Increased longevity poses a very real risk to defined benefit pension plans. Mortality improvement continues to trend upwards. This is particularly pronounced at older “retirement” ages. Medical developments are having an amazing impact on life expectancy. A recent study in the New England Journal of Medicine, the JUPITER study, looked at the impact of Statins on “healthy” lives (note that normally Statins are only prescribed to people with high cholesterol) and showed that major cardiovascular events were reduced by approximately half. We see a similar trend with mortality improvement for other specific impairments in Canada such as prostate cancer in males and breast cancer in females. In short, the risk is real.
Longevity risk has a material financial impact on defined benefit plans. An increased life expectancy of just one year (an increase in mortality improvement of 1% per year) can translate into a 4% change in plan value. In dollar terms, Canadian longevity exposure, which sits in excess of CDN$1 trillion, would increase by roughly $40 billion. The risk is material.
There are two types of products available to plan sponsors to manage longevity risk: 1) insurance solutions, where there is a complete transfer of longevity risk through indemnity coverage, and 2) index-based investment solutions, where longevity derivatives are structured through a linkage to population longevity, thus intended to be negatively correlated with the longevity risk embedded in pension liabilities. These index based solutions tend to have a high degree of basis or tracking risk, and a shorter term of seven years compared to the 60 year term associated with longevity insurance.
Interestingly, in either case the ultimate holder of longevity risk tends to be global life reinsurance companies. More than 85% of recent publicly announced longevity transactions ended up on reinsurers’ balance sheets. Life reinsurers are uniquely positioned to take on longevity risk as they have a natural offset with their life insurance business.
Increased longevity means life reinsurers will be paying out lower claims on their mortality portfolio, and to some degree this offsets the increased longevity claims.
Given the magnitude of global longevity risk – currently estimated at over US$20 trillion – reinsurers will at some point reach their capacity for longevity risk. Recognizing this emerging issue we are seeing the early stages of development in capital market solutions. The Kortis transaction, a longevity trend bond programme that transferred longevity risk to the capital markets, is an example of things to come.
Longevity insurance is currently the most practical way for a plan sponsor to manage longevity risk. It allows plan sponsors to exchange a series of uncertain payments for certain ones. The plan pays a series of fixed “premium” payments and receives the actual pension payments, or “claims”, from the insurer. Plan sponsors find longevity insurance attractive because there is no cash outlay, assets remain with the plan and premium amounts are defined in the contract at the outset. With longevity insurance there is a complete longevity risk transfer with no basis risk.
When we investigate the impact of longevity insurance on the plan from a risk adjusted basis, we find that the Sharpe ratio (risk adjusted return on equity) increases with longevity insurance.
Longevity insurance is also useful to plans considering liability driven investing (LDI), as managing assets to a fixed series of liability payments allows managers to focus on core competencies rather than having their asset strategies compromised by longevity risk.
George Graziani is Senior vice president, Swiss Re.