Download Longevity risk - Andrei Simonov

Demography, Capital Markets
and Pension Risk Management
session 2
Andrei Simonov
Strategic Asset Allocation
1
7/5/2017
Analysing pension risk
Surplus/Deficit Progression
300
Illustrative example
Y% probability of
being at least 100%
funded in 10 years
time
200
300
ASSET RETURN
RISKS
Rewarded
200
0
100
-100
-400
2009
2010
2011
5% Percentile
2012
2013
25% Percentile
2014
Year
50% Percentile
2015
2016
75% Percentile
2017
2018
2019
-300
95% Percentile
Longevity hedging should be considered alongside other risk mitigation
techniques using risk return framework
Total
Diversification
Credit
Alternatives
-200
Equity
-100
Longevity
-300
0
Liabilities
-200
1 in 20 chance that
deficit is at least
£Xm higher than
expected
£ million
Surplus/Deficit (£m)
100
LIABILITY
EXPOSURES
Unrewarded (no risk
premium)
Demographic factors at work

Increasing longevity

Lower fertility

Retirement of Baby Boom
3
From pyramids to columns
Age Group
100 +
95 - 99
90 - 94
85 - 89
80 - 84
75 - 79
70 - 74
65 - 69
60 - 64
55 - 59
50 - 54
45 - 49
40 - 44
35 - 39
30 - 34
25 - 29
20 - 24
15 - 19
10 - 14
5-9
0-4
B
B
B
A
A
A
4
People over SPA to those aged
20 – SPA*
0.6
With SPA fixed
at 65
0.5
0.4
With SPA rising
proportionally (to
68.5 in 2050 and
70.2 in 2070)1
0.3
0.2
0.1
0
2006
2020
2030
2040
2050
2060
2070
* SPA: State Pension Age
(1) This proportionate adjustment maintains the proportion of life over 20 years old which is spent in retirement at 27.5%
5
Lower fertility – The inherent
challenge to pension systems
PAYG
Increased ratio of pensioners to
contributors
Lower pensions relative to
average earnings
Higher contribution rates
Increase Pension Age more
than proportionally with life
expectancy
Funded
Savers of generation 1 have to
sell accumulated assets to
“smaller”* generation 2
Transitional asset price fall
effect
K/L rises: return on capital
falls
* Smaller can mean either absolutely smaller than G1 (if fertility  2.0) or “smaller than would be the case if fertility had not
fallen”
6
Possible de facto demographic effects on
funded systems and capital markets
Lower
Fertility
Transitional asset price fall effect
(at sale)
Inherent effect of shift
to lower fertility
K/L rises: return on capital falls
Increased
Longevity
Transitional asset price rise effect
Longer-term effect; K/L rises,
return on capital falls
Not inherent but
could occur if future
pensioners do not
adjust retirement ages
but instead increase
savings rate
7
Demographic impacts on
returns to capital
Model Results

Garry Young:
Baby-boom generation
Increased longevity
Falling fertility
-0.1%
-0.1%
-0.3%

David Miles:
Given future actual trends in UK
demographics, returns fall:
 4.56% (1990) to 4.22% (2030)
 4.56% (1990) to 3.97% (2060) if PAYG
phased out
8
Real S&P500 price index and % of 40-64
year olds among total U.S population
1950-2003
34
1800
33
1600
32
1400
31
1200
30
1000
29
800
28
600
27
400
26
200
25
0
24
1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050
Real S&P500 (LHS)
Percentage of 40-64 Population
Real S&P500 Price Index
Forecast
2000
40-64 population/ total population (RHS)
Source:: Poterba (2004), with additional data to 2006
9
Theoretical & empirical approaches
to measuring demographic effects
“Given the limited amount of time series on returns and
demographic variation, and the difficulty of controlling
for all of the other factors that may affect asset values
and asset returns, the theoretical models should be
accorded substantial weight in evaluating the potential
impact of demographic shifts”
Poterba: “The Impact of Population Ageing on Financial Markets”
10
Global glut of savings
hypothesis
In China and other East Asian
countries
• Fewer children enable
higher savings rate
• Awareness of greater
longevity, fewer children and
lack of social welfare net,
require a high savings rate
Developed countries save more
to cope with their
demographic/pension
challenges
Global glut of
savings relative to
investment
Long-term, not
just cyclical, fall in
real interest rates
Transitional
positive asset
price effects
11
01/01/2005
01/01/2004
01/01/2003
01/01/2002
01/01/2001
01/01/2000
01/01/1999
01/01/1998
01/01/1997
01/01/1996
01/01/1995
01/01/1994
01/01/1993
01/01/1992
01/01/1991
01/01/1990
01/01/1989
01/01/1988
01/01/1987
01/01/1986
Percent
Real yields to maturity on UK
index-linked
gilts
1986 – 2004
5
4.5
4
3.5
3
2.5
2
2.5 Year
5 Year
10 Year
20 Year
1.5
1
0.5
0
12
UK Long-term real interest
rates
11%
Real interest rate
9%
Long-term average (1700-2004)
7%
Estimate for 2005
5%
3%
1%
-1%
-3%
-5%
Estimate for
2005, as of 02
March 2005
-7%
1700 1716 1732 1748 1764 1780 1796 1812 1828 1844 1860 1876 1892 1908 1924 1940 1956 1972 1988 2004
Source: Morgan Stanley Research
13
Whole world gross savings rate
1981 - 2005
25
20
15
1981
1986
1991
1996
2001
2006
Source: IMF World Economic Outlook database
14
Gross savings rates: developing
Asia and the US % of GDP
1981 - 2005
40
35
Developing
Asia
30
25
20
15
USA
10
5
1981
1985
1989
1993
1997
2001
2005
Source: IMF World Economic Outlook database
15
Demographic challenges to
funded pension systems

Increasing longevity
• Lower fertility
Not inherent problem
but possible de facto
Overwhelmed in
short-term by
globalisation effect
• Uncertainty of
longevity forecasts
16
Survivor Products:
Managing longevity risk &
mortality improvements
17
Current Forces Affecting the Size and
Ownership of Longevity Risk
The Mosaic Today

Retirement population growing

Longevity continues to increase for retirees at historically
high rates against largely fixed retirement / entitlement dates

The current cost of life extension in the UK is estimated at
£12.5 to £24.7 billion per year

Current fiscal and monetary policy may be sowing the seeds
of high inflation and expectations of inflation

Strong forces are causing corporates to close existing
Defined Benefit (DB) schemes and transition to Defined
Contribution / Personal Account schemes

The Credit Crunch is causing a significant increase in DB
pensioner risk to move to the Pension Protection Fund (PPF)
Longevity extending
Cost of longevity significant and
rising
Inflation could exacerbate
longevity costs
Longevity risk moving from
corporates to individuals
Credit Crunch moving longevity
risk arguably to Government
18
The UK population of retirees (i.e. people 65+) is
set to increase by 60% by 2032 from 10 million to
16 million due mainly to the ageing of the baby
boom generation
2012…
Strategic Asset Allocation
19
7/5/2017
Date
Fund
Provider
Approx
size
Solution
February 2013
BAE Systems
Legal & General
£3.2bn
Pensioner bespoke longevity swap
December 2012
LV=
Swiss Re
£800m
Pensioner and all members over age
55
May 2012
Akzo Nobel
Swiss Re
£1.4bn
Pensioner bespoke longevity swap
January 2012
Pilkington
December 2011
British Airways
Goldman Sachs /
Rothesay Life
£1.3bn
Pensioner bespoke longevity swap
November 2011
Rolls-Royce
Deutsche Bank
£3bn
Pensioner bespoke longevity swap
August 2011
ITV
Credit Suisse
£1.7bn
Pensioner bespoke longevity swap
February 2011
Pall
J P Morgan
£70m
Non-pensioners index based
longevity hedge
July 2010
British Airways
Goldman Sachs /
Rothesay Lif
£1.3bn
Synthetic buy-in (longevity swap
plus asset swap)
February 2010
BMW
Abbey Life / Deutsche
£3bn
Bank
Pensioner bespoke longevity swap
November 2009
Royal Berkshire
Swiss Re
£1bn
Pensioner bespoke longevity swap
July 2009
RSA Insurance Group
Goldman Sachs /
Rothesay Life
£1.9bn
Synthetic buy-in (longevity swap
plus asset swap)
May 2009
Babcock
Credit Suisse
£1.5bn
Strategic Asset Allocation
Legal & General
£1bn of other
Pensioner
bespokeUK
longevity
swap
Here’s
a useful list
major
longev
Pensioner bespoke longevity swap
(three schemes)
20
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Strategic Asset Allocation
21
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Strategic Asset Allocation
22
7/5/2017
The problem

Nothing is certain in life except death and
taxes (B Franklin).

Over last 20 years, it has become clear that,
while death is no less inevitable than before:
– it is getting later
– and its timing has become increasingly uncertain.
23
The problem

When British welfare state began in 1948,
men could draw their state pension at 65 and
expect to live until 67 and only a few lived
beyond 70.

At beginning of 21st Century, British men can
still draw their pension from age 65 but now
live into their early 80s.

Significant proportion of women living into
24
their late 80s.
Mortality improvements over time
25
Strategic Asset Allocation
26
7/5/2017
Strategic Asset Allocation
27
7/5/2017
What is longevity risk?
(Broken limits to life expectancy – Oeppen & Vaupel)
28
Stochastic nature of
mortality improvements

Evident for many years that mortality rates
have been evolving in apparently stochastic
fashion.

Sequences do exhibit general trend, but
changes have an unpredictable element:
– not only from one period to next
– but also over the long run.
30
Longevity risk
Large number of products in life insurance and
pensions have mortality as key source of risk.
 Products exposed to unanticipated changes over
time in mortality rates of relevant reference
populations.
 Eg annuity providers exposed to risk that
mortality rates of pensioners will fall at faster
rate than accounted for in pricing and reserving
calculations:

– Current pool of annuitants living 2 years longer than
anticipated
31
Longevity risk
Annuities are commoditised products selling
on basis of price, profit margins have to be
kept low in order to gain market share.
 If mortality assumption built into price of
annuities turn out to be gross overestimate,
cuts straight into profit margins of annuity
providers.
 Most life companies claim to lose money on
annuity business.

32
Longevity risk

Yet life annuities are mainstay of pension
plans throughout the world:
– they are the only instrument ever devised capable
of hedging longevity risk.
Without them, pension plans will be unable to
perform their fundamental task of protecting
retirees from outliving their resources for
however long they live.
 Real danger that they might disappear from
financial scene.

33
Longevity risk
Equitable Life:
 Embedded options in annuity contracts
became very valuable in 1990's due to
combination of falling interest rates and
improvements in mortality.
 Problems avoided if EL could hedge
exposures to:

– interest-rate risk
– mortality improvement risk.
34
Longevity risk in UK pension
provision, £billion of total liabilitiesbroad estimates: end 2003
35
Figure 5.17 p181
Significant concern!
Reinsurers (eg Swiss Re)
have stopped reinsuring
longevity risk of life
offices!
36
Survivor Products
Long-dated survivor bonds:
 Life annuity bond: coupon payments decline
in line with mortality index:

– Eg based on population of 65-year olds on issue
date.
As population cohort dies out, coupon
payments decline, but continue in payment
until the entire cohort dies.
 Eg, if after one year 1.5% of population has
died out, 2nd year’s coupon payment is 98.5%
of 1st year’s etc

37
Survivor Products

Bond holder, eg life office writing annuities,
protected from aggregate mortality risk it
faces.

Based on Tontine Bonds issued by European
governments in 17th and 18th centuries

Recently revived by Blake and Burrows
(2001) and Lin and Cox (2004).
38
BNP Paribas Longevity Bond
November 2004
 Issuer: European Investment Bank (AAA)
 Issue: £540m, 25 year
 Mortality index: 65 year-old males from
England & Wales (ONS)
 Structurer/manager: BNP Paribas (assumes
longevity risk)
 Reinsurer of longevity risk: PartnerRe,
Bermuda
 Investors: UK pension funds
39

BNP Paribas Longevity Bond
Bond holders
Floating S(t)
Issue price
Interest-rate swap
EIB
BNP
Issue price
Mortality swap
Partner Re
40
41
Advantages of longevity bond

Provides better match for liabilities of pension
funds and life insurers than other available
investments:
– other than purchasing (re)insurance to cover the
longevity risk (i.e annuities)
Bond also provides long term interest rate
hedge.
 Longevity index transparent
 EIB has AAA credit rating.
 Life insurers holding longevity bond as hedge
may be able to hold lower prudential margins.

42
Longevity Bond
Annuity
Partial hedging of the
longevity risk
Full hedging of longevity risk
Low credit risk of EIB (rated
AAA)
Higher credit risk of the
insurer but there is
additional protection
through the government
compensation scheme
Fixed term of 25 years
Covers the full term of the
liability
Only level pensions matched
Different annuities can be
used to match non - level
pensions
43
Survivor Products

Short-dated, mortality-linked securities:

Market-traded securities whose payments are
linked to mortality index

Similar to catastrophe bonds (Schmock, 1999,
Lane, 2000, Wang, 2002, and Muermann,
2004)
44
Swiss Re Bond 2003


Designed to securitise Swiss Re’s own holding of
mortality risk!
3-year contract (matures 1 Jan 2007) which allows
issuer to reduce exposure to catastrophic mortality
events:
– severe outbreak of influenza
– major terrorist attack (WMD)
– natural catastrophe.

Mortality index (MI):
– US (70%), UK (15%), France (7.5%), Italy (5%), Switzerland
(2.5%).
– Male (65%), Female (35%)
– Also age bands
45
Influenza pandemics



All resulted from avian flu virus mutating with human
flu virus
11 outbreaks in 300 years
1580
– First confirmed flu pandemic

1782
– Summer Flu
– Started in China
– Hit young adults

1889
– Russian Flu
– Over 20% of world population infected
– 1m deaths
47
Influenza pandemics

1918-19
– Spanish Flu
– Started in Kansas
– Killed 50m people worldwide:

250,000 in UK
– More than died in WW1, in shorter period
– 20% of world’s population infected and 1% killed
– Spread along trade routes and shipping lines
48
Influenza pandemics

1957-58
–
–
–
–

Asian Flu
2m deaths
Hit teenagers hardest
Spread around world in 6 months
1968-69
–
–
–
–
Hong Kong Flu
Started in China
1m deaths
Spread slowly with moderate symptons
49
Influenza pandemics

2005-06
– Started in SE Asia
– H5N1 virus
– Closely related to 1918 Spanish virus
50
Swiss Re Bond 2003
$400m, principal at risk ‘if, during any single
calendar year, combined mortality index
exceeds 130% of baseline 2002 level’.
 Principal exhausted if index exceeds 150%
 Equivalent to a call option spread on the index
with:

– Lower strike price of 130%
– Upper strike price of 150%

Investors get quarterly coupons of 3-mo USD
Libor + 135bp
51
Swiss Re Bond 2003
Off balance
sheet
Swiss Re
Annual coupons
(USD LIBOR + 135bps)
SPV (Vita
Capital)
Bond holders
Principal
payment $400m
Up to $400m if
extreme
mortality is
experienced
Check
terminal
mortality
index value
Up to $400m if
extreme
mortality is not
experienced
52
100% 90% 80% 70% -
Exhaustion point
60% 50% 40% 30% 20% 10% 0% 1
Capital erosion
Attachment point
Principal Repayment (%)
Swiss Re Bond 2003
1.05
1.1
1.15
1.2
1.25
1.3
1.35
1.4
1.45
1.5
1.55
Mortality Index Level (q)
53
1.6
Swiss Re Bond 2003
Bond valued using Extreme Value Theory
(Beelders & Colarossi (2004))
 Assume Generalised Pareto Distribution
 Probability of attachment:

– P[MI(t)>1.3MI(2002)] = 0.31%

Probability of exhaustion:
– P[MI(t)>1.5MI(2002)] = 0.15%
Expected loss = 22bp < 135bp
 A good deal for investors!
 Bond trading at Libor + 100bp in June 2004

54
Survivor Products
 Survivor swaps:
 Counterparties swap fixed series of payments
in return for series of payments linked to
number of survivors in given cohort:
– UK annuity provider could swap cash flows based
on UK mortality index for cash flows based on
US mortality index from a US annuity provider
counterparty
– Would enable both counterparties to diversify
their longevity risks internationally.

Dowd et al (2004)
55
Survivor Products
Annuity futures:
 Prices linked to specified future market
annuity rate

Mortality options:
 Payout depends on underlying mortality table
at payment date.
 Eg, EL guaranteed annuity contract

58
Demand side of market
 Reference population underlying calculation
of mortality rates central to both:
– Viability
– Liquidity of contracts.
Hedging demand from investors (eg life
offices) wishing to hedge mortality exposures.
 If reference population v different from
investor’s specific population, then investor
will be exposed to significant basis risk:

– Might conclude that mortality derivative is not
worth holding.
59
Demand side of market

Speculative demand:
– depends on liquidity.

Adequate liquidity will require small number
of reference populations:
– Need to be chosen carefully to ensure that level of
basis risk is small for investors with hedging
demands.

Demand from hedge funds:
– seeking instruments that have low correlation
60
with existing financial instruments
Supply side of market

Government:
– Securitising social security budget

Corporates long longevity risk:
– Pharamceuticals
61
Barriers to development in cash market

After more than year, BNP Paribas longevity
bond had not generated sufficient demand to
be launched:
– Has been withdrawn for redesign

Suggests significant barriers need to be
overcome before sustainable market in
survivor products and derivatives emerges.
62
Barriers to development in cash market

Reasons why BNP bond did not launch:
– design issues

which make bond an imperfect hedge for longevity risk
– pricing issues
– institutional issues
63
Design issues

Small scheme will find it difficult to use bond
to match its liabilities:
– as variance between actual and expected mortality
will be quite large.
Mortality experience of individual pension
funds and life insurers may be different from
reference UK population.
 Bond only provides hedge for longevity of
males:

– pension funds and life insurers also exposed to
significant longevity risk from females. 64
Design issues
Liabilities for pension funds and life insurers
give greater weight to the lives receiving
larger pensions.
 Further, significant differences in mortality of
those receiving larger pensions compared to
those receiving lower pensions.
 As payments under bond effectively give
equal weight to all the lives in the UK
population, the already imperfect hedge
provided by the longevity bond is worsened.

65
Design issues

Bond only matches cashflow under level
pension
– while large portion of pensions paid by pension
funds and life insurers will be increasing at
RPI/LPI/CPI.

Bond is progressively worse hedge for
pension liabilities related to younger or older
cohorts.
66
Pricing issues
d .MI 3
d .MI1
d .MI 2
P=
+
+
+
2
3
(1+ r1 ) (1+ r2 )
(1 + r3 )
Need to forecast mortality index MI’s
 Need to estimate r’s
 Correlation between MI and r:

– Anticipated to be low
67
Pricing issues
d .MI 3
d .MI1
d .MI 2
P=
+
+
+
2
3
(1+ r1 ) (1+ r2 )
(1 + r3 )
Above model valid only in complete market
 In incomplete market, need to convert
projected deterministic mortality rates into
risk-neutral probabilities

– E.g using Wang transform
– Lin & Cox (2005)
68
Pricing issues
 Longevity risk premium built into initial price
of bond set at 20 basis points.
 Given that this is first ever bond brought to
market, markets have no real feeling as to
how fair this figure is.
 However, concern that up-front capital was
too large compared with risks being hedged
by bond:
– longevity and interest rate risks

leaving no capital for other risks to be hedged
– e.g. inflation
69
Institutional issues
 Issue size too small to create liquid market.
 Consultants reluctant to recommend it to
trustees.
 Fund managers do not currently have mandate
to manage longevity risk.
 Fund managers have not welcomed bond:
– since believe it would be closely held and they
would not make money from it being traded.

Partner Re is unlikely to be perceived as being
a natural holder of UK longevity risk.
70
Institutional issues
 Last point highly significant
 Reflects view that key determinant of future
issue of longevity bonds is availability of
sufficient reinsurance capacity.
 Neither UK-based nor EU-based reinsurer
willing to provide cover for BNP bond
 Partner Re not prepared to offer cover above
issue size of £540m.
 Has been questioned whether EU’s solvency
requirements render reinsurance cover within
EU prohibitively expensive.
71
Barriers to development in futures market

Following factors key to success of
particular futures contract:
–

defined as having consistently high volume of
trade and open interest:
Must be large, active and liquid spot market
for underlying with good price transparency:
–
–
by far the most important factor:
indeed no futures contract has ever survived
without a spot market satisfying these
conditions.
72
Barriers to development in futures market


Spot prices must be sufficiently volatile to
create hedging needs and speculative
interest.
Relative hedging demand can be measured
by level of open interest relative to volume:
–

since former excludes the many speculators who
do not hold overnight positions.
Low open interest to volume ratio is an
indication of high liquidity :
–
another sign of successful futures contract.
73
Barriers to development in futures market

Underlying must be homogeneous and/or
have well-defined grading system.

Market in underlying must not be heavily
concentrated on either buy or sell side:
–

since this can lead to price manipulation.
Futures contract must be effective in
reducing risk.
74
Barriers to development in futures market

Liquidity costs:
–
–
bid-ask spreads
execution risk:


risk of adverse price movements before trade
execution
Liquidity costs in the futures contract must
not be significantly higher than those
operating in any existing cross-hedge futures
contract.
75
Failure of futures contracts



CPI futures contract listed on US Coffee,
Sugar and Cocoa Exchange in June 1985
Delisted in April 1987 with only 10,000
contracts traded.
Reasons for failure:
–
–
–
no inflation-linked securities market at the time.
underlying was infrequently published index.
no stable pricing relationship with other
instruments.
76
Failure of futures contracts



Futures contract on Treasury inflationprotected securities (TIPS) listed on Chicago
Board of Trade in June 1997
Delisted before end of the year with only 22
contracts traded.
Reasons for failure:
–
–
–
–
TIPS had only started trading five months
before.
Only a single 10-year TIPS outstanding.
Futures contract competed with underlying for
liquidity.
Uncertainty over fate of TIPS programme.
77
Failure of futures contracts


CME launched CPI futures contract in February 2004
which is still trading.
Reasons for survival:
–
–
–
–
–
–
Inflation-linked securities have gained acceptance amongst
investors
TIPS have evolved into recognised asset class.
Well understood pricing relationships allowing for arbitrage
possibilities between TIPS, fixed-interest Treasury bonds and
CPI futures.
US Treasury committed to long-term TIPS issuance.
CPI futures do not compete directly with but rather
complement TIPS and uses same inflation index.
Contract traded on Globex electronic trading platform:

automated two-sided price quotes from lead market maker.
78
Important lessons for development
of mortality-linked futures market


Sufficiently large, active and liquid spot market in
longevity bonds must be established well before
any futures market started.
Mortality index behind longevity bond must be fair
estimate of true mortality and have minimal time
basis risk:
–
–
CPI index suffers from same potential problems
so survival of CPI futures contract on CME suggests
these problems can be overcome.
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Important lessons for development of
mortality-linked futures market


Although mortality indices are calculated
infrequently, spot prices of longevity bonds likely
to exhibit high degree of volatility on account of
bonds’ high duration.
Underlying mortality indices must be few in
number and well-defined:
–
–
small number of contracts helps to increase liquidity
but also leads to contemporaneous basis risk

arising from different mortality experience of population cohort
covered by mortality index and cohort relevant to hedger.
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Important lessons for development of
mortality-linked futures market

Potential weak point in longevity bond market is
on the supply side:
–

Futures contract would be effective in reducing
aggregate risk,:
–

since few natural issuers on supply side.
but small number of mortality indices might well leave
substantial basis risk.
No reason to suppose liquidity costs in futures
contract would be any higher than for other bond
futures contracts.
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Conclusion

Existence of survivor products:
– will facilitate the development of annuities
markets in the developing world
– and could well save annuities markets in the
developed world from extinction.

Essential to prevent annuity providers going
bust!
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Conclusion

If survivor products fail to be issued in
sufficient size:
– either the state (i.e., the next generation) is forced
to bail out pensioners
– or companies withdraw from pension provision
– or insurance companies stop selling annuities
– or pensioners risk living in extreme poverty in
old age, having spent their accumulated assets
83