Longevity & Mortality Risk Transfer via the Capital Markets

1. NOVEMBER29,2007 Challenges in Quantitative Risk Management for Insurance,International Centre for Mathematical Sciences,Edinburgh Longevity & Mortality Risk Transfer via the Capital Markets Guy Coughlan, Managing Director PENSION ADVISORY GROUP STRICTLYPRIVATEANDCONFIDENTIAL

2. LONGEVITY&MORTALITYRISKTRANSFERVIATHECAPITALMARKETS This material is not an offer or solicitation for the purchase or sale of any financial instrument, nor is it a commitment by J.P. Morgan Chase & Co. or any of its subsidiaries (collectively, “JPMorgan”) to enter into any transaction referenced herein. Any commentary/trade idea included herein was prepared by sales or trading personnel and does not represent the views of any JPMorgan research analyst. All information herein is indicative, is based on certain assumptions and current market conditions and is subject to change without notice. Accordingly, no reliance should be placed on the information herein. When making an investment decision, an investor should rely solely on the final documentation relating to any referenced transaction, which will contain the definitive terms and conditions of the transaction. JPMorgan makes no representation or warranty regarding the accuracy or completeness of the information herein. JPMorgan is not an advisor to any investor in respect of any referenced transaction. Each investor must make an independent assessment of any legal, credit, tax, regulatory and accounting issues and determine with its own professional advisors any suitability or appropriateness implications of any transaction referenced herein in the context of its particular circumstances. JPMorgan assumes no responsibility or liability whatsoever to any person in respect of such matters. JPMorgan, or any connected or associated person, may hold a long or short position or a derivative interest in, or act as a market maker in, the financial instruments of any issuer referred to herein or act as underwriter, distributor, advisor or lender to any such issuer. This material is specific to the recipient and must not be distributed to any other person or replicated in any form without the prior written consent JPMorgan. This material is directed exclusively at market professionals and institutional investors and is not for distribution in any jurisdiction to private customers, as defined by the rules of the Financial Services Authority (“FSA”). Private customers may not therefore rely on this material. Moreover, any investment or services to which this material may relate will not be made available to private customers. Investors should execute transactions through an authorised entity in their home jurisdiction unless governing law otherwise permits. J.P. Morgan Securities Ltd., J.P. Morgan plc., J.P. Morgan Europe Limited and JPMorgan Chase Bank, London Branch are each authorised by the FSA.

3. 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 don’t have to transfer 100% of the longevity risk to add value • Basis risk can be managed LONGEVITY&MORTALITYRISKTRANSFERVIATHECAPITALMARKETS 1

4. Longevity – a new market 1 2 Issues in hedging longevity risk 2 10 Derivatives for transferring longevity risk 3 15 LONGEVITY&MORTALITYRISKTRANSFERVIATHECAPITALMARKETS 2

5. Longevity appears to be a good candidate to become a new market 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 • Education • Longevity is an unfamiliar risk • Perceived as more complex than it is LONGEVITY–ANEWMARKET A market for longevity risk is emerging 3

6. Longevity US UKExposure 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, Moody’s, JPMorgan 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–ANEWMARKET 4

7. Buy longevity protection Sell longevityprotection Pension Plans • Hedge • Add synthetic exposure Annuity Providers • Hedge • Partial offset of risk in life business Life Insurers Life Settlement / Premium Finance Investors • Hedge longevitytrend risk • Earn risk premium • Add synthetic exposure Pension Buyout Funds • Hedge ILS Investors • Earn risk premium Other Hedge Funds • Earn risk premium Endowments • Earn risk premium • Issue longevity-linked debt Pharma Others (reverse mortgage, etc.) Potential players in the longevity risk marketplace LONGEVITY–ANEWMARKET 5

8. Pension plans & annuity providers Several are already looking to hedge at least some part of their longevity exposure There is capital seeking to be deployed on both sides of the market Hedgers: Longevity risk sellers Investors: Longevity riskbuyers • Investors see longevity as a new asset class enabling them to: • Earn a risk premium • Gain exposure to an uncorrelated asset class LONGEVITY–ANEWMARKET Want customized hedges to maximize effectiveness Want standardized investments to maximize liquidity Risk transfer products need to balance these opposing needs 6

9. Longevity Risk Longevity Risk Insurance Co. Pensionplan / Annuitybook Banks Hedge funds Endowments Asset managers Hedges Investments 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 LONGEVITY–ANEWMARKET 7

10. “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 LONGEVITY–ANEWMARKET Features • Transparent, non-proprietary, open-source and freely-available • International • Key Advisors: Watson Wyatt and The Pensions Institute 8

11. 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 LONGEVITY–ANEWMARKET 9

12. Issues in hedging longevity risk Longevity – a new market 1 2 2 10 Derivatives for transferring longevity risk 3 15 LONGEVITY&MORTALITYRISKTRANSFERVIATHECAPITALMARKETS 10

13. Customised Longevity Hedge: Standardised Longevity Hedge: • 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 • 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 Payment reflects growth in liability value from changes in longevity Pension Plan Hedge Provider Pension Plan Hedge Provider Fixed longevity Actual longevity There two broad categories of longevity risk hedges, both of which will transact ISSUESINHEDGINGLONGEVITYRISK 11

14. 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 Advantages and disadvantages of customised vs. standardised longevity hedges Advantages Disadvantages • 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 StandardisedHedge ISSUESINHEDGINGLONGEVITYRISK CustomisedHedge Standardised has advantages of simplicity, cost & liquidity 12

15. Hedge effectiveness is an important risk management concept… But in the context of longevity it is poorly understood Hedge effectiveness • 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 Risk (£mm) Risk Reduction (%) ISSUESINHEDGINGLONGEVITYRISK Source: “HEAT: Hedge Effectiveness” (2003) www.jpmorgan.com/heat Standardised hedges can still be highly effective 13

16. One key aspect of hedge effectiveness is the population basis risk associated with standardised hedges • Basis risk by age can be managed • Since mortality improvements are highly correlated across age Correlations in mortality improvementsShort-term correlations E&W males aged 65 • 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 Pension value males aged 65 CMI demographics vs LifeMetrics hedge ISSUESINHEDGINGLONGEVITYRISK 14

17. Derivatives for transferring longevity risk Longevity – a new market 1 2 Issues in hedging longevity risk 2 10 3 15 LONGEVITY&MORTALITYRISKTRANSFERVIATHECAPITALMARKETS 15

18. Longevity risk transfer products could be based on survivorship, life expectancy and/or mortality rates • 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. DERIVATIVESFORTRANSFERRINGLONGEVITYRISK 16

19. LifeMetrics longevity hedges can be tailored to individual pension plans and annuity books q-Forward: Hedge building-block • “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 Amountx realised mortality rate PensionPlan Hedge Provider Amountx fixed mortality rate Payout from q-forward DERIVATIVESFORTRANSFERRINGLONGEVITYRISK Fixed rate Payment to Pension Plan • 1.20% Realised mortality Lower realised mortality results in a payout to offset the increase in liabilities 17

20. Amountx realised mortality rate Pension Plan /Annuity Book Hedge provider Amount x fixed mortality rate Amountx fixed mortality rate Life Insurer Hedge provider Amountx realised mortality rate q-Forwards can hedge pension, annuity and life insurance liabilities Pension/annuity hedge: Receive fixed q • q-Forwards are building blocksCan 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) Life portfolio hedge: Pay fixed q DERIVATIVESFORTRANSFERRINGLONGEVITYRISK 18

21. Portfolio of LifeMetricsHedge Building Blocks Age 50-59Males Age 60-69Males Age 70-79Males Age 80-89Males Age 50-59Females Age 60-69Females Age 70-79Females Age 80-89Females Portfolio of building-blocks can provide an effective hedge of longevity risk for a pension plan Hedge Impact of increase in trend of mortality improvements 13.3% 13.2% Pension liability DERIVATIVESFORTRANSFERRINGLONGEVITYRISK Hedges are liquid, cost effective and effective 19

22. How much does it cost? Mortality rates for XX-year-old males (illustrative only) • 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 DERIVATIVESFORTRANSFERRINGLONGEVITYRISK 20

23. Conclusions • 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 don’t 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 DERIVATIVESFORTRANSFERRINGLONGEVITYRISK 21