On Longevity Derivatives

I am a firm believer in “you can’t get something for nothing.”  So it is when a new derivative is proposed.  Either there are natural counterparties to take up the exposure (reducing their risk), or speculators must be encouraged to take the risk (more likely).

So, with longevity derivatives, the risk is people living too long leading to more pension payments in future years.  The proposition is: find a party that is willing to make more payments if mortality is better than expected, and offer him a payment, or series of payments, as an inducement to enter the transaction.

Let’s think for a moment, what entities benefit from a rise in longevity?  I can think of one: life insurers.  But there is a problem: anti-selection.  People who buy life insurance tend to be sicker than those of the general population, who tend to be sicker than annuitants.  Annuitants live the longest, and their lifespans improve the most on average.  Life insurers would find taking on longevity risk to be a dirty hedge at best for their life insurance books.  In general there have been few reinsurance agreements for longevity risk for immediate annuity portfolios, but then, that would be a really small component of the life insurance industry at present.

Even when terminal funding was permitted (back in the 1980s to early 90s) — where plan sponsors could buy annuities from insurers to free themselves from their pension obligations, it typically wasn’t a big business, and what did get done transferred credit risk from the plan sponsor to the participant.  Life insurer insolvency means the pension is at risk, subject to the limits of the state guaranty funds.  An acquaintance of mine, who was an actuary, who partially lost a pension on such an insolvency, said the solution wasn’t that hard — allow a lump sum as an option to those for whom the obligation was being transferred from plan sponsor to insurer.

The terminal funding business ceased because of changes in IRS regulations because a few companies realized gains out of terminating their plans.  That sat ill with Congress, especially past the era of corporate raiders, so an excise tax dramatically reduced the business.

So, even when pension plans were able to use insurers to reduce/eliminate their liabilities, there were issues.  There will be issues for longevity derivatives as well.

A swap agreement could point to a “reference portfolio of lives” chosen from some neutral database, or could point to the actual lives that the plan sponsor is trying to hedge.  The first requires less underwriting, and can be more generic, the second has less basis risk, and solves the actual problem, but requires messy underwriting.

Swap agreements could be long or short, but if I were a plan sponsor, I would have a hard time deciding whether to do a long or short swap.  Long swap: counterparty risk.  Short swap: little risk relief.  And to me, long would be 30 years or more and short would be ten years or less.  On short swaps if I ended up on the winning side of the trade, I would probably find few new takers for swaps when the time period was up.

That leaves me with one idea that might work: use a long (~30 years) cat-bond-type structure, where the principal adjusts down as deaths occur.  But we still have the counterparty issue.  If it is the obligation of a operating corporation, there is credit risk.  If it is its own bankruptcy remote Special Purpose Vehicle (SPV – no recourse to a parent company), then there is the risk that the assets in the SPV might not earn the returns necessary over the long haul to pay the interest and redeem the principal.

Calling Ajit Jain.  This is one of those contingencies that yearns for a Buffett-like investor who has a strong balance sheet and can invest for the long haul with above average returns, and thus absorb the volatility of aging annuitants.

But such balance sheets and investors are few.  So I would submit the idea that if you could not get Berkshire Hathaway to issue longevity bonds through such a structure as I have described, you’ll have a hard time issuing long dated longevity bonds anywhere.

Short-dated structures are cute, but don’t offer the relief that pension plans need.  So, I look at this market and do not expect much from it.  Credit risk and longevity risk are at odds with one another, and can be solved by the “magic man” who can earn returns superior to any excess longevity, or unsolved, leaving a larger problem in his wake, by the charlatan that delivers subpar returns.

That said, if you know the “magic man,” the pension fund should disintermediate and hire him.  Problem solved.  Now, where is this genius?