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Home > Financial Risk Management Best Practice > Should Governments Step In and Start Issuing Longevity Bonds?

Financial Risk Management Best Practice

Should Governments Step In and Start Issuing Longevity Bonds?

by David Blake, Tom Boardman and Andrew Cairns

This Chapter Covers

  • Systematic longevity risk is a risk that cannot be hedged with existing financial instruments.

  • Governments could help pension plans and annuity providers to hedge systematic longevity risk by issuing longevity bonds in exchange for receiving a longevity risk premium.

  • This would enable the private sector to deliver more secure pensions and better-valued annuities.

  • There is growing international support for governments to issue longevity bonds from bodies such as the Organisation for Economic Co-operation and Development (OECD), World Economic Forum and International Monetary Fund (IMF).1

Introduction

Insurance companies and defined-benefit plans face the risk that retirees might live longer than expected. This risk might adversely affect both the willingness and ability of financial institutions to supply retired households with financial products to manage their wealth decumulation (the conversion of a person’s accumulated pension assets into pension income). Longevity bonds are instruments that would allow financial institutions to hedge systematic (or aggregate) longevity risk. These bonds, which involve no repayment of principal, would pay a coupon that is linked to the survivorship of a cohort, say 65-year-old males born in 1945. The coupon rate in any year would reflect the actual survivorship of this cohort. If a higher than expected proportion of this cohort survived to, say, age 80—a development that would cost the insurance company or pension plan more than expected—the coupon rate would increase, allowing the providers to offset some of their cost. Alternatively, if a lower proportion of the cohort survived, then the coupon would be reduced. The key questions of interest are how longevity bonds would work in practice, who could issue them, and how would they be priced.

This chapter highlights the benefits that could flow from a transparent and liquid capital market in longevity-linked instruments, and argues that the government could play an important role in helping this market to grow. The line of reasoning comes from the United Kingdom, but it has validity for all countries with mature funded pension systems.

Why Worry about Longevity Risk?

Longevity risk is borne by every institution making payments that depend on how long individuals are going to live. These include sponsors of defined-benefit pension plans in the private sector, insurance companies selling life annuities, and governments through the social security system and the defined-benefit plans they sponsor for public-sector employees.

Longevity risk consists of random variation risk and trend risk (Figure 1). Random variation risk exists because some people will die before their life expectancy and some will die after. Trend risk involves the possibility that unanticipated changes in lifestyle or medical advances significantly improve the average longevity of all the members of a particular birth cohort.2

Private-sector institutions can reduce random variation risk by pooling and relying on the law of large numbers to reduce the degree of variability as the size of the pool increases. Trend risk, on the other hand, is a “systematic risk” that cannot be diversified away by pooling. The private sector is unable to hedge this risk effectively without a suitable hedging instrument.

The presence of such a nonhedgeable risk in the face of an increasing demand for annuities creates two problems. First, a big growth in annuities could result in an unhealthy concentration of risk among a small number of insurance companies, leading to insolvency should mortality rates decline faster than forecast. Second, the capital in the insurance/reinsurance industry is insufficient to deal with total global private-sector longevity risk. European Union regulators have proposed that additional capital should be required for liabilities with nonhedgeable risks.3 The cost of the extra capital would have to be passed on to customers, resulting in a reduction of up to 10% in the income annuities can provide. Longevity bonds address both these problems.

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Further reading

Articles:

  • Blake, David, and William Burrows. “Survivor bonds: Helping to hedge mortality risk.” Journal of Risk and Insurance 68:2 (June 2001): 339–348. Online at: www.jstor.org/stable/2678106
  • Blake, David, Tom Boardman, and Andrew Cairns. “Sharing longevity risk: Why governments should issue longevity bonds.” Discussion paper PI-1002. Pensions Institute/Cass Business School, February 18, 2013. Online at: pensions-institute.org/workingpapers/wp1002.pdf
  • Blake, David, Andrew J. G. Cairns, and Kevin Dowd. “Living with mortality: Longevity bonds and other mortality-linked securities.” British Actuarial Journal 12:1 (March 2006): 153–228. Online at: tinyurl.com/lepm9c9 [PDF].
  • Cairns, Andrew J. G., David Blake, and Kevin Dowd. “A two-factor model for stochastic mortality with parameter uncertainty: Theory and calibration.” Journal of Risk and Insurance 73:4 (December 2006): 687–718. Earlier version online at: www.pensions-institute.org/workingpapers/wp0611.pdf
  • Dowd, Kevin. “Survivor bonds: A comment on Blake and Burrows.” Journal of Risk and Insurance 70:2 (June 2003): 339–348. Online at: dx.doi.org/10.1111/1539-6975.00063

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