DO NOT PAY THE FERRYMAN UNTIL HE SECURITISES YOUR RISK FACTOR / THE FINANCIAL TIMES

Do not pay the ferryman until he securitises your risk factor

By Paul J. Davies

Published: February 8 2010 17:30

Today, most people would be very surprised to know exactly who ultimately put up the funding for their mortgage. In future, we might be saying the same thing about who ultimately is paying our pension.

It has long been a dream for pension funds, life insurers and of course investment bankers to be able to trade the risks that people either live too long or die too quickly – in other words to “securitise” those risks. But successive attempts to drum up interest and activity have been stillborn.

One big obstacle has been finding a kernel of complementary economic needs. At first glance, life insurers and pension funds present a yin and yang of a natural market. However, the former wants protection against the loss of younger people who have not yet paid enough premiums, while the latter will be hurt by their elders hanging on – and on. Different lives, different risks.

Now, with companies evermore focused on the costs of their pension scheme liabilities, especially in the UK, the dream of such a market could finally be realised. A group of investment banks and insurers is working on a standardised set of products that they hope will form the fungible base of a liquid market for longevity risks. JPMorgan, one of the banks involved, is even willing to donate its own intellectual property in the form of its Life Metrics index.

The first longevity derivative trades by real pension schemes – first Babcock International and then RSA – have generated huge excitement about the market’s more than £1,000bn potential. However, such deals are likely to remain the exception, not the rule.

Instead, insurers such as Pension Corporation, Prudential and Legal & General – all founder members of the Life and Longevity Markets Association, or Llama – will need to act as transformation engines. They will have to turn the open-ended risks related to specific groups of lives into non-specific securities of certain duration.

And this points to the biggest reason why there is greater impetus for a longevity market now. Policymakers in Frankfurt and Brussels are drawing up new European capital rules for insurers – known as Solvency II. Like the Basel rules for banks, these will be governed by the principle that capital requirements should be set in line with risks taken. If insurers can demonstrate that a risk can be measured and hedged through a liquid market, it will attract lower capital requirements. The reinsurers who are stepping up their exposures to longevity risk can already hold less capital against it than the insurers they buy it from because they benefit from increased diversity.

But capital market investors will need to be careful. First, there is a classic asymmetry of information problem. Insurers have all the data and experience of mortality and longevity as it happens. They can also pool their knowledge through an analysis service such as Club Vita, run by the pensions consultants Hymans Robertson, which tells them how their own mortality experience deviates from the national picture.

Second, longevity is seen as a risk that is only realised very slowly over a long period. This is true in the sense that the pension funds and annuity providers that write very long-term contracts can find themselves repenting at extreme leisure. However, the realisation that patterns of longevity have changed can still come incredibly quickly – and so a market could change course equally rapidly.

Two specific things have led to quite sudden accelerations in the rate of longevity improvement of the baby boomers, especially among men, since the early 1990s. One was the widespread reduction in smoking once everyone knew it was a health hazard, the other was the broad use of statins, a drug for reducing blood pressure. Both significantly reduced cardiac-related deaths. The effects of each were highly uncertain at first, but became sharply apparent as groups of people kept ageing and not dying.

Given what we now know, what would the introduction of smoking bans in public places have done to longevity markets?

The more disquieting question – given public exposure to longevity risk through health and aged care budgets and public pensions – is would a government with such a ready market view of the costs of longevity have introduced a smoking ban or statins in the same way?

Ultimately, the success of a market in longevity securities will rest less on views about which way the risk is going and more on differences in how much capital different types of company must hold against the same risk.

Regulators will have the tricky task of judging whether the market is truly liquid, and of making sure they know who is really responsible for looking after us in our old age.
Copyright The Financial Times Limited 2010.