Pension funds welcome a new bond indexed to life expectancy which should cut the cost of matching a growing risk.
Deal: European Investment Bank’s longevity bond
Size: £540 million
Structurer/manager: BNP Paribas
Date announced: November 8 2004 Asked what he thought about old age, Maurice Chevalier replied that he preferred it to the alternative. So do the rest of us. The EU expects the number of people aged 80 and over in its 15 pre-accession members to increase by nearly 50% in the next 15 years.
This raises the issue of how annuity providers can tackle longevity risk – the risk that people will live longer than expected. Life insurers are increasingly aware of longevity risk. “Someone who is 65 today will have a shorter life expectancy than someone who is 65 in 10 years’ time and that’s taken into account in pricing,” says Franck Pinette, head of life at global multi-line reinsurer PartnerRe.
If longevity trends are not accurately forecast, or are volatile, reserves and losses will have been wrongly estimated.
Similar problem
Pension funds face a similar problem. Annuities are paid for life. If funds are making payments to beneficiaries until those beneficiaries die, the longer people live the more money their fund has to pay them. In July, David Willetts, the Conservative opposition’s work and pensions spokesman, suggested that the UK government should issue bonds indexed to changes in longevity.
In the event, Chevalier’s countrymen at BNP Paribas, along with PartnerRe and the European Investment Bank, beat them to it. The trio has devised a way to hedge longevity risk. The longevity bond is a 25-year, £540 million ($1.02 billion) bond to be issued by the EIB. Its longevity index is the survival rate of the entire male population of England and Wales who are aged 65 at the bond’s launch date, as published by the UK government’s Office for National Statistics (ONS). The bondholders will receive an annuity adjusted according to the year-by-year survival rate of that population.
If the longevity bond pays, say, £1,000 a year, and five years after it is launched 90% of the population is still alive, the bond pays £900 in its fifth year. So, although cashflows must decline over time, the longer people live the more the bondholders get paid.
“That’s the mirror image of the liability structure of a pension fund,” says Denis Autier, head of global risk solutions at BNP Paribas. “The key change is the introduction of longevity as part of a financial instrument.”
Why don’t pension funds continue to buy cover from reinsurers and let those reinsurers go to the capital markets themselves? Buying cover from an insurance company that takes over liabilities is expensive, capacity is limited (there are only two insurers in the UK providing this buy-out service), and a direct bond issue by reinsurers cannot compete with the longevity bond, which benefits from the EIB’s AAA rating. “Most pension funds do not want to take a lower rating for such a long-dated issue,” says Autier.
Data quality
“A buy-out requires a lot of resources to analyze the data provided by the ceding companies, and sometimes the quality of that data isn’t so good,” says Pinette. “Good data reduces costs and volatility.”
The longevity bond is not a perfect hedge. Longevity in the population of a pension fund might diverge from the general trend for English and Welsh men, although actuaries think that having such a large sample in the index reduces the problem.
“What is important is not the absolute level of mortality but the trend in mortality,” says Autier. If, say, advances in genetic medicine push longevity up, a bond whose interest payments go up to reflect this will help pension funds pay their annuitants.
And a bond shows up as part of the buyer’s assets and liabilities and not on its profit and loss account, where an insurance premium would appear.
“We can already use the capital markets to hedge interest rates, inflation, and duration, and to change asset allocation quickly,” says Terry Faulkner, chairman of the UK’s National Association of Pension Funds. A longevity bond addresses NAPF’s members’ last big unmatchable risk. “It’s not a perfect hedge, but there is nowhere else to match longevity.”
The EIB gets another funding tool and helps the EU member states address their pension funding crisis. PartnerRe is the final taker of longevity risk. It needs to write longevity business to balance its mortality portfolio, reinsuring term insurance products where the risk is that policy holders die too soon.
The big if remains the reinsurance market’s capacity to take further longevity risk. One bond will not help the biggest annuity providers match all their liabilities. BNP Paribas approached a number of reinsurers to back the bond, and they all have constraints. “We have limitations on capital allocations and need to balance this with our mortality business,” says Pinette.
