Nov 29, 2010

Longevity Swaps: The Next Bubble

Last century our Human Footprint Index (the relative human influence in each terrestrial biome on Earth) increased exponentially.

According to the Human Footprint Index, not only Europe (left picture), but also India and the North East of the U.S.  are  'humanized'.......  Step by step we - human beings - are 'amazingly' filling up every little corner of the world.

Just a few more years and - as a species - we'll be 'omnipresent'.

Yes, we are crowding this good old earth at an immense speed, as our health increases and we keep living longer every year. The social and financial effects of this population growth will be enormous.

Nevertheless we're very unsure about how our population will grow in the future...

Key point is that population growth will strongly differ per region and country. The growth in the western countries will be driven by the aging population, while the growth in developing countries, like Africa, will be driven by new births. In the' aging countries' population growth will undermine our social and first pillar pension systems....

Pension Fund Transform
This aging society development implies that our mature pension funds will have to transform from pension-saving to pension-paying.

Secondly 'longevity risks' become more and more important and can not be 'financed' anymore from the declining funding margin.

Example: The Longevity Trap
Let's take a simple example.

Rule of Thumb Nr. 1
In the so called developed countries, every year we live, our life expectancy increases (on average) with 3 months! Or, as Harry de Quetteville from the Telegraph stated it more humorous:

For every year we live, we are only really nine months closer to death!

Rule of Thumb Nr. 2

This rule of thumb states the financial impact of longevity:

One year increase in life expectancy from age 65 equates to approximately a 3% to 5% increase in pension value liabilities.

Combining  rule I and II leads to the conclusion that on average the pension liabilities of mature pension funds currently urge for a yearly 1% increase of liabilities, just for financing the cost of extended longevity.

A decade ago, the slowly increasing 'sniper costs' of extended longevity could easily be financed out of the pension fund's margin.

Nobody (not even an actuary!!!) could imagine that longevity would become a substantial issue.

Later that decade, disappointing stock returns and low long term liability discounting rates shrinked the pension margin and even turned it negative. This pension margin reduction put the cost of extended longevity in quite a different perspective. The 'Actuary Longevity Trap' had become a fact!

What really had happened was that the high returns and interest rates of recent decades masked the (increasing) costs of extended longevity.

'Once bitten, twice shy', one would think.... But not for actuaries, as
the next bubble is coming up........

Longevity Swaps
The Next Bubble

Not only pension funds but also Life insurers are facing significant longevity risks as mortality rates are still declining. Reinsurance companies like Swiss Re and Münchener Rück try to fight the underestimated longevity effects of pension funds with so called ‘Longevity Swaps’.

The essence of a longevity swap is that a pension fund trades the - due to longevity - uncertain estimated future pension payments until death (floating leg) against the actual future pension payments for the scheme’s pensioners payments (fixed leg).

Why a Longevity Swap is a bubble?....

The Longevity Swap only transfers the risk to a counter party (reinsurer), but this counter party in general doesn't have a complementary risk to match the accepted risk of the longevity swap. The counter party bases his underwriting only on a more 'safe' calculation. 

This implies that whoever is sitting at the end op the swapping chord, will finally pay the bill (systematic risk!) in case longevity risks are structurally being kept underestimated. Now if one thing is a fact, it is that - for decades - longevity risks are underestimated en this underestimating behavior will continue in the future, as we actuaries are apparently ignorant at this point.

Just like the high interest rates in the past masked the actual cost of the extended longevity, current longevity swaps wrap' long term unsure and underestimated  future mortality rates' in interest-discounted derivatives. 

Whatever reinsurers are discounting after 30-50 years at interest rates above 2% doesn't really count anymore in terms of present value. but will reveal itself in the coming decades....

By the way, is a 90% (asymmetric?) confidence level resulting in a 11 year life expectation spread in 2050 consistent with a 97,5% or 99,5% confidence level used as basis for a longevity swap?

Probably not.........

But who cares about consistency, when 'short money' is on the table?
You? (Hope you do..)

We're left with no other conclusion than that it will turn out that longevity swaps in their current form are the new systematic risks of the future!

Any solutions? 
The only solution to prevent longevity swaps from becoming a bubble is to find complementary 'matching' risks that compensate the accepted risk (profile).

It's hard to find matching risk profiles for the reinsurer. The fact that longevity mainly applies to older people (top around age 80-85) makes it hard/impossible to compensate longevity risks with mortality risks at younger ages.

Perhaps a kind of solution could be that pension funds could offer the relatives of a pensioner the possibility of insuring (life insurance) the calculated liability of the pensioner (or the remaining annuities until the age of 80) at the moment of death  (a kind of liability legacy life insurance).

Perhaps some creative actuaries have some other ideas? Please let me know...

Sources & Related Links:
- Life Tables United States Social Security Area (2005)
- The Human Footprint Index Graphics
- World Population Growth
- Wapedia: World Population
- A model for longevity swaps
- Understanding Modeling and Managing Longevity Risk
The pros and cons of longevity hedging(2010)
- Longevity Risk in Pension Annuities (2005)
- Increasing Longevity: Effects on Pension (2009)
- Longevity swaps as an investment (2010)
- Pensions: Change management (2009) 
- Pensions: On the wrong track? (2009)

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