The involvement of the capital markets in terms of its capability to absorb longevity risk has been talked about for years, but action has been largely absent. Life Risk News’ Greg Winterton caught up with David Blake, Professor of Finance & Director of the Pensions Institute, Bayes Business School, to get his thoughts on the current state of the longevity financing conundrum.
GW: David, let’s start with mortality. The CMI recently incorporated Covid-19 data into its mortality projections, the result being lower life expectancies. What’s your view of the impact here?
DB: In July 2023, the CMI reported that deaths in the UK in June 2023 were 5% higher than in pre-pandemic June 2019. Across the UK, there have been 200,100 more deaths from all causes than expected from the start of the pandemic to 30 June 2023. Of these, 75,600 were in 2020, 56,600 in 2021, 39,400 in 2022 and 28,500 in the first half of 2023. Pension liabilities would be £8bn lower than three years previously anticipated for schemes going through their triennial valuation between September 2022 and September 2023, according to The Pensions Regulator.
This longevity slowdown when combined with the significant reductions in liabilities as a result of rising interest rates over the past 18 months is likely to lead to larger pension fund surpluses and bring forward planned de-risking strategies, including buy-outs, buy-ins and longevity swaps.
GW: In early September, the 18th edition of your annual Longevity conference took place. What’s been the most notable trend, from the perspective of the capital markets, in the past nearly two decades of the event?
DB: We held our first Longevity conference in February 2005, just after the European Investment Bank and BNP Paribas announced the launch of a longevity bond to hedge systematic longevity risk. Unfortunately, the bond failed to attract sufficient interest to get launched. But it did encourage investment banks to introduce less capital-intensive solutions, such as longevity swaps. These were just beginning to gain traction when the Global Financial Crisis struck, and, in the aftermath of the Dodd-Frank Act, investment banks pulled out of this market. This left insurance companies to take over the longevity risk transfer market with their buy-outs and buy-ins. They laid off the longevity risk with global reinsurers via longevity swaps. But none of these products have any real liquidity, so they cannot easily be transferred to third parties.
The transfer market has grown rapidly in the last few years and it is becoming increasingly clear that there is insufficient capacity in the global insurance/reinsurance market to absorb all this risk.
This led to attempts to bring in new sources of third-party capital. A key example is the reinsurance sidecar – which is a way to share risks with new investors when the latter are concerned about the ceding reinsurer having an informational advantage. Formally, a reinsurance sidecar is a financial structure established to allow external investors to take on the risk and benefit from the return of specific books of insurance or reinsurance business. It is typically set up by existing (re)insurers that are looking to either partner with another source of capital or set up an entity to enable them to accept capital from third-party investors.
It is established as a special purpose vehicle (SPV), with a maturity of two to three years. It is capitalised by specialist insurance funds, usually by preference shares, though sometimes in the form of debt instruments. It reinsures a defined pre-agreed book of business or category of risk. Liability is limited to the assets of the SPV and the vehicle is unrated. The benefit to insurers is that sidecars can provide protection against exposure to peak longevity risks, help with capital management by providing additional capacity without the need for permanent capital, and can provide an additional source of income by leveraging underwriting expertise. The benefit to investors is that they enjoy targeted non-correlated returns relating to specific short-horizon risks and have an agreed procedure for exiting; investors can also take advantage of temporary price hikes, but without facing legacy issues that could affect an investment in a typical insurer. By 2021, more than $20bn in third-party capital from sidecar investors had been deployed to support around $400bn worth of life and annuity book transfers.
So the history of the last 20 years has been one of ups and downs for the capital markets when it comes having a significant role in the market for longevity risk transfers. Early successes were followed by a virtual withdrawal from the market as insurers took over. But things could be changing…and soon.
GW: Some would argue that it’s taking a long time – too long – for solutions to emerge that will encourage more participation by the capital markets in longevity risk. Why is it taking so long, and what’s the solution?
DB: Yes, it has taken far too long for sustainable capital markets solutions to emerge. But the reason for this is clear from my earlier answers. There is no real liquidity in existing longevity risk hedging solutions: buy-ins, buy-outs, longevity swaps or reinsurance sidecars. This also explains why reinsurance sidecars only have maturities of up to three years: third-party investors do not currently want to be committed for longer periods. A key reason for the lack of liquidity in existing solutions is that they are customised to the specific hedging needs of different pension funds and so are based on the specific mortality experience of these funds.
The solution is to introduce a longevity or life market to create liquidity in longevity-linked products by facilitating the exchange of these products between third-party investors. This, in turn, requires standardisation of these products. This implies that they have to be linked to an index based on national population mortality data. This, in turn, introduces two challenges that need to be circumvented.
The first challenge is basis risk, the risk that the specific mortality experience of a pension fund diverges from the mortality experience of the national population. The second challenge is capital relief, the allowance that the financial regulator grants to hedge providers such as insurance companies when determining the level of capital that they must raise in order to conduct risk taking activities. These challenges are linked, since the lower the basis risk, the more effective the hedge and hence the greater the capital relief. Naturally, insurers want to minimise the amount of capital they devote to their risk-taking activities.
Hedging solutions, involving options linked to national population mortality indices, have been invented in recent years in order to minimise basis risk. But these solutions have failed to gain the capital relief hoped for in the countries in which they have been introduced.
A group of us (David Blake, Professor Andrew Cairns of Heriot-Watt University, Avery Michaelson and David Schrager of Longitude Solutions, and Douglas Anderson and Steven Baxter of Club Vita) felt that the regulator needed to have more and better information about the benefits of index-based hedges. This is why we have recently established the Index Longevity Market Action Committee (ILMAC). The aim of ILMAC is to ‘build a consensus on a framework, ideally a market standard (to be incorporated into regulations such as Solvency UK or Solvency II, and related guidance) for basis risk quantification, combined with a set of principles for the development of an internal model for institutions seeking to use their own approach to basis risk quantification. This is intended to provide clarity on the capital relief that a regulated (re)insurer would achieve from using an index-based hedging structure’. To date we have had one meeting with the UK Prudential Regulation Authority (PRA). We are currently working on a realistic case study that calculates the capital relief for a pension fund that uses an index-based longevity hedge with minimal basis risk.
GW: Back in 2015, you warned about the risks to the insurance industry in terms of its exposure to systematic longevity risk. In the past eight years, however, the volume of PRT deals has grown substantially. Are we at risk of a situation where something will only change when a disaster occurs – something akin to Basel III as a response to the global financial crisis?
DB: Over the last eight years a significant amount of systematic longevity risk has been concentrated in a small number of global reinsurers. This has attracted the attention of the PRA which in January 2023 wrote to UK insurance companies warning them that: ‘In light of the multiple external uncertainties facing insurers, it is important that firms take proactive steps to assess the adequacy of their risk management and control frameworks. Firms should be able to respond to market and credit risk conditions different from those that prevailed for a long time. Firms need to be prepared for novel risks, changes in risk correlations and increases in distressed assets. … We are paying close attention to whether the continued high level of longevity reinsurance reduces the protection UK policyholders should have, beyond the risk tolerance. In particular, we see the potential for offshored counterparty concentration risk to arise from rapidly growing levels of reinsurance’.
The best way to avoid a crisis is to introduce a regulator-approved capital market for longevity risk transfers and this will help to reduce concentration risk. This is because the risk will be spread across the whole capital market, in particular long-term investors – such as sovereign wealth funds and endowments – that seek returns that are uncorrelated with traditional bond and equity assets.
GW: Lastly, David, let’s try and put a crystal ball in here. Fast forward five years; where do you hope the longevity risk asset class will be? What’s the best-case scenario here?
DB: I am very positive about developments in the longevity risk space over the next five years. Although the longevity risk transfer market began in the early 2000s, this year (2023) was the first year that we (via ILMAC) have started to have serious discussions with a regulator about capital relief on index-based longevity hedges. Last year, the Longitude Exchange was established in Bermuda as the first digital marketplace for trading longevity risk in index-based format. It aims to connect hedgers and investors on a platform optimised for trading longevity risk and hence build an efficient and deep market for trading longevity risk.
So, if we can regulatory support for our approach to capital relief, then this could lead to a regulator-approved capital market for longevity risk transfers taking off over the next few years – fulfilling ambitions that go back two decades.
David Blake is Professor of Finance & Director of Pensions Institute, Bayes Business School