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Home > Financial Risk Management Best Practice > Obstacles to the Further Development of the Longevity Swaps Market for Pension Funds

Financial Risk Management Best Practice

Obstacles to the Further Development of the Longevity Swaps Market for Pension Funds

by Martin Bird and Tim Gordon

Longevity Index Solutions

An obvious solution is to provide a standard medium of exchange for longevity risk. This has received a lot of attention, initially being developed by JP Morgan through the LifeMetrics framework and then more recently through the Life & Longevity Markets Association (LLMA) based in London, whose stated aim is “to promote a liquid traded market in longevity and mortality-related risk.” The idea is that longevity indices can form the basis for a traded market in longevity risk which would, in turn, facilitate access to longevity risk protection and price discovery. This is a laudable objective, but the generic longevity index approach currently seems to be stalled.

In order to be suitable, a longevity index needs to be based on mortality experience data with strong assurances concerning:

  • stability of the definition of the population on which it is based;

  • sufficient past data to measure risk;

  • the availability of future data, along with their objectivity and reliability.

For UK pension schemes, the only population that meets these criteria is the national mortality data set as measured by the Office for National Statistics (ONS). However, the recent restatement1 of England and Wales mortality experience data (specifically, the population data) has illustrated that even nationally produced longevity indices are not 100% reliable.

The main problem is that longevity risk is not fungible—i.e. the future improvements in longevity for one group of individuals will not be the same as for another—and therefore one cannot reliably offset the longevity risk for one sector of the population against the longevity risk for a different one. This gives rise to basis risk, i.e. the risk that the mortality experience of the wider population on which the index is based will differ from the population at risk. Pension plan populations in particular differ from the national population because their members tend to be better off and, in addition, the liability impact is weighted toward the even better-off.

Even quantifying longevity basis risk is difficult. Not only do we not have good-quality data on past mortality experience by subpopulation, but even if we did we would still struggle. This is because it is almost impossible to determine whether a past difference between longevity improvements for different populations will:

  • continue into the future, i.e. the longevity of the different populations will continue to diverge forever;

  • fall to zero, i.e. the difference between the different populations will remain at its current level; or

  • reverse, i.e. the longevities of the different populations will reconverge.

We can find examples of each of the above by comparing different national mortality data sets. In particular, the difference between male and female mortality rates provides a striking example of mortality reconvergence in the United Kingdom and other Western World countries. If, in 1970, one had assumed that past differences between male and female longevity improvement would persist, the assumption would have led to a massive understatement of male longevity improvement. So basis risk is not only difficult to quantify, but given the wider possible range of outcomes it seems that it is necessarily quite large. And given that index solutions rely on leveraging to be effective, the basis risk is magnified still further.

There are other problems.

  • Although longevity index forwards are sometimes portrayed as being analogous to forwards in other markets, longevity has more dimensions because it is age-dependent. They are not simple to work with and introduce an additional step into the hedging process—i.e. the need to determine an optimal combination of various forward contracts, which is an ongoing process. By way of contrast, under a normal longevity swap structure, there is no need to calibrate, reconcile risk, and/or rebalance over time.

  • q- and S-forwards, the index contracts that have been suggested to date (LLMA, 2010), are zero-coupon structures and therefore are likely to be more expensive than a normal longevity swap. The underlying exits, i.e. capital markets and reinsurers, typically prefer a payout profile that pays an income. An investment bank therefore has to transform the forward starting q/S-forward structure into a coupon-paying structure for the exits. It would be cleaner (for example, there would be no queries or additional credit charges from the bank’s internal credit management) if the bank could simply pass on the swap cash flows without such manipulation.

  • q- and S-forwards are written in nominal sterling, whereas UK pension plan cash flows tend to be linked to inflation, requiring a further layer of intermediation.

What all this means is that, at present, using longevity index solutions is materially more expensive than a bespoke longevity swap, while at the same incurring a material but difficult-to-quantity basis risk. It should therefore come as no surprise that, at the time of writing, activity in index-based longevity swaps is somewhere between nil and small compared with bespoke swaps. It would be a hugely positive development if we had a large and liquid longevity index market, but we expect that the future will instead see quirky, one-off index-based trades.

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Further reading

Report:

  • Life & Longevity Markets Association. “Longevity pricing framework: A framework for pricing longevity exposures developed by the LLMA.” October 29, 2010. Online at: tinyurl.com/ln29zgn [PDF].

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