The unique structure utilised within the recently completed Aegon longevity risk transfer transaction has been developed in the hope of bringing some standardisation, transparency and more deal flexibility to the longevity hedging market.
The successful completion of the transaction, which was covered on Wednesday, saw Aegon transfer €1.4 billion of longevity risk to third-party investors and reinsurers including SCOR, through the unique structure developed by Société Générale Corporate & Investment Banking (SG CIB) with risk modelling support from RMS.
Société Générale has been working on a new structure for longevity risk transfer to the capital markets for some time, hoping to create a longevity risk equivalent of the catastrophe bond market, where longevity risks could be packaged up and sold to syndications of capital market investors, who will take on the risk in return for an interest payment.
This first transaction using the new structure shows that SG CIB have succeeded in creating something that meets the appetite of capital markets investors for a longevity risk instrument which they will accept as an alternative asset.
We wrote about a potential new longevity risk transfer deal from SocGen in the summer, when market rumours suggested that the transaction would include exposure to Dutch longevity risk and U.S. mortality exposure. The transaction completed for Aegon is this deal, it combines these two risks which Aegon required the hedge for in this transaction.
The structure allows transaction sponsors to effectively do more longevity business. Typically they assume longevity risks through an actual versus expected indemnity swap with pension plans, which results in a closed pool. This transaction structure provides out-of-the-money index options as a hedge, a tailored indexed hedge targeted against longevity outcomes, which allows those hedging longevity risks to reduce associated capital charges and thus assume more longevity risk.
You can think of this transaction almost like providing retrocessional reinsurance to those longevity risk takers. In this way it is bringing new capital into the market utilising the indexed options approach. This is very similar to how the industry loss warranty (ILW) market began, bringing new capital into the catastrophe reinsurance market, allowing reinsurers to assume more cat risks.
The clever thing about this structure is that it allows transaction sponsors to grow their business, with the capital markets and other capital sources providing capital relief through the indexed options, which as a result means they have to set aside less capital against the longevity business they assumed.
Jeff Mulholland, Managing Director and Head of Insurance and Pension Solutions in the Americas at SG CIB, commented; “This is the first of many transactions using our structure, as we believe this is the beginning of a standardized approach to the market that provides an attractive opportunity for both transaction sponsors and risk takers.”
SG CIB’s aim is to become the leading investment bank and structurer in a capital market for longevity risk, through its Cross Asset Solutions business, using what it says is a unique approach. SG CIB worked with Aegon on this transaction as both the structurer of the deal as well as syndicating the risk to both the reinsurance and capital markets.
SG CIB clearly sees the structure as potentially transformational for the longevity risk transfer market. Mulholland told Risk Magazine earlier this year; “What we’re working on will be a watershed execution for the longevity markets. We’ve cracked the code and developed a structure that allows us to execute deals more quickly, and to hedge longer underlying exposures.”
The tailored nature of the underlying indices used for the transaction means that factors can be adjusted to suit the sponsor, allowing it to minimise the basis risk within the transaction. SG CIB’s work to standardise documentation and the creation of these indices means that the deal should be easily replicable for other clients, depending on their needs.
Catastrophe modelling firm RMS provided risk assessment analysis for the capital markets instrument used by Aegon to hedge the €1.4 billion of longevity reserves in this deal, protecting them against the possibility that mortality improvements in the Netherlands exceed expectations and outpace those in the U.S.
RMS provided the medically based model of longevity risk that underpins the structure of this transaction. RMS said that at the 20-year maturity of the deal, the final payment is based on modeled scenarios projecting mortality another 50 years into the future – which effectively allows Aegon to hedge 70 years of longevity risk with a 20-year instrument.
RMS was also involved in helping investors to get comfortable with the structure, providing scenario-based modeling results allowing the investors to gain a deeped insight into the risk being transferred.
“Models make markets,” commented Peter Nakada, head of RMS LifeRisks. “This feels very much like the early days of the catastrophe bond market except that the potential size of the longevity market is at least five times larger than the market for natural catastrophe risk.”
That’s a very interesting statement. For a number of years Artemis has been covering longevity risks on the understanding that sponsors, investors, service providers and market makers believed it could become another risk asset class, akin to ILS and cat bonds. With this transaction completed, all involved are suggesting that this moment is getting nearer, which bodes well for the creation of a market.
“RMS was pleased to work with Aegon and Societe Generale on this deal. We believe that it is a watershed deal that will pave the way for many more similar transactions in the future,” added Nakada.
For Aegon, the requirement was to hedge both the Dutch longevity risk and the U.S. mortality, but going forwards it’s expected that transactions will focus on longevity risks as this is more in demand.
The next step for SG CIB will be to try to attract more sponsors to the market and to generate some secondary liquidity, which will help to attract more investors to the space. Secondary liquidity is particularly important for fund managers, such as ILS managers, who have to offer their investors a level of liquidity. Until we see some secondary trading occurring in longevity risk these investors are unlikely to become large players in a longevity risk market.
What SG CIB needs is for a number of deals to come to market along the lines of this one and for some to become oversubscribed by investors. Once demand reaches a level where oversubscription becomes more common some level of secondary trading is likely, giving investors the ability to come into the market when a deal is subscribed but then move out of a transaction for a slight mark-to-market profit. If that level of activity can be stimulated by this new transaction then who knows how large a capital market in longevity risk could become.
The Société Générale Corporate & Investment Banking longevity risk transfer deal has been in the works for some time, as the bank tweaked the structure to best suit both sponsors and investors, while working hard to ensure documentation was as transparent and the deal as easily replicable as possible.
It now feels that it has a structure which is easy to replicate and expects to bring more deal flow to market using it. We understand that another transaction is in the offing and there are hopes it could close in the coming months.