The longevity trend bond arrives

By Felix Salmon
December 27, 2010

Swiss Re reinsures a lot of life insurance. As a result, it could lose billions of dollars if a lot of insured people die young, due to pandemics, terrorism, or the like. To hedge that risk, it has sold about $1.8 billion in mortality bonds to date. Such bonds earn a healthy yield, so long as there’s no big rise in mortality. If there is, then the bondholders lose some or all of their principal, and it’s used instead to make those unexpected life-insurance payouts.

Mortality bonds are an expensive hedge, though — one last year had a yield of 617bp over benchmark lending rates. Swiss Re would much rather hedge its mortality risk in a profit-making manner, by writing longevity risk. That’s what it did last year with the UK’s Royal County of Berkshire Pension Fund: in return for a steady stream of insurance premiums, Swiss Re contracted to pay out Berkshire’s pension obligations. The risk in that kind of deal is that the pensioners live too long, and that Swiss Re’s total payouts will be much bigger than the total insurance premiums.

Insuring longevity risk, then, is a great deal for Swiss Re: not only should it be profitable, if it’s priced correctly, but it also helps to naturally offset the company’s mortality risk. If people live longer, then pension payouts will be higher, but life-insurance payouts will be lower. And vice versa.

As a result, you’re unlikely to see a market in longevity bonds developing alongside the market in mortality bonds. Insurers’ longevity risk is already hedged, by their larger mortality risk, so they don’t need to go to capital markets to buy expensive hedge there.

Still, the hedge is not perfect, and so now we’re beginning to see Swiss Re come to the market hedging its basis risk: the risk that its longevity portfolio won’t act as a hedge for its mortality portfolio.

“We are hedging against the risk that life duration patterns between older, retired British males and younger US males diverge significantly,” said Alison McKie, head of life and health risk transformation at Swiss Re.

Swiss Re transferred $50 million of longevity trend risk to investors through an off-balance sheet investment vehicle called Kortis. “The bond is triggered by how the risks diverge,” McKie said.

This bond is small, at just $50 million, but the way it works is interesting. Swiss Re is essentially short the life of UK pensioners, and long the life of US workers. So the worst case scenario for the reinsurer is that UK pensioners start living longer even as US workers start dying early. And if that happens, the people who bought this bond, which pays a coupon of 4.72% per year through 2017, will lose some or all of their principal.

It’s an interesting concept, but it seems to me that basis risk is a very difficult thing to hedge, just because the sums involved when the two legs of your trade both move against you are so enormous. I suspect that basis bonds like this—the term of art seems to be “longevity trend bond”—are going to be a bit like catastrophe bonds: a good idea in theory, which has difficulty taking off in practice, and which never really reaches the critical mass needed to make a difference. Especially since there’s no natural buyer of this risk.

Update: Be sure to see the great comment from David Merkel below.


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I wonder which population data this will be based on…

And at least insurance firms have learned a lesson from the previous crisis – instead of using a total return swap from Lehman like a lot of ILS pre-2008, the collateral is securities issued by the International Bank for Reconstruction and Development.

Posted by Suncaked | Report as abusive

Haven’t insurance companies been doing this for ages? Writing life insurance with one hand, issuing annuities with the other? Why does Swiss Re need to purchase exposure? Is this an attempt to expand beyond their organic growth?

Posted by TFF | Report as abusive

Actually, @TFF, the annuity business has always been a small fraction of the size of the life-insurance business. It’s weird, I’m not entirely sure of why that should be.

Posted by FelixSalmon | Report as abusive

Thanks, Felix. I wasn’t aware of that. I could guess at some reasons…

* Annuities depend on the accumulation of substantial savings, something most people have trouble doing.

* Pensions and Social Security meet much of our societal need for annuities, limiting the market for private annuities.

* People often buy life insurance for poor reasons, or buy more years of insurance than they truly need. Whole life policies are often inappropriately marketed.

The funny thing is that I would *think* that this imbalance would tend to improve the returns on annuities. If there is a large unmatched life insurance liability just begging for an annuity to balance it, then somebody willing to purchase an annuity ought to get generous terms. Yet the payout schemes I’ve seen seem to equate to a negative real return.

Posted by TFF | Report as abusive

@ Felix and TFF,

…Also, the annuity biz has loads of competitors (e.g. Mutual funds, CDs, mattresses).

Thanks Felix, this is interesting, and I never heard of this. I was thinking about “Catastrope” bonds while reading this.

I guess insurance cos. could issue securities against any peril. There are still a number of yield chasers out there.

Posted by khumphrey86 | Report as abusive

A few notes — both annuitants and those with life insurance antiselect. Healthier people buy annuities, sicker people by life insurance. That difference gets more significant with the amount of time past underwriting, making the mortality risk hedge of writing the two poor. Yes, there is a macro hedge in terms of some sort of catastrophe like the 1918 avian flu, but aside from massive events like that, variations in the overall death rate are swamped by the antiselection effect.

Second, in terms of assets, annuities of all sorts are bigger. But most annuities are used as complex savings accounts. Only 0.5% of them get annuitized. Agents never want clients to annuitize, because then they can never earn another commission on that money again.

So, there are never enough annuities with longevity risk to balance of a book of life insurance with mortality risk, even if that hedge did work. Now there are structured settlements also, but that’s a specialized business that few do well at.

Third, annuities are written as relatively short liabilities. Mix that with life insurance and other long liabilities, and the investment department can work wonders, because it is investing against a long ladder of payments, which allows for clever and opportunistic purchases and sales of assets. A long ladder is a thing of beauty!

Fourth, there is a kind of dedicated buyer base for Cat insurance risk. The High Yield community goes gaga for this stuff, because the risk is uncorrelated with the credit cycle, and few of these deals go bad.

Fifth, if you are a major life reinsurer (a part of the oligopoly), you have a happy life but a major problem. There are few willing to do retrocessional cover, and from my last talk with the CEO and CFO of RGA, it is dominated by three wealthy Canadians who talk to each other, forming a cartel of sorts. So, if you want to dispose of excess mortality risk as a reinsurer, your options are very limited.

I’m sorry Felix, was this longer than your post? My days as an actuary and buy side analyst still cling to me.

Looking forward to seeing you someday soon.

Full disclosure: long RGA

Posted by DavidMerkel | Report as abusive

DavidMerkel, no need to apologise for your usual high standard post….

Hope the new business is going well.

Posted by Danny_Black | Report as abusive

Thanks, David, very informative!

Posted by TFF | Report as abusive

Thanks David!

Would love to know more about those three wealthy Canadians…

Posted by FelixSalmon | Report as abusive