Risk comes in many different forms; one such form is longevity risk. From a personal perspective, longevity risk is the risk of outliving one’s savings. This would lead to these individuals living in poverty, not being able to assist family through inheritance, or both. From a business perspective, longevity risk is the risk of increasing life expectancy, which could lead to future situations in which payout is higher than expected for pension funds or insurance companies. Self-insuring this risk could be of great cost, as mortality is uncertain, and thus is a stochastic process. It is of great importance to measure longevity as accurately as possible. Actuaries working in fields of both pensions and insurance are called upon to analyze the challenges that come with longevity risk and work to predict life expectancy accurately while seeking ways to combat the risk.
The life expectancy of humans is increasing. Healthcare and working conditions have improved tremendously over the years, and the public has a better understanding of how to properly take care of themselves. These factors have caused life expectancy to increase at a rapid pace. This increase in life expectancy is welcome from a progressive standpoint; however, it is of potential concern to retirement systems and other similar businesses.
Businesses that could be adversely affected by longevity risk, such as managers of pensions plans and annuities, as well as life insurance companies, will look to mitigate the risk. This can be done through hedging with longevity derivatives. As the possibility of growing life expectancy increases, the probability of increased costs resulting from the increased life expectancy rises. It is no surprise that this creates additional risk to providers, primarily providers of retirement benefits. Longevity derivatives help hedge against this risk by increasing payouts to holders of longevity derivatives as life expectancy increases. The provider would have additional costs with increased life expectancy; however, this would be offset by the greater payout from the derivative. If the life expectancy is low, there are no additional costs that would accompany high life expectancy, but the derivative would not provide much payout. The two sides move inversely, which leads to the longevity risk being hedged.
In addition to hedgers, mortality-based securities could be of great interest to a general investor, such as an investment bank. Longevity risk has a low correlation with most standard market risk factors, which allows investors to diversify in order to minimize unsystematic risk. This low beta and the potential for a positive alpha make these mortality-based securities attractive for investors. Speculators find these securities attractive for similar reasons.
There are many different types of longevity derivatives of both the symmetric and asymmetric variety. These include longevity bonds, longevity options, longevity swaps, and longevity forward contracts. The first and arguably the most common example is a longevity bond, which is often referred to as a survivor bond. Survivor bonds pay a coupon, but the amount of the coupon is contingent on the proportion of a given population group that is still alive (survivors), as the name suggests. The longer individuals live, the greater the coupon payout. When life expectancy increases, providers are faced with additional costs; however, survivor bonds provide greater coupon payments under these conditions, which allows providers to avoid taking large net losses. The risk of individuals living longer than expected is mitigated because of the survivor bond.
There are also zero-coupon longevity bonds, which offer no coupons, as the name suggests. The principal payment is linked to a survivor index. These bonds are attractive because they can be used to provide a good fit for tailor-made positions, and they can therefore be constructed in such a way that portfolios fit the features that are needed.
Collateralized longevity obligations (CLOs) are tranches of longevity bonds. The various tranches each have a different exposure to longevity risk. The higher tranches come with less risk but also have a smaller expected return. Conversely, lower tranches come with more risk and a larger expected return. CLOs operate like collateralized debt obligations (CDOs) in this way.
Due to the large amount of capital required in the early stages of longevity bonds while the risk is low, an attractive hedging tool is deferred longevity bonds. Payments are deferred to a later date, which frees up capital that would otherwise be spent in the early stages. Deferred longevity options resemble mortality forward contracts in this way. Since deferred longevity bonds allow users to increase the impact of a hedge with a smaller initial expenditure of capital, they are attractive to those desiring to hedge longevity risk.
One of the first longevity derivatives was introduced in December 2003 when Swiss Re offered a three year mortality bond in which the principal payment was tied to an international mortality index. If investors took on the risk of a significant worsening of mortality, they received generous floating rate payments. Investors enjoyed the floating rate payments, and Swiss Re was able to pass off some of its risk. More companies began to implement similar longevity bonds in recent years, and other longevity derivatives came soon after. In December 2005, the CSFB Longevity Index was created, with the purpose of providing a benchmark with which to tie various longevity derivatives.
One of the next longevity derivatives that was created was a longevity option. Longevity options are very useful for hedgers, as they provide non-linear payoffs. With longevity options, hedgers are able to protect their exposure to downward movements while leaving themselves open to upward movements.
An example of a longevity option is a Longevity Experience Option (LEO.) LEOs are call options that were first introduced by Deutsche Bank in 2013. The LEOs from Deutsche Bank were out-of-the-money bull call option spreads with 10 year maturities. A bull call spread is an option trading strategy that is used when the trader believes the underlying asset will have a price increase. An out-of-the-money option is cheaper than an in-the-money option because there is a greater chance that the underlying asset will be unable to reach the strike price. The fact that the LEOs from Deutsche Bank were out-of-the-money call options indicates that the strike price exceeded the current price. This LEO was based off of 10 year forward survival rates.
LEOs give a cheap and liquid alternative to longevity swaps. Longevity options are much simpler to put into practice than longevity swaps. Gains occur if survival rates are greater than the forward rates; however, the gains are limited in order to protect the investors who are providing the hedge.
Speculators can also make use of longevity options. While hedgers trade on views of mortality level, speculators trade on views on volatility. Options are useful for this purpose similarly to how they are useful for hedging; beliefs about the direction of the market can be acted on in an attempt to realize a gain with limited downside risk.
Longevity swaps are another commonly used derivative to hedge against longevity risk. In a longevity swap, the risk that individuals will live longer than expected is transferred to a counterparty, such as an insurance company. In return, an agreed stream of payments will be paid to the company that transferred the risk. This swap is essentially an example of reinsurance; the risk is being transferred to another entity. This is very beneficial as the reinsurance provides insurance against excessive loss. If life expectancy continued to rise beyond predictions, this would limit the loss that could come from additional costs.
As would be expected of a swap, longevity swaps are traded in the over-the-counter market. Longevity swaps are desirable to many due to the fact that they can be made to fit the desires of the individual entering into the swap. This allows for better correlation, which can help prevent excess gains or losses in a hedge and thus leads to low basis risk. Conversely, longevity swaps are undesirable in that they do not have much of a secondary market, and hence investors are not easily able to get out of existing positions; they are illiquid compared to other forms of longevity derivatives. Swaps are useful for helping individuals on two different sides of a situation meet their respective needs. An insurer looking to manage longevity risk could enter into a swap with another insurer looking to acquire longevity risk exposure. As a result of the swap, both parties have what they were looking for and are better off in that sense.
In April 2007 Swiss Re and Friends’ Provident entered into the first publicly announced longevity swap. This swap was based on Friends’ Provident’s £1.7 billion book of annuity contracts. Friends’ Provident kept administrative rights while Swiss Re made payments and took on the longevity risk in return for a premium.
Longevity forward contracts are another type of longevity derivative and are similar in structure to longevity swaps. They are desirable due to great liquidity, which stems from secondary market depth. They are undesirable due to increased basis risk. What is desirable for longevity forward contracts is undesirable for longevity swaps, and what is undesirable for longevity forward contracts is desirable for longevity swaps.
There are several examples of longevity forward contracts including mortality forwards (q-forwards), survivor forwards (s-forwards), and k-forwards. A q-forward (q is the standard actuarial symbol for mortality rate) is a zero-coupon swap in which the two parties involved in the swap can be thought of as a “fixed rate payer” and a “fixed rate receiver.” The fixed rate payer pays a fixed rate based off of the fixed mortality rate and receives a rate based off of the actual realized mortality rate. The opposite is true of the fixed rate receiver. The party that is facing the longevity risk can hedge the risk by entering this swap as a fixed-rate receiver. This would result in its receiving of a fixed payment from the counterparty when mortality is lower than anticipated (life expectancy is higher than anticipated.) The liability of additional costs from lower mortality than predicted could be aided by the payment that is received in situations when costs are higher than anticipated. In many ways q-forwards form the foundation for more complex longevity derivatives.
S-forwards are very similar to q-forwards. The general idea behind the two is the same; however, s-forwards are linked to a survival rate for a given group while a q-forward is linked to mortality rates. The provider pays the estimated population survival rate for a particular cohort, and the provider receives the realized survival rate. The s-forward is only able to hedge the systematic longevity risk; the interest rate risk and unsystematic risk can be handled through diversification and the usage of other derivatives and trades. S-forwards are more complex than q-forwards, as the survival rate that s-forwards are linked to is a function of multiple mortality rates at multiple points in time.
K-forwards are like q-forwards except for the fact that they are linked to a parametric mortality index in a stochastic model. The parametric mortality index is able to give more information about mortality than the nonparametric mortality indexes used in q-forwards and s-forwards. While k-forwards are not as common as q-forwards, the additional information they provide is attractive to some.
Longevity risk is a subject that did not enter the spotlight until the start of the 21st century with the rise in human life expectancy. The growing longevity risk has been combatted with a growing number of longevity derivatives, including longevity bonds, longevity options, longevity swaps, and longevity forward contracts. Actuaries are given the task of modeling the risk in such a way that it can be managed effectively. Longevity derivatives enable those exposed to longevity risk to mitigate the risk to avoid catastrophic losses.
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