Finance 432: Managing Financial Risk for Insurers

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Finance 432 Managing Financial Risk for
Insurers

• Longevity Risk

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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

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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

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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)

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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

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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

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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

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Swiss Re Bond

• Ratings A3/A
• Fully subscribed
• Investors included pension funds
• High coupon
• Natural hedge

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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-

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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)

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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

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New Mortality-Linked Securities

• Longevity Bonds
• Mortality swaps
• Mortality futures
• Mortality options

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Characteristics of Securities

• Exchange traded or Over-the-Counter (OTC)
• Basis risk
• Liquidity
• Credit risk

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Longevity Bonds

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

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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

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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

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Mortality Options

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

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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

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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