1. Longevity & Mortality Risk Transfer via the Capital Markets Guy Coughlan, Managing Director PENSION ADVISORY GROUP S T R I C T L Y P R I V A T E A N D C O N F I D E N T I A LS T R I C T L Y P R I V A T E A N D C O N F I D E N T I A L N O V E M B E R 2 9, 2 0 0 7N O V E M B E R 2 9, 2 0 0 7 Challenges in Quantitative Risk Management for Insurance, International Centre for Mathematical Sciences, Edinburgh

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3. L I F E M E T R I C SL I F E M E T R I C S Overview A new market for longevity risk is emerging Investors are showing increasing interest in longevity-linked investments Pension plans and insurance companies are evaluating hedging Longevity hedging via the capital markets is now possible Hedges are available Obstacles to market development are being addressed Standardization Education Hedgers (pension plans + annuity providers) need to better understand: Longevity risk should be measured and this can be done quite easily You dont have to transfer 100% of the longevity risk to add value Basis risk can be managed 1 L O N G E V I T Y & M O R T A L I T Y R I S K T R A N S F E R V I A T H E C A P I T A L M A R K E T SL O N G E V I T Y & M O R T A L I T Y R I S K T R A N S F E R V I A T H E C A P I T A L M A R K E T S

4. Agenda Page L I F E M E T R I C SL I F E M E T R I C S Derivatives for transferring longevity risk Issues in hedging longevity risk Longevity – a new market 2 2 10 15 L O N G E V I T Y & M O R T A L I T Y R I S K T R A N S F E R V I A T H E C A P I T A L M A R K E T SL O N G E V I T Y & M O R T A L I T Y R I S K T R A N S F E R V I A T H E C A P I T A L M A R K E T S

5. L I F E M E T R I C SL I F E M E T R I C S This is because longevity exposure: Is transferable in principal Is economically significant: >£10 trillion globally Cannot be hedged in existing markets But market development also requires: Standardization to create liquidity Standardized Index Standardized instruments The two sides of the market are hedgers and investors Investors are prepared to invest in longevity Longevity appears to be a good candidate to become a new market Education Longevity is an unfamiliar risk Perceived as more complex than it is A market for longevity risk is emerging 3 L O N G E V I T Y – A N E W M A R K E TL O N G E V I T Y – A N E W M A R K E T

6. L I F E M E T R I C SL I F E M E T R I C S Pension plans have by far the biggest exposure to longevity/mortality risks Large imbalance between long and short exposures Short exposure is 30-40 times larger than long exposure Hedging demand from pension plans will drive market Longevity USUK Exposure Defined Benefit Pensions Short£3 trillion£800 billion Life Insurance Industry Annuity Reserves*Short<£50 billion£135 billion Life Insurance Reserves*Long£75 billion£38 billion * These are only the portion of reserves linked to mortality/longevity risk Sources: 2006 data from: OECD, UK Pensions Regulator, US Council of Insurers, Moodys, JPMorgan 4 L O N G E V I T Y – A N E W M A R K E TL O N G E V I T Y – A N E W M A R K E T

7. L I F E M E T R I C SL I F E M E T R I C S Pension Plans Annuity Providers Life Insurers Life Settlement / Premium Finance Investors Pension Buyout Funds ILS Investors Other Hedge Funds Endowments Pharma Others (reverse mortgage, etc.) Partial offset of risk in life business Earn risk premium Issue longevity- linked debt Add synthetic exposure Buy longevity protection Sell longevity protection Add synthetic exposure Earn risk premium Hedge longevity trend risk Earn risk premium Hedge Potential players in the longevity risk marketplace 5 L O N G E V I T Y – A N E W M A R K E TL O N G E V I T Y – A N E W M A R K E T

8. L I F E M E T R I C SL I F E M E T R I C S Pension plans & annuity providers Several are already looking to hedge at least some part of their longevity exposure Investors see longevity as a new asset class enabling them to: Earn a risk premium Gain exposure to an uncorrelated asset class Hedgers: Longevity risk sellers Investors: Longevity risk buyers Risk transfer products need to balance these opposing needs Want customized hedges to maximize effectiveness Want standardized investments to maximize liquidity There is capital seeking to be deployed on both sides of the market 6 L O N G E V I T Y – A N E W M A R K E TL O N G E V I T Y – A N E W M A R K E T

9. L I F E M E T R I C SL I F E M E T R I C S Intermediaries will play a crucial role in this market Repackaging to meet both the needs of buyers and sellers Providing credit intermediation Providing liquidity through market making in standardized contracts Pension plan / Annuity book Banks Insurance Co. Hedge funds Endowments Asset managers Longevity Risk HedgesInvestments 7 L O N G E V I T Y – A N E W M A R K E TL O N G E V I T Y – A N E W M A R K E T

10. L I F E M E T R I C SL I F E M E T R I C S LifeMetrics is a toolkit developed to catalyse the market by providing standardisation and education What is LifeMetrics? Launched by JPMorgan in March 2007 and freely available from the website Longevity Index Longevity & mortality indices based on national population US, England & Wales and the Netherlands Framework Methods and analytics for risk measurement & management Software Tools for modelling and forecasting mortality Features Transparent, non-proprietary, open-source and freely-available International Key Advisors: Watson Wyatt and The Pensions Institute 8 L O N G E V I T Y – A N E W M A R K E TL O N G E V I T Y – A N E W M A R K E T

11. L I F E M E T R I C SL I F E M E T R I C S Current and historic data available on website and Bloomberg www.lifemetrics.com Designed to: Increase visibility of longevity risk Provide a standardized reference for longevity hedges Data on crude and graduated mortality rates, and period life expectancy Broken down by Gender, Age, Country, Period Full documentation also available from the website 9 L O N G E V I T Y – A N E W M A R K E TL O N G E V I T Y – A N E W M A R K E T

12. Agenda Page L I F E M E T R I C SL I F E M E T R I C S Derivatives for transferring longevity risk Issues in hedging longevity risk Longevity – a new market 10 2 15 L O N G E V I T Y & M O R T A L I T Y R I S K T R A N S F E R V I A T H E C A P I T A L M A R K E T SL O N G E V I T Y & M O R T A L I T Y R I S K T R A N S F E R V I A T H E C A P I T A L M A R K E T S

13. L I F E M E T R I C SL I F E M E T R I C S Standardised Longevity Hedge: Hedge Provider Pension Plan Payment reflects growth in liability value from changes in longevity Standardised to reflect national population longevity experience But calibrated to match mortality sensitivity of liabilities Structured as a value hedge Maturity of Hedge: Finite: E.g. 10 years or 20 years Financial risk management paradigm There two broad categories of longevity risk hedges, both of which will transact Tailored to reflect actual longevity experience of the pension/annuitants Structured as a cash flow hedge Maturity of Hedge: When last member/annuitant dies Indemnification paradigm Customised Longevity Hedge: Fixed longevity Hedge Provider Pension Plan Actual longevity 11 I S S U E S I N H E D G I N G L O N G E V I T Y R I S KI S S U E S I N H E D G I N G L O N G E V I T Y R I S K

14. L I F E M E T R I C SL I F E M E T R I C S Advantages and disadvantages of customised vs. standardised longevity hedges Disadvantages Advantages Customised Hedge Standardised Hedge Standardised has advantages of simplicity, cost & liquidity Exact hedge, no residual basis risk More expensive than standardised High set-up & operational costs Poor liquidity Longer maturity so larger counterparty credit exposure Less attractive to investors Cheaper than customised hedge Lower set-up / operational costs More liquid Shorter maturity so lower counterparty credit exposure Not a perfect hedge Basis risk Roll risk 12 I S S U E S I N H E D G I N G L O N G E V I T Y R I S KI S S U E S I N H E D G I N G L O N G E V I T Y R I S K

15. L I F E M E T R I C SL I F E M E T R I C S Hedge effectiveness is an important risk management concept… But in the context of longevity it is poorly understood A hedge can be less than 100% effective and still add value The indemnification paradigm means that this is not widely acknowledged. Insurance risk transfer is generally 100% effective Most hedges of financial risk are not 100% effective Hedge effectiveness is about risk reduction Quantifying how a hedge reduces potential for monetary loss Need to measure residual risk Standardised hedges can still be highly effective Risk (£mm) Source: HEAT: Hedge Effectiveness (2003) www.jpmorgan.com/heat Risk Reduction (%) Hedge effectiveness 13 I S S U E S I N H E D G I N G L O N G E V I T Y R I S KI S S U E S I N H E D G I N G L O N G E V I T Y R I S K

16. L I F E M E T R I C SL I F E M E T R I C S One key aspect of hedge effectiveness is the population basis risk associated with standardised hedges Correlations in mortality improvements Short-term correlations E&W males aged 65 Basis risk by age can be managed Since mortality improvements are highly correlated across age Pension value males aged 65 CMI demographics vs LifeMetrics hedge Pension value males aged 65 CMI demographics vs LifeMetrics hedge Basis risk by socio-economic group can be managed Short term correlations in mortality improvements have a low correlations But mortality movements are correlated over the long term 14 I S S U E S I N H E D G I N G L O N G E V I T Y R I S KI S S U E S I N H E D G I N G L O N G E V I T Y R I S K

17. Agenda Page L I F E M E T R I C SL I F E M E T R I C S Derivatives for transferring longevity risk Issues in hedging longevity risk Longevity – a new market 15 2 10 15 L O N G E V I T Y & M O R T A L I T Y R I S K T R A N S F E R V I A T H E C A P I T A L M A R K E T SL O N G E V I T Y & M O R T A L I T Y R I S K T R A N S F E R V I A T H E C A P I T A L M A R K E T S

18. L I F E M E T R I C SL I F E M E T R I C S Successful products will best meet needs of all economic agents Mortality rates are most likely to form the basis of liquid products Simple building bocks Allows creation of smallest number of instruments Can be combined in a portfolio to replicate survivorship and life expectancy Can be used by all hedgers: pensions, annuity provides, life insurers, etc. Longevity risk transfer products could be based on survivorship, life expectancy and/or mortality rates 16 D E R I V A T I V E S F O R T R A N S F E R R I N G L O N G E V I T Y R I S KD E R I V A T I V E S F O R T R A N S F E R R I N G L O N G E V I T Y R I S K

19. L I F E M E T R I C SL I F E M E T R I C S LifeMetrics longevity hedges can be tailored to individual pension plans and annuity books Building-block approach Standardised hedging building- blocks called q-forwards Building-blocks are carefully combined to provide an effective hedge for a specific portfolio What are these building-blocks? Simple capital market instruments Based on LifeMetrics Index Involve exchange of realised mortality rate in a future period for a fixed mortality rate Payment to Pension Plan Realised mortality Fixed rate 1.20% Pension Plan Hedge Provider Amount x realised mortality rate Amount x fixed mortality rate Payout from q-forward q-Forward: Hedge building-block Lower realised mortality results in a payout to offset the increase in liabilities 17 D E R I V A T I V E S F O R T R A N S F E R R I N G L O N G E V I T Y R I S KD E R I V A T I V E S F O R T R A N S F E R R I N G L O N G E V I T Y R I S K

20. L I F E M E T R I C SL I F E M E T R I C S Pension/annuity hedge: Receive fixed q q-Forwards can hedge pension, annuity and life insurance liabilities q-Forwards are building blocks Can be combined to hedge: Pension liabilities Annuity liabilities Life insurance liabilities A small set of standardised contracts can provide effective hedges A specific maturity (e.g. 10 yrs) Split by gender (males & females) Age groups (40-49, 50-59, 60-69, 70-79, 80-89) Pension Plan / Annuity Book Hedge provider Amount x realised mortality rate Amount x fixed mortality rate Life Insurer Hedge provider Amount x realised mortality rate Life portfolio hedge: Pay fixed q 18 D E R I V A T I V E S F O R T R A N S F E R R I N G L O N G E V I T Y R I S KD E R I V A T I V E S F O R T R A N S F E R R I N G L O N G E V I T Y R I S K

21. L I F E M E T R I C SL I F E M E T R I C S Portfolio of LifeMetrics Hedge Building Blocks Age 50-59 Males Age 60-69 Males Age 70-79 Males Age 80-89 Males Age 50-59 Females Age 60-69 Females Age 70-79 Females Age 80-89 Females Portfolio of building-blocks can provide an effective hedge of longevity risk for a pension plan Impact of increase in trend of mortality improvements Hedge Pension liability 13.3%13.2% Hedges are liquid, cost effective and effective 19 D E R I V A T I V E S F O R T R A N S F E R R I N G L O N G E V I T Y R I S KD E R I V A T I V E S F O R T R A N S F E R R I N G L O N G E V I T Y R I S K

22. L I F E M E T R I C SL I F E M E T R I C S Mortality rates for XX-year-old males (illustrative only) How much does it cost? The market is net short longevity There are more economic agents with short longevity positions than with long positions So to transfer longevity risk investors will require compensation Mortality forward rate should be settled below the expected mortality rate Best Estimate or Expected Mortality Curve Forward Mortality Curve Risk Premium 20 D E R I V A T I V E S F O R T R A N S F E R R I N G L O N G E V I T Y R I S KD E R I V A T I V E S F O R T R A N S F E R R I N G L O N G E V I T Y R I S K

23. L I F E M E T R I C SL I F E M E T R I C S Longevity hedging via the capital markets is now a reality Hedges are now available The development of liquidity requires Standardisation Education Hedgers (pension plans + annuity providers) need to better understand: Concepts of hedge effectiveness You dont have to transfer 100% of the risk to add value Basis risk can be managed A liquid market requires standardised instruments Concentrate liquidity in a small number of contracts initially q-Forwards are a good candidate for developing a liquid market Conclusions 21 D E R I V A T I V E S F O R T R A N S F E R R I N G L O N G E V I T Y R I S KD E R I V A T I V E S F O R T R A N S F E R R I N G L O N G E V I T Y R I S K