Extending the lifeline

Longevity as an asset class has been in existence for a very long time. For years, pension providers and insurance companies have been exposed to and have had to manage and deal with this risk.

As transactions have typically been extremely large, in the hundreds of millions of dollars. Historically they have been inaccessible to most investors in the capital market. However, in the last few years, we have seen a sea change as more investment banks are entering into this arena, which in turn is making this asset class increasingly more accessible to investors. So what is longevity risk?

As the name suggests, longevity risk centres on people living longer than expected. Typical institutions that are exposed to this risk include annuity providers, defined benefit pension plan providers, not to mention holders of life settlements portfolios, who are obliged to pay out a guaranteed or pre-determined amount during the lifetime of the insured. Any extension in the longevity of the insured could have a negative impact on the return to investors or shareholders.

On the opposite side is mortality risk which centres on people living shorter lives than expected. Typical institutions exposed to this risk are pension providers, life insurance companies and lifetime mortgage providers. Insurance companies collect premiums which form their revenue stream from policyholders until such time as the policy matures at which point the insurance companies will have to pay out the face value of the policy. So from their point of view, the longer the insured lives, the higher the revenue stream and the greater the deferment on the pay-out of the death benefit, thereby increasing the return to shareholders or investors.

Until recently it has not been easy for investors to invest purely in longevity or mortality risk due to the size of the transactions. The only way investors could gain exposure was to invest directly into the stocks of the relevant companies but the risk taken on was not distilled and was correlated to the wider financial market. As more players enter the longevity market, more financial products are being offered, making it increasingly easy for investors to participate without having to take on the financial market risk. Instruments that are available in the longevity market include:

 Cash market – life settlements, blocks of annuities, reverse mortgages and life tenancies

 Longevity/Mortality swap – longevity/mortality swap or options

 Structured notes – pass-through, principal protected notes, coupon protected notes and leveraged notes

 Indices – Targeted population indices and broad population indices

At the heart of longevity risk is the risk in the mortality improvement of the population or sample. Mortality rates therefore underpin the analysis of longevity risk. Historical mortality rates are easily observable and are represented by the probability of people at a given age, of a particular gender and of a particular health status, dying in a particular year. The new financial products on longevity risk can be broadly split into macro longevity and micro longevity.