On the Failure (Success) of the Markets for Longevity Risk Transfer

• Date: 01 April 2017
• DOI: http://doi.org/10.1111/jori.12205
• Published date: 01 April 2017

ON THE FAILURE (SUCCESS)OF THE MARKETS FOR

LONGEVITY RISK TRANSFER

Richard MacMinn

Patrick Brockett

ABSTRACT

Longevity risk is the chance that people will live longer than expected. That

potentialincrease in life expectancy exposes insurersand pension funds to the

risk of not having sufficient funds to pay a longerstream of annuity benefits

than promised. Longevitybonds and forwards provide insurers and pension

funds with financialmarket instruments designed to hedge the longevityrisk

that these organizationface. The European Investment Bank and World Bank

have both discussedlongevity bond issues, but those issues have faileddue to

insufficient demand. Forward contracts have also been created, but that

market remains dormant. The extant literature suggests that these failures

may be due to design or pricing problems. In this article the analysis shows

that the market failure is instead due to a moral hazard problem.

INTRODUCTION

One of the largest sources of risk faced by pension funds and life insurance companies

offering annuities is longevity risk. Longevity risk is the risk that members of a

population live longer, on average, than expected when originally pricing the product.

If the population is a pool of annuitants, then longevity risk is the risk that annuitants

live longer on average than predicted in the life companies’ mortality tables used to

price the annuities. Longevity risk is an important societal problem because of the

uncertainty concerning the longevity projections and because of the large exposure to

longevity risk. The uncertainty of longevity projections is illustrated by the fact that life

expectancy for men aged 60 was more than 5 years longer in 2005 than it was predicted

to be in mortality projections made in the 1980s (Hardy, 2005). The significance of this

uncertainty is further illustrated by noting that the amount at risk (exposure) in

the U.S. defined benefit plans was estimated to be approximately $2.2 trillion in 2007

(Oppers et al., 2012) and covered 42 million participants. Swiss Re estimated the total

global exposure to longevity risk at approximately $21 trillion(Burne, 2011).

Richard MacMinn is a Senior Research Fellow at National Chengchi University, Taipei, Taiwan

and at The University of Texas, Austin, Texas. MacMinn can be contacted via e-mail:

richard@macminn.org. Patrick Brockett is at the Department of Information, Risk, and

Operations Management, The University of Texas at Austin McCombs School of Business,

Austin, Texas.

© 2017 The Journal of Risk and Insurance. Vol. 84, No. S1, 299–317 (2017).

DOI: 10.1111/jori.12205

299

Exposure to longevity riskis a serious issue, and yet, traditionally, life companiesand

pensionsfunds have had few means of managing it. Until recently,longevity risks were

not securitized

1

and there were no longevity derivativesthat institutions could use to

hedge their longevityrisk exposures. This state of affairs has changed,and the new life

market for longevity linked financial instruments has begun to develop.

2

Most

prominent among these financial instruments are longevity bonds, which are

instruments in which at least one payment, and possibly more, depends on the

realization of a survivorindex.

3

Survivor or longevitybonds are designed to hedge the

required annuity payments of an insurer or pension fund. Thus, the payoff of the

longevity bond to the bond investorfrom the bond issuer decreases when survivorship

increases (which is when the annuity provider or pension fund needs more money).

Two types of survivorship indices might be used. One is an index based on the actual

survivorship of the annuitant pool insured (an indemnification payoff structure). A second

possibility for the survivorship index is to base it on general population survivorship (an

indexed payoff structure). In the index payoff bond structure there will generally be a

difference between the payoffs required for the actual pool of survivors in the insurers

annuity book of business versus the payoff for the pool of survivors in the population. The

difference between the indemnity and index payoffs is known as basis risk.

There are other instruments designed to hedge longevity risk including longevity

swaps and q-forward contracts.

4

The swap pays the difference between the indemnity

payoffand the index payoff at each date while the q-forward exchanges the risky payoff

“then” with a certain payoff.

Renewed interest in the notion of a survivor or longevity bond was initiated by Blake

and Burrows (2001). Since then the literature on mortality and longevity risks and

capital market instruments designed to hedge those risks has grown significantly. In

2003 Swiss Re successfully introduced a “mortality”-based security designed to

hedge excessive mortality changes for its book of life insurance. The concern was

mortality risk, that is, the risk of experiencing a higher death rate than was expected

and priced. Since then mortality bonds have become common instruments for the

transfer of mortality risk to the capital markets.

In 2004,the European InvestmentBank (EIB) introduceda “longevity”bond designedto

hedge longevity risk occurring with decreases in mortality (increased longevity). By

utilizing such a financial instrument pension and annuity, providers could hedge the

risk of adverse financial consequencesarising from mortality improvements that were

not anticipated and priced. The EIB longevity bond was ultimately not issued due to

insufficientdemand. In 2008and 2009 the World Bank (WB) introducedlongevitybonds

1

The issues involved in the securitization of longevity risks are discussed further by Cowley

and Cummins (2005) and Krutov (2006).

2

See Blake et al. (2013) for a discussion of the new life market.

3

As its name suggests, the survivor index is the proportion of some initial reference population

that is still alive at some future time t.

4

The q is common notation for mortality in actuarial science and so is used here to identify the

forward contract.

300 THE JOURNAL OF RISK AND INSURANCE