality rates
• Vanilla mortality swaps (VMS)
– Fixed side – declining payments based on initial
mortality index
– Floating side – payments based on realized mortality
index
• Other potential mortality swaps
– Swaps on spreads, cross-currency swaps
Mortality Futures
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Exchange traded
Significant market needed
Volatility essential
Underlying index
– Well defined
– Not concentrated on buy or sell side
– Widely accepted
• Hedgers and speculators
Mortality Options
• Options
– Protects one sided risk
– Upfront payment
• Survivor Caps
• Survivor Floors
Mortality Index
• Single index
– Advantages – liquidity, acceptability
– Problems – basis risk
• Multiple indices
– Advantages – closer correlation
– Problems – confusion, less liquidity
• Credit Suisse Longevity Index
http://www.csfb.com/institutional/fixed_income/l
ongevity_index.shtml
Conclusion
• Insurers are likely to have a number of options
for transferring longevity risk in the future
• Appropriate use of these products could reduce
risk and enhance profitability
• Inappropriate use could be very costly
• Importance of understanding risk management
techniques