A new research effort will now get underway to investigate and develop a method for assessing the basis risk in longevity risk transactions, after Cass Business School and Hymans Robertson successfully won the bid for the research work.
Cass Business School, part of City University in London, UK, and Hymans Robertson, an independent consultancy and actuarial firm with a focus on pension risks, have announced their successful bid for a Longevity Basis Risk Quantification research project for the Longevity Basis Risk Working Group (LBRWG) today.
The project is being funded by the Institute and Faculty of Actuaries (IFoA) and the Life and Longevity Markets Association (LLMA), who founded the LBRWG in 2012.
Through the research project, Cass and Hymans Robertson hope to develop a methodology to quantify the basis risk associated with the use of population-based mortality indices for managing the longevity risk inherent in specific blocks of pension benefits or annuitant liabilities.
This is a key problem facing insurance companies and pension funds which are seeking to transfer their longevity risk, either through insurance, reinsurance or a capital markets swap or other structure. The use of indices to assist with longevity hedging is seen as key, but a way to quantify and eventual manage, or offset, the basis risk between the index and the actual longevity or mortality experience, is one area that the market requires a solution for.
Sarah Mathieson, Head of Research at the IFoA, commented on the project; “In the context of a longevity hedge, longevity basis risk is the potential mismatch between the behaviour of the longevity hedge and the portfolio of pensioners or annuitants being hedged, when the hedge has been based on a generic mortality index rather than the actual pool of lives in the pension scheme or annuity book. This project aims to develop a methodology to quantify the risk, which we believe will benefit a range of parties involved in pensions, from scheme sponsors to scheme members, as well as writers of annuity business.”
Dan Ryan, a spokesperson for the LLMA, said; “With the help of Cass and Hymans Robertson, the Life and Longevity Markets Association believes that this project will go a long way to develop market clarity and support our brief to grow this marketplace. The resulting research will hopefully bring a real and quantifiable solution to the issue of Longevity Risk.”
Lead researcher and Cass Dean Professor Steven Haberman commented; “This project offers us a great opportunity to bring together the School’s strengths – academic excellence and practical industry knowledge. We will be using statistical knowledge and original research to produce a solution to a real industry problem. We look forward to working closely with our partners Hymans Robertson on this project.”
Andrew Gaches, Partner at Hymans Robertson, added; “Pension schemes are increasingly looking to reduce their exposure to longevity risk and are demanding solutions which complement their existing use of bespoke longevity swaps. Index-based solutions are a promising approach. But to use them, schemes need a way of assessing the ‘basis risk’ – how well mortality-based population indices will match a scheme’s specific portfolio of members. We are excited about working with Cass Business School to create a new, practical methodology that will help pension schemes and insurers assess the benefits of index-based longevity solutions, and enable them to make the best decisions for managing longevity risk.”
The LLMA launched its hunt for a research team to study longevity hedging basis risk back in March. Now that it has awarded the research project the difficult task of studying and developing a method to quantify this basis risk begins. If basis risk can be quantified it will allow those entering into a longevity risk transfer or longevity hedge transaction to work to offset the basis risk, perhaps through use of other financial instruments or additional reinsurance.
The LLMA publishes a set of indices linked to population mortality statistics. These indices were seen as an important milestone towards a longevity market where risk management can be carried out through transactions that are linked to standardised population-level data. The LLMA says that index-based hedges can provide effective risk and capital management for all holders of longevity risk.
The LLMA also publishes standardised documentation for longevity risk transfer, aiming to make the work to get a deal to market simpler and more efficient.
Despite these efforts, so far the market for longevity risk hedging has not gained significant traction. Quantifying and establishing mechanisms to either offset or eliminate basis risk in index-based longevity hedges would be another valuable step forwards in building a liquid market in longevity risk.