New research allows longevity swap basis risk to be better assessed

A newly published piece of paper provides, what researchers are calling, a novel readily applicable methodology allowing insurers and pension schemes to assess the basis risk associated with index-based longevity swap transactions.

The research, commissioned by the Institute and Faculty of Actuaries (IFoA) and Life and Longevity Markets Association (LLMA) and carried out by a joint research team from Hymans Robertson and Cass Business School, aims to enable the use of simpler, more standardised and easier to execute index-based longevity swaps and other solutions.

The researchers say that there are also broader applications for insurers and pension funds that need to better manage their capital requirements relating to longevity risk, so has implications for Solvency II preparation and pension scheme risk management.

Index-based longevity swaps allow pension schemes and insurers to offset the risk that liabilities increase due to members, or insureds, living longer than projected. The researchers say that until now it has been difficult to assess how well the index-based longevity swap can reduce the longevity risk for the particular pension scheme or insurance book. That can result in basis risk, if the assessment is inaccurate or not close enough to the actual longevity experience

The new methodology developed be the researchers is said to advance the thinking on how this is assessed, thus enabling the basis risk to be better quantified and so reduced. The framework has been designed to be applicable to both large schemes (which can use their own data in their models) and smaller schemes (by capturing demographic differences such as socio-economic class and deprivation).

Longevity swaps have often been the preserve of large pension schemes, due to the cost and complexity of transaction them. But researchers believe that this work could make longevity swaps more accessible to smaller schemes and insurers.

As a result, they believe that this work has the potential to transform the £10Bn per annum longevity swap market, opening it up to pension schemes for which the current bespoke longevity swap solutions have not proved appropriate. They predict that this work could provide a catalyst for further growth in the still nascent longevity swap market.

“Understanding and managing longevity risk is a key challenge for pension funds and life insurers. As a thought leader in the longevity field the IFoA, together with the LLMA, saw a need for a practical methodology underpinned with robust academic research. We are delighted with the outcome of this research and see application for insurers with Solvency II and integrated risk management for pension schemes, as well as for any transactions they may undertake in the longevity swap market,” commented Nick Salter President of the Institute and Faculty of Actuaries.

Daniel Ryan, spokesperson for the LLMA, added; “This is a significant moment for the pensions and insurance industry. The LLMA has co-sponsored the research because we believe in the need to de-mystify longevity basis risk analysis and to provide a practical solution which will enable greater longevity risk transfer to the capital markets.”

Andrew Gaches, a partner at Hymans Robertson, also commented; “Longevity swaps have proved an excellent innovation, but their typical bespoke structure does not provide a solution in all cases. Index-based solutions provide a simple and effective answer to this problem. Our hope is that this work will enable many more schemes and insurers to better understand their risks and more effectively hedge against them, enabling the uptake of index-based longevity swaps and turning them mainstream. We are delighted to publish our findings and make this contribution to the democratisation of the longevity swap market.”

Co-author of the report Professor Steven Haberman, Dean of Cass Business School, explained the importance of the work; “We have developed a simple and easily applicable methodology for measuring and quantifying longevity basis risk. Longevity basis risk arises because different populations have different survival rates and hence longevity and life expectancy. Our methodology focuses on the demographic and socio-economic differences between a national population and a pension scheme or annuity portfolio, and how these differences in turn affect longevity.

“The findings will help insurance and pensions providers to use national population-based mortality indices to manage longevity risk in pension schemes and annuity portfolios. We hope the research helps companies to more effectively set annuity prices and meet their regulatory requirements. We also hope it leads to the further development of the longevity swap market which will help transfer risk to the reinsurance and financial markets,” Haberman continued.

The longevity swap market shows significant promise, particularly while so much capacity is available for these risks in the traditional reinsurance market. Any improvement in the methodologies to assess basis risk could stimulate increased use of index-based swaps for risk transfer, which could be extremely welcome to pension schemes facing growing liabilities.

Any increase in index-based longevity swap transactons and a reduction in basis risk for sponsors could see a resurgence of initiatives which look to generate liquidity in the longevity market, by putting indices and transactions on exchanges. That could also stimulate greater interest in longevity swaps from third-party capital, which would further grow the capacity available to hedge longevity risk globally, while also making it a simpler asset class to invest in.

The full research paper can be downloaded via the Institute and Faculty of Actuaries website here.

View our list of longevity swap and risk transfer transactions.

So far in 2014 we have recorded longevity swap, reinsurance and risk transfer transactions in more currencies than just GBP. Adding up all the 2014 longevity deals we have listed in our directory and converting them using today’s exchange rate gives us a total for 2014 longevity swap, reinsurance and risk transfers of £40.79 billion ($63.88 billion or €51.05 billion).