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“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/ longevity_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