1. Longevity Bonds or Securitizing Longevity Dr. Rodolfo Wehrhahn, ACLI

2. Copyright American Council of Life Insurers 2005 ContentsContents  Should I care about longevity risk?  How does securitization work?  Should I care about securitization of longevity?  Longevity bonds and beyond

3. Copyright American Council of Life Insurers 2005 Should I care about longevity risk?  Pension funds are chosen based on certain characteristics –Solvency: today’s and on the long run –Investments expertise: best expected returns –Administrative skills: high quality service  Asset liability management  Longevity risk expertise?

4. Copyright American Council of Life Insurers 2005 Should I Care About Longevity Risk?  Life expectancy has been increasing for as long as we having taking measurements –Improved nutrition and sanitation –Better safety and working conditions –Widespread immunizations and antibiotics

5. Copyright American Council of Life Insurers 2005 Should I Care About Longevity Risk?  How much more improvement can we expect? –Medical and technological breakthroughs could lead to important leaps –Dr. Aubrey de Grey at the University of Cambridge caused a storm at an aging conference in his assertion that the human lifespan could increase to 1,000 years once medical researchers learn how to fix cell damage

6. Copyright American Council of Life Insurers 2005 Should I Care About Longevity Risk?

7. Copyright American Council of Life Insurers 2005 Should I Care About Longevity Risk? Mortality improvement – how big is it?  Life expectancy for a 60 year old Chilean annuitant at today’s mortality rates with 1% annual improvements is 22.5  Each additional 1% increase in mortality improvement factors lengthens this by 1.5 years  Thus, mortality improvement needs to be clearly understood and quantified

8. Copyright American Council of Life Insurers 2005 Should I Care About Longevity Risk? How mortality improvement & life expectancy relate  If a static mortality table is used (with no improvement factors), then every reduction in absolute rates reflects an increase in life expectancy  However, when pricing insurance products, life expectancy typically reflects an assumed annual future rate of improvement –Thus, it changes only if there is a change in future mortality improvement –A 0.25% increase in mortality improvement translates to a 4 month increase in life expectancy –So life expectancy will continue to increase only if the mortality improvement factors continue to increase

9. Copyright American Council of Life Insurers 2005 Should I Care About Longevity Risk? Does mortality improvement vary by age?  Mortality improvement scales typically tend to vary by gender and by age  Recent Chilean improvement factors were approximately 1% at all ages  An unexpected shock would likely affect young and old differently –Example – AIDS

10. Copyright American Council of Life Insurers 2005 Should I Care About Longevity Risk? Impact of changes in mortality on annuity prices  A 1% increase in improvement factors reduces the pricing spread by 0.28%  A 3% increase in improvement factors reduces the pricing spread by 1.00%

11. Copyright American Council of Life Insurers 2005 Should I Care About Longevity Risk? Impact of changes in mortality on annuity prices  Impact of shock discovery that life expectancy is 5 years longer than expected: –Mortality rates would now be approximately 50% of expected –Pricing spreads would shrink by 1.3% –From this, we can estimate how much of a shock we can absorb, given different pricing spreads

12. Copyright American Council of Life Insurers 2005 Should I Care About Longevity Risk?

13. Copyright American Council of Life Insurers 2005 ContentsContents  Should I care about longevity risk?  How does securitization work?  Should I care about securitization of longevity?  Longevity bonds and beyond

14. Copyright American Council of Life Insurers 2005 How does securitization work  Securitization: Transforming the value or future cash flows of a given business into financial instruments that can be traded in the capital markets

15. Copyright American Council of Life Insurers 2005 How does securitization work  Mortality bonds: The instruments will pay coupons depending on the mortality performance of the underlying block of business. The coupons or even the principal could be at risk if mortality does not perform well, i.e. there are more deaths than expected

16. Copyright American Council of Life Insurers 2005 How does securitization work  Longevity bonds: The instruments will pay coupons depending on the longevity performance of the underlying block of business. The coupons or even the principal could be at risk if longevity does not perform well i.e. there are less deaths than expected

17. Copyright American Council of Life Insurers 2005 Structure of an Asset Backed Security Originator Customer ProductPayment

18. Copyright American Council of Life Insurers 2005 Structure of an Asset Backed Security Investor Originator Customer Asset Backed Security ProductPayment Cash Asset Securities Investment

19. Copyright American Council of Life Insurers 2005 Structure of an Asset Backed Security Swap Counterparty Investor Originator Customer Asset Backed Security ProductPayment Cash Asset Fixed RateFloating Rate Securities Investment

20. Copyright American Council of Life Insurers 2005 Structure of an Asset Backed Security

21. Copyright American Council of Life Insurers 2005 How does securitization works Characteristics of a business that can be securitized  Well defined  Public and of easy access independent indicators  Stable and predictable under “normal” circumstances  Large enough to support fluctuations and transactional costs  Repeatable

22. Copyright American Council of Life Insurers 2005 ContentsContents  Should I care about longevity risk?  How does securitization work?  Should I care about securitization of longevity?  Longevity bonds and beyond

23. Copyright American Council of Life Insurers 2005 Should I care about Securitization of longevity  Securitization of longevity as a risk managing tool –Mortality risk transfer instrument –Hedging tool  Securitization as a source of financing –Access to the capital markets –Uncorrelated investment

24. Copyright American Council of Life Insurers 2005 Securitization of longevity as a risk managing tool  Tail risk reduction or elimination  Reduce or eliminate adverse mortality experience  Diversification of the risk  Uncorrelated investment  Hedging tool

25. Copyright American Council of Life Insurers 2005 Securitization of longevity as a risk managing tool Life term insurance vs. annuities  Mortality improvements have opposite impacts on insurance and annuity products; for example, a 1% increase in mortality improvement factors: –Increases an annuity liability by 5% –Decreases a typical term liability by 20%  These changes are reasonably linear

26. Copyright American Council of Life Insurers 2005 Securitization of longevity as a source of financing  A profitable block of business can be the ideal source of low cost financing: –It is less sensitive to present economic environment –It is relatively independent of the issuer present performance –It does not necessarily impact the balance sheet –The asset it is already existing and profits can be accelerated

27. Copyright American Council of Life Insurers 2005 Securitization of longevity as a source of financing  A profitable block of business can be the ideal source of low cost financing: –It does not necessarily impact the balance sheet –The asset is already existing and profits can be accelerated

28. Copyright American Council of Life Insurers 2005 ContentsContents  Should I care about longevity risk?  How does securitization work?  Should I care about securitization of longevity?  Longevity bonds and beyond

29. Copyright American Council of Life Insurers 2005 Examples of Securitizations SPVAmount (US $Mil) S& P Rating Issue Date MaturitySpread Premium to LIBOR (bps) Queensgate Spl Purp A Quensgate Spl Purp B Queensgate Spl Purp C Vita Capital II Ltd. B Vita Capital II Ltd. C Vita Capital II Ltd. D 175.0 45.0 25.0 62.0 200.0 100.0 A+ BBB A- BBB+ BBB- Dec-04 Apr-05 Dec-24 Jan-10 146 247 90 140 190

30. Copyright American Council of Life Insurers 2005 Longevity Bond Summary of Terms  Issued byEuropean Investment Bank  Security£550 million longevity linked EMTN  IndexPublicly available mortality for cohort of 65 year old males  Longevity Risk PeriodCalendar years 2003 to 2027  Maturity25 years

31. Copyright American Council of Life Insurers 2005 Longevity Bond Summary of Terms  Bond Payoff£50 million * CSRt  CSRtCumulative survival rate at time t  Index PublishedONS Publication DH1 Mortality Statistics Table 8  Payment FrequencyAnnual

32. Copyright American Council of Life Insurers 2005 Longevity Bond Cash Flow Profile

33. Copyright American Council of Life Insurers 2005 Longevity Bond Annual Payment Determination Payment year200520062007 Reference year200320042005 Age of cohort656667 Annual mortality rate1.50%1.80%2.10% Annual survival rate98.50%98.20%97.90% Cumulative survival rate98.50%96.73%94.70% Payment (£1,000 base)£985.00£967.30£947.00

34. Copyright American Council of Life Insurers 2005 Longevity bonds and beyond Challenges going forward:  Cost and complexity of issuing  Market interest: risk- return ratio  Secondary market creation

35. Longevity Bonds or Securitizing Longevity Dr. Rodolfo Wehrhahn, ACLI