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

Reinsurance

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..)


Conclusion
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)

What's that, an actuary? Kamikaze Investors

'Housing' is probably one of the most complex assets and also one of the most interesting.

Wake up...
At the next birthday party when somebody asks you the regular line: 'What's that, an actuary?....'  Don't answer the obligatory way, but demonstrate your actuarial risk management abilities in an interactive way....

Just ask who of your birthday friends would call himself a private - non professional - risky investor?........

After some hesitation and discussion, probably all of them will answer something like:  'No, I would not dare to risk much money, I put most of my savings in a 'safe - as possible - bank account'.

Than, your next question is: "Who owns a house?"
Now, probably more than 60% of your friends will raise their finger......

Congratulations! Now you may congratulate this 60% of your friends with the fact that they are probably a more risk taking investor than an average pension fund, because they are most likely (by far) overfunded  in the asset category "Housing".

After grasping the point of your little quiz, most of your friends will first laugh, than think, and after a while some of them will ask you what they should do about being a Kamikaze-investor?

Now you get to the tricky part of being an actuary:

1. Never tell anyone what to do, 
2. Just show them the possible scenarios
3. Point out and quantify the risks, and 
4. Help them take their own decisions 

House-Pricing
 A lot of research has been done around House pricing and risk.

Although their seems to be a positive relationship between interest rate and housing-price growth, the housing risk is much more complicated than that.

Also housing prices differ strongly by country, as the next Economist table shows:

And because as actuaries, we're little Kamikaze-investors as well, the Economist has developed an interactive application to get sight at the housing-price development in your country relative to others.

Have fun with this House-Price Calculator

Related links:
- Economist House-Price Development Calculator 
- Housing consumption-based asset pricing and residential mortgage default risk. (2009) 
- Home Values and Household Debt Present Global Risks
- Running on funds: Complete (2007) Fitch Table

How to prevent cutting pension benefits?

Continuing increase of lifespan, low interest rates and stock market under-performance are the cause of pension fund's funding ratios (FR) falling to a level of underfunding (< 100%).

Sure..., it's questionable whether valuing assets an liabilities at market value is the best way to value a pension fund (after all, a 'run on the pension fund' is not possible!). However, changing a pension fund's 'valuing method' to a more artificial method (e.g. 5 years average risk free discount rate) seems no realistic option to prevent underfunding. It would be perceived as a cosmetic brew and no solution at all for sponsors that have to consolidate pension obligations in their balance sheet.

Left without alternatives, pension funds are forced by law (and the regulator) to take action. There seems to be no other choice, than to 'cut pension rights'....  Or is there?

Conditional Benefits
A quite simple and effective solution is to split up current an future Pension Benefits (PB) in a guaranteed (certain) part PB_certain (99,9% confidence level) and a conditional part PB_conditional .

The Liabilities of the the conditional part L_cond, can be used to act as a Reserve to guarantee the liabilities of the guaranteed pension benefits  L_certain. In this approach all inflation, longevity and investment results are absorbed by the conditional part L_cond.
As a consequence, the funding ratio (FR) of the pension fund gets 'cured'....

Let's see how this turns out for a healthy pension fund without a shortage:

What in fact is happening here, is that we use the cooperational characteristics of a pension fund to finance its own equity (Reserve + L_cond). As no shareholders are involved, all equity is owned by the members of the pension fund, who profit not by means of dividend, but in the form of conditional pension benefits.

Now have a look at that same pension fund with a shortage on basis of conditional pension benefits:

Undoubtedly this 'new pension model' situation looks much better than the old model and certainly better than the pension balance sheet after cutting pension benefits:

Just imagine what 'reforming a pension fund on basis of conditional pension rights' could mean for your pension fund.

When life gets difficult, we have to turn to simple actuarial solutions....

How Rewards Pay Out

Let's take the 'Candle Test' as constructed by the psychologist Karl Duncker (1930).

Just take a look at the materials on the left picture.

A candle, a box of thumbtacks, and a book of matches.

Here's the simple task:

Attach the candle to the wall so that it doesn't drip onto the table below.

(Please, don't read any further until you solved this challenge....)

Solution

Here's the solution:

Empty the box with thumbtacks. Place the candle in the emptied box. Fix that box to the wall using the thumbtacks. Place the candle in the box.

If you managed to find this solution (without cheating) within 4 minutes, you're still an enlightened actuary.

If not? Don't mind, things will get better after reading this blog.

To find the solution you had to overcome what is called “functional fixedness”: You had to see beyond the thumbtack box as purely a container for the thumbtacks.

Rewarding Performance
In the sixties Sam Glucksberg used the 'Candle Test' to test the impact of extrinsic motivational factors on the problem solving ability.

Glucksberg created two groups of participants. The first group was told they would be timed to establish norms for how long it would typically take people to solve this sort of puzzle. The second group of participants were offered $5 each, if the time they took to solve the problem was in the top 25% of all those tested. The fastest achievement would be rewarded with $20.

The outcome of this experiment was that it took the extrinsically incentivized second group on average three and a half minutes longer to solve the problem. Obviously the incentives narrowed the participants minds and blocked them to think literally 'out of the box'....

From this experiment it became clear that rewards fail and work contrarily in case of complex situations.

Similar experiment....
Then, Glucksberg took a similar experiment in a slightly different way.

He presented two new groups the situation on the left picture.
Can you predict the outcome this time?

This time, the rewarded group defeated the non-incentivized group by miles....

Why???? Because the tacks were OUT of the box !!!!

By placing the thumbtacks out of the box and placing the thumbtack box empty on the table, Glucksberg had changed the problem.

Instead of achieving a heuristic task (i.e. a complex task that requires analysis and experimenting with possibilities to develop a solution), the problem was reduced to a more algorithmic problem (i.e. the solution comes down to a set of simplistic steps down a single pathway to one conclusion).

Conclusion
To summarize: financial short-term rewarding of complex tasks leads to output reduction instead of a better performance.

More than actuaries, professionals like quants, investment managers and bank managers are rewarded on short-term output, while - at the same time - their professional challenges and objectives are complex like a Gordian knot.

A way out

If we want to get out of the current economic crisis, we'll have to stop rewarding short term results one way or the other. Our complete (economic) system should be rebased on rewarding long(er) sustainable results and well calculated risk. Don't wait any longer, just start today at your department.

Excuses....
The issue of "not getting the 'right' professionals if we don't pay enough" is a fable. No matter how professionals like CEOs, Bank managers or actuaries are: if they just go for the short-term money and aren't intrinsically motivated to make this world a little better with their gifts and skills, please let them leave.

Tip: Include rewarding in your risk models!

Let's conclude with an interesting video by Dan Pink who examines the puzzle of motivation, explaining that traditional rewards aren't always as effective as we think.




Related/Used sources:
- Carrots and sticks
- Functional_fixedness