survivor products managing longevity risk mortality improvements l.
Download
Skip this Video
Loading SlideShow in 5 Seconds..
Survivor Products: Managing longevity risk & mortality improvements PowerPoint Presentation
Download Presentation
Survivor Products: Managing longevity risk & mortality improvements

Loading in 2 Seconds...

play fullscreen
1 / 57

Survivor Products: Managing longevity risk & mortality improvements - PowerPoint PPT Presentation


  • 553 Views
  • Uploaded on

Survivor Products: Managing longevity risk & mortality improvements. Professor David Blake Director Pensions Institute Cass Business School d.blake@city.ac.uk. The problem. Nothing is certain in life except death and taxes (B Franklin).

loader
I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
capcha
Download Presentation

PowerPoint Slideshow about 'Survivor Products: Managing longevity risk & mortality improvements' - MartaAdara


An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript
survivor products managing longevity risk mortality improvements
Survivor Products: Managing longevity risk & mortality improvements

Professor David Blake

Director

Pensions Institute

Cass Business School

d.blake@city.ac.uk

slide2

The problem

  • Nothing is certain in life except death and taxes (B Franklin).
  • Over last 20 years, it has become clear that, while death is no less inevitable than before:
    • it is getting later
    • and its timing has become increasingly uncertain.
slide3

The problem

  • When British welfare state began in 1948, men could draw their state pension at 65 and expect to live until 67 and only a few lived beyond 70.
  • At beginning of 21st Century, British men can still draw their pension from age 65 but now live into their early 80s.
  • Significant proportion of women living into their late 80s.
slide7

Stochastic nature of mortality improvements

  • Evident for many years that mortality rates have been evolving in apparently stochastic fashion.
  • Sequences do exhibit general trend, but changes have an unpredictable element:
    • not only from one period to next
    • but also over the long run.
slide8

Longevity risk

  • Large number of products in life insurance and pensions have mortality as key source of risk.
  • Products exposed to unanticipated changes over time in mortality rates of relevant reference populations.
  • Eg annuity providers exposed to risk that mortality rates of pensioners will fall at faster rate than accounted for in pricing and reserving calculations:
    • Current pool of annuitants living 2 years longer than anticipated
slide9

Longevity risk

  • Annuities are commoditised products selling on basis of price, profit margins have to be kept low in order to gain market share.
  • If mortality assumption built into price of annuities turn out to be gross overestimate, cuts straight into profit margins of annuity providers.
  • Most life companies claim to lose money on annuity business.
slide10

Longevity risk

  • Yet life annuities are mainstay of pension plans throughout the world:
    • they are the only instrument ever devised capable of hedging longevity risk.
  • Without them, pension plans will be unable to perform their fundamental task of protecting retirees from outliving their resources for however long they live.
  • Real danger that they might disappear from financial scene.
slide11

Longevity risk

  • Equitable Life:
  • Embedded options in annuity contracts became very valuable in 1990's due to combination of falling interest rates and improvements in mortality.
  • Problems avoided if EL could hedge exposures to:
    • interest-rate risk
    • mortality improvement risk.
longevity risk in uk pension provision billion of total liabilities broad estimates end 2003
Longevity risk in UK pension provision, £billion of total liabilities- broad estimates: end 2003

Figure 5.17 p181

slide13

Significant concern!

Reinsurers (eg Swiss Re) have stopped reinsuring longevity risk of life offices!

slide14

Survivor Products

  • Long-dated survivor bonds:
  • Life annuity bond: coupon payments decline in line with mortality index:
    • Eg based on population of 65-year olds on issue date.
  • As population cohort dies out, coupon payments decline, but continue in payment until the entire cohort dies.
  • Eg, if after one year 1.5% of population has died out, 2nd year’s coupon payment is 98.5% of 1st year’s etc
slide15

Survivor Products

  • Bond holder, eg life office writing annuities, protected from aggregate mortality risk it faces.
  • Based on Tontine Bonds issued by European governments in 17th and 18th centuries
  • Recently revived by Blake and Burrows (2001) and Lin and Cox (2004).
slide16

BNP Paribas Longevity Bond

  • November 2004
  • Issuer: European Investment Bank (AAA)
  • Issue: £540m, 25 year
  • Mortality index: 65 year-old males from England & Wales (ONS)
  • Structurer/manager: BNP Paribas (assumes longevity risk)
  • Reinsurer of lengevity risk: PartnerRe, Bermuda
  • Investors: UK pension funds
slide19

Advantages of longevity bond

  • Provides better match for liabilities of pension funds and life insurers than other available investments:
    • other than purchasing (re)insurance to cover the longevity risk (i.e annuities)
  • Bond also provides long term interest rate hedge.
  • Longevity index transparent
  • EIB has AAA credit rating.
  • Life insurers holding longevity bond as hedge may be able to hold lower prudential margins.
slide21

Survivor Products

  • Short-dated, mortality-linked securities:
  • Market-traded securities whose payments are linked to mortality index
  • Similar to catastrophe bonds (Schmock, 1999, Lane, 2000, Wang, 2002, and Muermann, 2004)
slide22

Swiss Re Bond 2003

  • Designed to securitise Swiss Re’s own holding of mortality risk!
  • 3-year contract (matures 1 Jan 2007) which allows issuer to reduce exposure to catastrophic mortality events:
    • severe outbreak of influenza
    • major terrorist attack (WMD)
    • natural catastrophe.
  • Mortality index (MI):
    • US (70%), UK (15%), France (7.5%), Italy (5%), Switzerland (2.5%).
    • Male (65%), Female (35%)
    • Also age bands
slide23

Influenza pandemics

  • All resulted from avian flu virus mutating with human flu virus
  • 11 outbreaks in 300 years
  • 1580
    • First confirmed flu pandemic
  • 1782
    • Summer Flu
    • Started in China
    • Hit young adults
  • 1889
    • Russian Flu
    • Over 20% of world population infected
    • 1m deaths
slide24

Influenza pandemics

  • 1918-19
    • Spanish Flu
    • Started in Kansas
    • Killed 50m people worldwide:
      • 250,000 in UK
    • More than died in WW1, in shorter period
    • 20% of world’s population infected and 1% killed
    • Spread along trade routes and shipping lines
slide25

Influenza pandemics

  • 1957-58
    • Asian Flu
    • 2m deaths
    • Hit teenagers hardest
    • Spread around world in 6 months
  • 1968-69
    • Hong Kong Flu
    • Started in China
    • 1m deaths
    • Spread slowly with moderate symptons
slide26

Influenza pandemics

  • 2005-06
    • Started in SE Asia
    • H5N1 virus
    • Closely related to 1918 Spanish virus
slide27

Swiss Re Bond 2003

  • $400m, principal at risk ‘if, during any single calendar year, combined mortality index exceeds 130% of baseline 2002 level’.
  • Principal exhausted if index exceeds 150%
  • Equivalent to a call option spread on the index with:
    • Lower strike price of 130%
    • Upper strike price of 150%
  • Investors get quarterly coupons of 3-mo USD Libor + 135bp
slide30

Swiss Re Bond 2003

  • Bond valued using Extreme Value Theory (Beelders & Colarossi (2004))
  • Assume Generalised Pareto Distribution
  • Probability of attachment:
    • P[MI(t)>1.3MI(2002)] = 0.33%
  • Probability of exhaustion:
    • P[MI(t)>1.5MI(2002)] = 0.15%
  • Expected loss = 22bp < 135bp
  • A good deal for investors!
  • Bond trading at Libor + 100bp in June 2004
slide31

Survivor Products

  • Survivor swaps:
  • Counterparties swap fixed series of payments in return for series of payments linked to number of survivors in given cohort:
    • UK annuity provider could swap cash flows based on UK mortality index for cash flows based on US mortality index from a US annuity provider counterparty
    • Would enable both counterparties to diversify their longevity risks internationally.
  • Dowd et al (2004)
slide32

Survivor Products

  • Annuity futures:
  • Prices linked to specified future market annuity rate
  • Mortality options:
  • Payout depends on underlying mortality table at payment date.
  • Eg, EL guaranteed annuity contract
slide33

Demand side of market

  • Reference population underlying calculation of mortality rates central to both:
    • Viability
    • Liquidity of contracts.
  • Hedging demand from investors (eg life offices) wishing to hedge mortality exposures.
  • If reference population v different from investor’s specific population, then investor will be exposed to significant basis risk:
    • Might conclude that mortality derivative is not worth holding.
slide34

Demand side of market

  • Speculative demand:
    • depends on liquidity.
  • Adequate liquidity will require small number of reference populations:
    • Need to be chosen carefully to ensure that level of basis risk is small for investors with hedging demands.
  • Demand from hedge funds:
    • seeking instruments that have low correlation with existing financial instruments
slide35

Supply side of market

  • Government:
    • Securitising social security budget
  • Corporates long longevity risk:
    • Pharamceuticals
slide36

Barriers to development in cash market

  • After more than year, BNP Paribas longevity bond had not generated sufficient demand to be launched:
    • Has been withdrawn for redesign
  • Suggests significant barriers need to be overcome before sustainable market in survivor products and derivatives emerges.
slide37

Barriers to development in cash market

  • Reasons why BNP bond did not launch:
    • design issues
      • which make bond an imperfect hedge for longevity risk
    • pricing issues
    • institutional issues
slide38

Design issues

  • Small scheme will find it difficult to use bond to match its liabilities:
    • as variance between actual and expected mortality will be quite large.
  • Mortality experience of individual pension funds and life insurers may be different from reference UK population.
  • Bond only provides hedge for longevity of males:
    • pension funds and life insurers also exposed to significant longevity risk from females.
slide39

Design issues

  • Liabilities for pension funds and life insurers give greater weight to the lives receiving larger pensions.
  • Further, significant differences in mortality of those receiving larger pensions compared to those receiving lower pensions.
  • As payments under bond effectively give equal weight to all the lives in the UK population, the already imperfect hedge provided by the longevity bond is worsened.
slide40

Design issues

  • Bond only matches cashflow under level pension
    • while large portion of pensions paid by pension funds and life insurers will be increasing at RPI/LPI.
  • Bond is progressively worse hedge for pension liabilities related to younger or older cohorts.
slide41

Pricing issues

  • Need to forecast mortality index MI’s
  • Need to estimate r’s
  • Correlation between MI and r:
    • Anticipated to be low
slide42

Pricing issues

  • Above model valid only in complete market
  • In incomplete market, need to convert projected deterministic mortality rates into risk-neutral probabilities
    • E.g using Wang transform
    • Lin & Cox (2005)
slide43

Pricing issues

  • Longevity risk premium built into initial price of bond set at 20 basis points.
  • Given that this is first ever bond brought to market, markets have no real feeling as to how fair this figure is.
  • However, concern that up-front capital was too large compared with risks being hedged by bond:
    • longevity and interest rate risks
  • leaving no capital for other risks to be hedged
    • e.g. inflation
slide44

Institutional issues

  • Issue size too small to create liquid market.
  • Consultants reluctant to recommend it to trustees.
  • Fund managers do not currently have mandate to manage longevity risk.
  • Fund managers have not welcomed bond:
    • since believe it would be closely held and they would not make money from it being traded.
  • Partner Re is unlikely to be perceived as being a natural holder of UK longevity risk.
slide45

Institutional issues

  • Last point highly significant
  • Reflects view that key determinant of future issue of longevity bonds is availability of sufficient reinsurance capacity.
  • Neither UK-based nor EU-based reinsurer willing to provide cover for BNP bond
  • Partner Re not prepared to offer cover above issue size of £540m.
  • Has been questioned whether EU’s solvency requirements render reinsurance cover within EU prohibitively expensive.
slide46

Barriers to development in futures market

  • Following factors key to success of particular futures contract:
    • defined as having consistently high volume of trade and open interest:
  • Must be large, active and liquid spot market for underlying with good price transparency:
    • by far the most important factor:
    • indeed no futures contract has ever survived without a spot market satisfying these conditions.
slide47

Barriers to development in futures market

  • Spot prices must be sufficiently volatile to create hedging needs and speculative interest.
  • Relative hedging demand can be measured by level of open interest relative to volume:
    • since former excludes the many speculators who do not hold overnight positions.
  • Low open interest to volume ratio is an indication of high liquidity :
    • another sign of successful futures contract.
slide48

Barriers to development in futures market

  • Underlying must be homogeneous and/or have well-defined grading system.
  • Market in underlying must not be heavily concentrated on either buy or sell side:
    • since this can lead to price manipulation.
  • Futures contract must be effective in reducing risk.
slide49

Barriers to development in futures market

  • Liquidity costs:
    • bid-ask spreads
    • execution risk:
      • risk of adverse price movements before trade execution
  • Liquidity costs in the futures contract must not be significantly higher than those operating in any existing cross-hedge futures contract.
slide50

Failure of futures contracts

  • CPI futures contract listed on US Coffee, Sugar and Cocoa Exchange in June 1985
  • Delisted in April 1987 with only 10,000 contracts traded.
  • Reasons for failure:
    • no inflation-linked securities market at the time.
    • underlying was infrequently published index.
    • no stable pricing relationship with other instruments.
slide51

Failure of futures contracts

  • Futures contract on Treasury inflation-protected securities (TIPS) listed on Chicago Board of Trade in June 1997
  • Delisted before end of the year with only 22 contracts traded.
  • Reasons for failure:
    • TIPS had only started trading five months before.
    • Only a single 10-year TIPS outstanding.
    • Futures contract competed with underlying for liquidity.
    • Uncertainty over fate of TIPS programme.
slide52

Failure of futures contracts

  • CME launched CPI futures contract in February 2004 which is still trading.
  • Reasons for survival:
    • Inflation-linked securities have gained acceptance amongst investors
    • TIPS have evolved into recognised asset class.
    • Well understood pricing relationships allowing for arbitrage possibilities between TIPS, fixed-interest Treasury bonds and CPI futures.
    • US Treasury committed to long-term TIPS issuance.
    • CPI futures do not compete directly with but rather complement TIPS and uses same inflation index.
    • Contract traded on Globex electronic trading platform:
      • automated two-sided price quotes from lead market maker.
slide53

Important lessons for development of mortality-linked futures market

  • Sufficiently large, active and liquid spot market in longevity bonds must be established well before any futures market started.
  • Mortality index behind longevity bond must be fair estimate of true mortality and have minimal time basis risk:
    • CPI index suffers from same potential problems
    • so survival of CPI futures contract on CME suggests these problems can be overcome.
slide54

Important lessons for development of mortality-linked futures market

  • Although mortality indices are calculated infrequently, spot prices of longevity bonds likely to exhibit high degree of volatility on account of bonds’ high duration.
  • Underlying mortality indices must be few in number and well-defined:
    • small number of contracts helps to increase liquidity
    • but also leads to contemporaneous basis risk
      • arising from different mortality experience of population cohort covered by mortality index and cohort relevant to hedger.
slide55

Important lessons for development of mortality-linked futures market

  • Potential weak point in longevity bond market is on the supply side:
    • since few natural issuers on supply side.
  • Futures contract would be effective in reducing aggregate risk,:
    • but small number of mortality indices might well leave substantial basis risk.
  • No reason to suppose liquidity costs in futures contract would be any higher than for other bond futures contracts.
slide56

Conclusion

  • Existence of survivor products:
    • will facilitate the development of annuities markets in the developing world
    • and could well save annuities markets in the developed world from extinction.
  • Essential to prevent annuity providers going bust!
slide57

Conclusion

  • If survivor products fail to be issued in sufficient size:
    • either the state (i.e., the next generation) is forced to bail out pensioners
    • or companies withdraw from pension provision
    • or insurance companies stop selling annuities
    • or pensioners risk living in extreme poverty in old age, having spent their accumulated assets