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Finance 432: Managing Financial Risk for Insurers

Finance 432: Managing Financial Risk for Insurers. Longevity Risk. Overview. Longevity risk defined How insurers are exposed to longevity risk How organizations could manage this risk Life insurers Pension funds Longevity derivatives

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Finance 432: Managing Financial Risk for Insurers

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  1. Finance 432: Managing Financial Risk for Insurers Longevity Risk

  2. Overview • Longevity risk defined • How insurers are exposed to longevity risk • How organizations could manage this risk • Life insurers • Pension funds • Longevity derivatives Reading: “Living with Mortality: Longevity Bonds and Other Mortality-Linked Securities” by Blake, Cairns and Dowd

  3. Longevity Risk • Longevity risk is the risk of mortality rates deviating from expected levels • Over last century, mortality rates have steadily declined, leading to longer life expectancies • Significant improvement for most recent period has been noted • Primary concern for insurers and pension funds is improvement for those age 60 and older

  4. Exposure to Longevity Risk • Life insurance • Risk is if mortality rates increase • Coverage concentrated on particular ages (30-70) • Recent concerns • Catastrophic losses • Pandemics • Annuities and pension funds • Risk is if mortality rates decline more than expected • Annuities are concentrated on particular ages (60+)

  5. Managing Longevity Risk • Life insurers • Could balance life insurance and annuity exposure • Difficult to accomplish • Reinsurance for sudden increased mortality • Concentration of reinsurers • Cost of coverage • Pension funds • Spreading losses forward under pension accounting • Use of asset returns as discount rate

  6. Longevity Derivatives • First life insurance securitizations involved offsetting premium loadings or reducing reserve requirements • Current securitizations involve securitizing mortality risk • Swiss Re (2003) • Life insurance catastrophe bond • EIB/BNP (announced 2004, on hold) • Long term longevity bond

  7. Swiss Re Mortality Index Bond • Issued December, 2003 • $400 million in 3 year notes, quarterly coupons • Bond paid LIBOR + 135 basis points • Mortality rate was based on the weighted average mortality of US, UK, France, Italy and Switzerland • Option to reduce repayment on bond if mortality exceeds 130% of 2002 mortality rate • Principal is reduced 5% for every 0.01 increase in mortality over threshold • Vita Capital was the Special Purpose Vehicle

  8. Swiss Re Bond • Ratings: A3/A+ • Fully subscribed • Investors included pension funds • High coupon • Natural hedge

  9. Swiss Re– Second Mortality Bond • Second bond announced in April 2005 • $362 million, maturity date of 2010 • Three tranches: • Class B: 120% trigger, LIBOR + 90 bp, A- rating • Class C: 115% trigger, LIBOR + 140 bp, BBB+ • Class D: 110% trigger, LIBOR + 190 bp, BBB-

  10. EIB/BPN Longevity Bond • Announced in November 2004 • Issued by the European Investment Bank (EIB) • BNP Paribas was the originator • Partner Re was the longevity risk reinsurer • ₤540 million, 25 year maturity • Amortizing bond • Floating coupon payments tied to cohourt survivor index (English and Welsh males age 65)

  11. EIB/BNP Bond Problems • Required upfront payment by hedgers • Cost to hedge ~20 basis points • Credit risk • EIB (AAA rating) • BNP (AA) • Partner Re (AA) • Cross-currency swap involved (euros/sterling) • 25 year maturity may be too short

  12. New Mortality-Linked Securities • Longevity Bonds • Mortality swaps • Mortality futures • Mortality options

  13. Characteristics of Securities • Exchange traded or Over-the-Counter (OTC) • Basis risk • Liquidity • Credit risk

  14. Longevity Bonds • Principal at risk • Coupon based • Classical longevity bond • Payments linked to survivorship • Stochastic maturity • Zero-coupon longevity bonds • Deferred longevity bonds

  15. Mortality Swaps • Exchanging future cash flows based on mortality index • Current market developing • Published mortality and counterparty mortality rates • Vanilla mortality swaps (VMS) • Fixed side – declining payments based on initial mortality index • Floating side – payments based on realized mortality index • Other potential mortality swaps • Swaps on spreads, cross-currency swaps

  16. Mortality Futures • Exchange traded • Significant market needed • Volatility essential • Underlying index • Well defined • Not concentrated on buy or sell side • Widely accepted • Hedgers and speculators

  17. Mortality Options • Options • Protects one sided risk • Upfront payment • Survivor Caps • Survivor Floors

  18. Mortality Index • Single index • Advantages – liquidity, acceptability • Problems – basis risk • Multiple indices • Advantages – closer correlation • Problems – confusion, less liquidity • Credit Suisse Longevity Index http://www.csfb.com/institutional/fixed_income/longevity_index.shtml

  19. Conclusion • Insurers are likely to have a number of options for transferring longevity risk in the future • Appropriate use of these products could reduce risk and enhance profitability • Inappropriate use could be very costly • Importance of understanding risk management techniques

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