OECD calls for capital markets to embrace longevity risk hedging

With life expectancies set to continue improving, the OECD yesterday called for the capital markets to offer additional capacity for the hedging of longevity risk, but said that longevity risk instruments need to be standardised to increase transparency and liquidity.

In its annual Pensions Outlook 2014, the Organisation for Economic Co-operation and Development or OECD highlights the need for a liquid market in longevity hedging instruments and highlights the fact that capacity from insurance and reinsurance firms alone may not be sufficient to enable all pensions and insurers to mitigate the risk.

As a result the OECD recommends that the capital markets be considered as a source of longevity risk transfer capacity, but notes that for capital market investors to become more involved the instruments used will need to be more transparent, standardised and liquid.

The pressure on both public and private pension systems is mounting, according to the report, with low growth, low interest rates and low investment returns compounding problems for pension plans and schemes. On top of the fiscal and economic issues that pension funds face, the issue of longevity risk is a constant threat to their future funding and ability to continue to pay retirees the pensions they expect.

The OECD reports calls for the regulatory framework to help pension funds and annuity providers to deal with longevity risk to be strengthened. Regulators should ensure that the most up to date mortality tables are used by providers when accounting for longevity, so that the latest forecasts for life expectancy are used. Failure to factor such mortality rate improvements into their accounting can result in shortfalls of as much as 10% for pension and annuity providers, the OECD notes.

The capital markets could offer the additional capacity required for the hedging and transfer of longevity risks, the OECD report says, but work is required to facilitate the standardisation, transparency and liquidity of instruments used to hedge longevity risks.

The OECD is also calling for initiatives such as longevity indices and the issuance of longevity bonds to be revisited, saying that by issuing bonds linked to longevity risk with a standardised index in place the market will support the development of longevity risk instruments with the provision of benchmarks for pricing and risk assessment.

Finally the OECD also calls for the regulatory framework to reflect the reduction of risk exposure that longevity risk hedging instruments offer, by ensuring they are appropriately valued by the appropriate accounting standards and that they reduce the level of required capital for any entities hedging their longevity risk.

So the OECD feels that the capital markets can address the need for standardisation, benchmarking, liquidity, likely exchange trading and also the capacity requirements for the transfer of longevity risk. Governments can also help with this goal through the provision of longevity indices to serve as a benchmarking tool.

Interestingly, the OECD notes that there are capacity constraints that insurance and reinsurance firms face with respect to assuming longevity risks. However some sources of traditional reinsurance capacity are currently extremely bullish as to their ability to assume more longevity risk, which suggests that for the moment the capital markets are not required to support the types of large transactions that we have seen coming to market recently.

For the capital markets to support these large reinsurance capacity providers, the standardisation, liquidity and transparency are required conditions that need to be met to help third-party investors to assume these risks. Also needing to be addressed is the misalignment of incentives, between insurers or pension funds seeking protection and the capital market investors seeking to provide it, the OECD believes.

Appropriate legislation and regulation also needs to be in place to increase the understanding of the significance and magnitude of longevity risks, the OECD says.

Index-based longevity hedging could solve a lot of the misalignment of interest issues, the OECD believes, allowing transactions to be performed more simply, with standardised benchmarks and an opportunity for secondary liquidity due to the reference index which could be traded against.

Index-based longevity hedges can provide capital market investors with a new asset class that is largely uncorrelated with broader financial market benchmark movements, while at the same time offering a new source of capacity for pension funds seeking longevity risk transfer capacity.

The transparency of index calculations is vital for investors to fully buy into providing capital to back longevity swaps and hedges and the use of accepted indices as reference measures can provide this to the end investor. The transparency and ability to calculate a value for such instruments would also stimulate the potential for secondary markets to emerge in longevity risk.

Of course here the basis risk becomes an issue for the pension fund or insurer seeking the longevity protection, a core concern which has held back the use of indices for longevity swaps and hedging in previous years, despite longevity indices having existed for some time.

However, advances in research on longevity risk such as the one we covered yesterday here, suggest that longevity risk transfer sponsors or cedents may be able to better calculate and make provisions for the basis risk inherent in index-based longevity swaps now, which could result in greater uptake.

The OECD concludes that insurers and reinsurers cannot keep assuming longevity risk forever.The OECD explains; “While insurers can benefit to an extent from the diversification of longevity risk with the mortality risk coming from their life insurance business, this diversification is limited and they will face constraints in the amount of longevity risk they will be able to continue to accept.”

Awareness and understanding of the dynamics of longevity risk needs to increase, the OECD says, in order for appropriate solutions to be developed to address it. At some point in the future the traditional longevity risk transfer capacity will run out, after which the only possible destination for longevity risk to be transferred to is the capital markets. The sooner preparations are made, standards put in place and instruments developed that promote liquidity the sooner the capital markets will be able to participate in this market.

The full OECD pensions outlook report can be read online here.

Also read:

– New research allows longevity swap basis risk to be better assessed.

– Okay to account for pension plan longevity swaps at fair-value: IFRS.

– Longevity swaps cover £22 billion of liabilities so far in 2014: Aon Hewitt.