With direct contribution (DC) schemes replacing traditional direct benefit (DB) systems in more and more countries, the longevity risk in pensions is increasingly being shifted onto individuals. However, individuals are often unwilling to bear this risk, and so demand for individual annuities sold by life insurance companies is rising.
Longevity is now challenging annuity providers. They risk that the duration of their assets can mismatch that of their liabilities and that policyholders' mortality rates fall at a faster rate than they anticipated in their pricing and reserving calculations.
According to the European Central Bank's Financial Stability Review (December 2006), profit margins in annuity provision tend to be low because they reflect competition. That means if mortality assumptions built into annuity prices are overestimated, profit margins of annuity providers will be squeezed. While some companies cover themselves against this risk by only quoting prices for annuities on uncompetitive terms, life insurers can also use new mortality tables, or hedge longevity risk with risk management tools. They often turn to financial markets as an alternative for institutional risk pooling, as longevity risk is difficult to diversify.
Reinsurance group Swiss Re, for example, decided to issue mortality-linked securities to manage adverse mortality risk. In December 2003, Swiss Re and special purpose vehicle Vita Capital issued a three-year floating-rate bond linked to a mortality index worth $400m (€310m). The repayment of principal was linked to an index of mortality rates experienced in five countries - France, Italy, Switzerland, the UK and the US. The spread was set at 135bps over benchmark interest rate index Libor, and the bond also covered catastrophic mortality risk.
Survivor or longevity bonds issued by governments are also seen as a very effective way to address longevity risk, although the role of governments in the provision of such
bonds is still debated. Members of a particular cohort cannot insure themselves against the risk of unexpected, increasing life expectancy for that cohort. Only governments can spread risk across future generations and run up debts to be paid by future taxpayers, whereas financial companies cannot sell instruments to the unborn.
The availability of sufficient reinsurance capacity is the key determinant for the future of longevity bonds. Whether this capacity problem is related to the EU's solvency requirements, which make reinsurance cover within the EU very expensive, is also important.
In the case of the European Investment Bank (EIB)/BNP Paribas bond - which was created in 2004 to address the longevity challenge and was aimed at purchase by UK pension funds but was withdrawn in late 2005 without ever being issued - neither a UK-based nor an EU-based reinsurer was willing to provide cover. And Bermuda-based reinsurance company PartnerRe, recipient of the longevity risk embedded in the bond, was not prepared to offer cover above the issue's total value of £540m (€822m), which questions whether sufficient reinsurance capacity really exists. The bond is also believed to have failed because it was capital-intensive and because it provided a poor hedge for a typical annuity book, as its reference population was restricted to UK males only.
For financial stability, a credit-enhancement agreement is also essential as without such agreement, potential investors might be discouraged from subscribing to the issue.
In the case of the EIB longevity bond, the investors' main credit risk lay with the EIB itself. As the EIB is AAA rated, the inclusion of a credit-enhancement agreement in the contract was probably unnecessary. However as with other mortality-linked securities the first point of contact for the investor may be a lower-rated institution, a credit-enhancement agreement should be in place, the review says.
According to the review, new initiatives and capital market solutions are needed. Several theoretical options are available such as mortality swaps, mortality futures or mortality options.
The CS Longevity Index, whose launch was announced by Credit Suisse in December 2005, provides an objective mortality and longevity index for investors and institutions exposed to longevity risk. Securities that offset the risk based on such an index have an overall lower longevity risk. But basis risk still remains an issue for insurers and pension plans.
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