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Longevity Risk from the Perspective of the ILS Markets . Morton N Lane Ph. D. Director, M Sc in Financial Engineering, University of Illinois President , Lane Financial LLC Sixth International Longevity Risk and Capital Markets Solutions Conference September 9,10th, 2010

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longevity risk from the perspective of the ils markets

Longevity Risk from the Perspective ofthe ILS Markets

Morton N Lane Ph. D.

Director, M Sc in Financial Engineering,

University of Illinois

President,

Lane Financial LLC

Sixth International Longevity Risk and Capital Markets Solutions Conference

September 9,10th, 2010

Swiss-Grand resort and Spa, Bondi Beach, Sydney, Australia

slide2

Longevity Risk from an ILS Perspective - Size

  • The Natural Catastrophe Market is tiny compared to Life
  • Accumulated Issuance* in the past 15 years is $30 - $40 Billion
  • $12 Billion is currently outstanding
  • About 10% of the issuance has been in Extreme Mortality
  • * The universe under consideration is all bonds that contain a risk analysis, i.e. where there is an Expected Loss
slide3

Longevity Risk from an ILS Perspective; Exchange, Origins

  • The ILS market started with the Loss from Hurricane Andrew
  • in 1992. A market born out of disaster and commercial necessity
  • Its first incarnation was an Exchanged Traded Option (at CBoT)
  • The CBoT market died after 5 Years (Soft Market)
  • Since then, Exchanges have been tried in New York, Bermuda
  • London and again in Chicago. All would have enabled public
  • access.
  • None has (robustly) succeeded
  • The wrong Economics? Auctions?
slide4

Longevity Risk from an ILS Perspective - Indices

  • The following loss measures have been used on the Exchanges,
  • Loss ratios
  • PCS Industry Numbers (by region and proportionate to loss)
  • Guy Carpenter (customizable) loss ratios
  • PCS Industry Numbers (by region and binary event)
  • Hurricane Index formula (based on storm Intensity)
slide5

Longevity Risk from an ILS Perspective - Indices

  • Private transactions have used all the preceding loss indices
  • plus, Sigma, Munich Nat Cat Services, plus
  • PCS Industry Numbers (modeled to book), PERILS
  • Parametric earthquake measures, Wind speeds
  • Paradex, AIR, Modeled Loss, Computer modeled replications
  • of cedants book
  • To paraphrase Lance Armstrong, Its not about the Index
  • Its about the need – or opportunityIf the need is there,
  • almost any index will do – Cat in the Box
  • Better Indices are good, but will not provide the tipping point.
  • 20-30% of annual issuance remains indemnity based.
slide6

Longevity Risk from an ILS Perspective – Event Driven

  • The development of Cat bond has been event driven more
  • than anything else.
  • What are the extreme events that will drive Longevity risk?
  • Two that I believe stimulated the first mortality bonds were,
  • Terrorism (dirty bombs) andPandemics
  • Swiss Re issued the first Mortality Bond the year after the
  • SARS outbreak and a little over 2 years after 9/11
slide7

Longevity Risk from an ILS Perspective – Event Driven

  • Nearly 90% of all Cat ILS are Occurrence based
  • Aggregate covers, even erodible thresholds are not popular
  • They are subject to greater secondary market fluctuation
  • What are the “Occurrence” event risks that need be transferred
  • by annuity/pension providers?
  • Cure for Cancer, Diabetes Pill, Shifts in Trend?
slide8

Longevity Risk from an ILS Perspective – Capital or Risk?

  • If the longevity risk has to be transferred because of mandate
  • or a desire to write or hold a bigger book
  • A sidecar, or quota share to a more appropriate analog than ILS
  • Sidecars have worked well to increase capacity in a hard
  • market. They do not serve to reduce risk in the retained book
  • Sidecars are not wanted when capital is plentiful
  • (even to generate fees)
  • Swaps which substitute fixed for floating seem like finite
  • reinsurance?
slide9

Longevity Risk from an ILS Perspective – Bonds or Swaps

  • MostILS issuance has been done in the form of Bonds not Swaps
  • Bonds allow for distribution to many investors; Swaps tend to be
  • private 1:1 transactions or club transactions
  • Swaps depend on the rating of the counterparty, not the swap itself.
  • Also, if they need to be reversed, its usually the same counterparty
  • Bonds Ratings make for wider investor based distribution
  • Separately rated tranches also allow access to conservative and
  • more risk taking investors. Specialist and opportunistic investors
  • Rated Bonds also allows secondary market trading – necessary
  • for hedge fund valuations
  • Liquidity for all investors is in very high demand
slide10

Longevity Risk from an ILS Perspective – Bonds or Swaps

  • ILS structures have eschewed swaps since the Lehman Default
  • 90% of all issues since the end of 2008 have avoided swaps (prior
  • to 2008, 90% contained swaps)
  • Where swaps are used they heavily collateralized and managed
  • ILS investors at present do not want counterparty credit risk
slide11

Longevity Risk from an ILS Perspective - Term

  • ILS investors and issuers like short terms –
  • the average maturity is between 2 and 3 years. Investors also dislike
  • long development period. This is a necessary component of
  • indemnity- based bonds, even PCS.
  • The longest ILS issued was 10 years. One three year bond took six
  • years to close – without an ultimate loss.
  • Dead Capital, frozen collateral.
  • Notwithstanding, the ILSmarket has been established,
  • participants behave rationally through the cycle
  • Maturities are extended in soft markets, shortened in hard ones
  • Terms and conditions tighten in hard markets , get more relaxed in
  • soft markets. e.g. more perils added
slide12

Longevity Risk from an ILS Perspective - Price

  • ILS investors require a high price to accept a risk, even a
  • diversifying one
  • Multiples of expected loss range from 2 to 20 times
  • Multiples will be higher in hard markets
  • Are cedant’s prepared to pay?
slide19

Mortality Bonds Trade with the Market

  • Absent Financing Rates Cat has Higher Returns
  • Most Cat bonds are Issued in the BB range
  • Most Extreme Mortality Bonds issued AA Range
  • Total Returns for CAT are therefore Double Life Returns
  • Deduct Financing - the “Insurance” Return is 4 times
  • Broadly the Bonds move in tandem –whether CAT or Life
  • Katrina affected Life and ILS – Hard Market
  • Lehman - both CAT and Life succumbed to Liquidity and CDS
  • Independent Life Behavior observed with H1N1 concerns
slide20

END

mlane@lanefinancialllc.com

mnlane@illinois.edu