The longevity trend bond arrives

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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