08 February 2010
Published in: Longevity - mortality
Trading longevity risk will need time to develop
It will take time before investors become as confident in longevity risk as they are with catastrophe risk, notes Benjamin Serra in Moody's Weekly Credit Outlook. Longevity risk is a very long duration risk, and there is no consensus on longevity models, especially beyond a medium-term horizon (e g, ten years).
Also, while longevity-based assets are uncorrelated to other asset classes, Serra says "investors' appetite is limited as the structures are usually complex, making it difficult to evaluate the underlying risk."
This is why the Longevity and Life Markets Association (LLMA), launched a week ago (IERM, longevity/mortality, 1 February, Association formed to trade longevity risk) is aiming to develop standardized products, focusing initially on longevity swaps, standardized valuation methods and published longevity indices. "The variety of players involved in this new project enhances the chances of the association's success compared with previous initiatives," Serra remarks.
He adds that for insurers with sizeable exposure to longevity, such as large UK annuity writers (e g, Prudential, L&G) or US life insurance companies (e g, MetLife, AIG, Manulife, Principal), "the transfer of longevity risk to capital markets is a plausible alternative to reinsurance - where capacity is limited - and a good opportunity to enhance their credit profile."
International Financial Services London estimates that total pension liabilities (insured and in pension funds) exceed $19tr in the US and $3tr in the UK. Given the duration of these liabilities, an increase of one year in longevity from current expectations could cause a 3% increase in liabilities, translating into a financial risk of around $600bn in the US and $90bn in the UK. Although the risk may be less significant in other countries, it is set to increase everywhere.
If a longevity risk transfer market develops, this will be positive for primary insurers, the Moody's analyst considers. "We think annuity writers in particular will have a good opportunity to enhance their credit profile, as their exposure to longevity risk is increasingly a drag on their credit quality. However, standardized products have the drawback of not providing a perfect hedge to an insurer, and these solutions will arguably only be of optimal use to insurers with very large portfolios and limited basis risk."
For reinsurers, Serra concludes, the alternative capacity provided by capital markets will present additional competitive capacity, potentially placing downward pressure on prices. "However, reinsurers will also be able to use the market capacity to transfer their own longevity risk and will have the ability to take on more risks themselves. It could also allow them to be more active in the reinsurance of smaller pension funds or insurers that are unable to directly tap capital markets."