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Finance 432: Managing Financial Risk for Insurers

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Life insurance catastrophe bond. EIB/BNP (2004) Long term longevity bond ... based on the weighted average mortality of US, UK, France, Italy and Switzerland ... – PowerPoint PPT presentation

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Title: Finance 432: Managing Financial Risk for Insurers


1
Finance 432 Managing Financial Risk for
Insurers
  • Longevity Risk

2
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

3
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

4
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)

5
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
  • Lower investment returns can no longer cover
    increasing longevity

6
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 (2004)
  • Long term longevity bond

7
Swiss Re Mortality Index Bond
  • 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

8
Swiss Re Bond
  • Ratings A3/A
  • Fully subscribed
  • Investors included pension funds
  • High coupon
  • Natural hedge

9
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-

10
EIB/BPN Longevity Bond
  • 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)

11
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

12
New Mortality-Linked Securities
  • Longevity Bonds
  • Mortality swaps
  • Mortality futures
  • Mortality options

13
Characteristics of Securities
  • Exchange traded or Over-the-Counter (OTC)
  • Basis risk
  • Liquidity
  • Credit risk

14
Longevity Bonds
  • Principal at risk
  • Coupon based
  • Classical longevity bond
  • Payments linked to survivorship
  • Stochastic maturity
  • Zero-coupon longevity bonds
  • Deferred longevity bonds

15
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

16
Mortality Futures
  • Exchange traded
  • Significant market needed
  • Volatility essential
  • Underlying index
  • Well defined
  • Not concentrated on buy or sell side
  • Widely accepted
  • Hedgers and speculators

17
Mortality Options
  • Options
  • Protects one sided risk
  • Upfront payment
  • Survivor Caps
  • Survivor Floors

18
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/lon
    gevity_index.shtml

19
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
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