Longitude Solutions second quarterly update of 2019 examines the influence of recent actuarial and regulatory developments in the Longevity Risk market and suggests this will lead to a banner year for longevity de-risking and greater involvement from capital markets investors.
Continued Reductions in Mortality Improvements
Globally, mortality improvement rates have been slowing or even turning negative. This has been caused by several factors, including a tailing-off of some mortality improvement drivers of the last decades (e.g., decreased smoking rates).
The observed slowdown in UK general population mortality improvement rates, since 2011 (when they were around 2% per annum), continued in 2018 with improvement rates recently around 0.5% per annum.
The incorporation of the latest data, along with tweaks to the CMI_2018 model and its parameters, resulted in lower mortality improvements and around 6 months lower cohort life expectancies than produced by CMI_2017 for both males and females aged 65.
The recent trend of Dutch mortality improvement has been in line with the UK experience. According to the Dutch projection table AG2018, published in September 2018 by The Royal Dutch Actuarial Association (Koninklijk Actuarieel Genootschap or ‘AG’), higher mortality in the past 2 years resulted in a reduction in the growth rate of life expectancy, as compared with AG2016.
The change in US mortality improvement has been even more dramatic than in the UK and The Netherlands, as life expectancies actually declined in both 2015 and 2017. Moreover, the underlying drivers of this change (led by increased suicides and drug overdoses) are themselves increasing, meaning the recent trend may not reverse for some years.
Booming Markets for Buy-outs and Longevity Swaps
The slowdown in mortality improvement rates have reduced reserving requirements for longevity risk, which, combined with relatively positive asset performance, has put more pension funds in a position to afford de-risking options.
Many pension funds have already made significant progress on investment de-risking, and therefore are finding longevity risk to be the dominant remaining risk. The market for Longevity Swaps from Insurers to Reinsurers has also been very busy, and will continue to grow as most buy-out insurers are reaching their limit for longevity risk and, as a result, will reinsure a large percentage of the longevity risk in their new business.
Private equity capital is seeking a diverse set of ways to enter the pension buy-out market and are certain to succeed at some point. Pension funds (and their advisors) will welcome the additional capacity and market competition, especially as the size of pension transactions is expected to increase.
The US pension buy-out market grew with $26 billion of transactions completed in 2018, caused in part by an increase in the number of mid- to large-size pension risk transfer deals. Increased demand was met with increased capacity, as two more companies entered the market. Further, there was much talk at the 2019 ReFocus Conference, in Las Vegas, about increased reinsurance of US longevity risk.
Regulatory Changes Support Increased De-Risking
In February 2019, significant regulatory events took place in the three most active longevity risk transfer markets, each of which support increased de-risking activity.
The UK insurance regulator, PRA, issued Consultation Paper CP3/19, entitled “Solvency II: Longevity risk transfers – simplification of pre-notification expectations”. In part, this paper encourages reinsurance of longevity risk by removing the requirement give advance notice to the PRA of transactions, except when the new reinsurance is large and/or complex.
It does, however, introduce an explicit mention for “basis risk” in longevity risk transfers, saying they “expect firms to include their appetite for basis risk within their risk management frameworks”. This seems to be a recognition, by the PRA, that index-based longevity risk transfer will begin in the UK, and their wish to ensure the risks are properly considered by insurers in consultation with the PRA.
Proposals to add a longevity risk capital charge to the Insurance Risk component of Risk Based Capital (“RBC”) models may lead to an increase of around 5% for insurers where mortality and longevity risks are relatively balanced. However, for insurers with a concentration of longevity risk, there could be a 25% to 33% increase in RBC depending on the final agreed level of negative correlation between mortality and longevity risks.
Clearly, such an increase would motivate insurers wishing to participate in the pension
buy-out market to reduce (or avoid) an overweight longevity position by seeking reinsurance or other ways to hedge longevity risk.
The DNB issued a Q&A on the “Recognition of risk mitigation techniques using reinsurance contracts in the Solvency II Standard Formula”. It was issued during the early rounds of the sale process for Vivat (a large Dutch insurer), which has led commentators to suspect it might have been directed at bidders in that process whose plans may have included large-scale reinsurance of liabilities to carriers outside The Netherlands.
The Q&A focuses on the credit risk of reinsurance arrangements. Longitude Solutions believes the Q&A should be welcomed by both insurers and reinsurers as it provides greater clarity for all parties involved, and hence will be supportive of well-structured reinsurance transactions taking place.
Who will be first to turn to Capital Markets?
These developments may lead market demand to outstrip the available capacity. At that point longevity risk will increasingly need to flow into the capital markets – as it is able to diversify longevity trend risk by spreading it over multiple investors (as a small part of their portfolio). Market disruptors are already opening these channels to position themselves for the time when demand spikes.
Longevity Swap pricing is quite expensive for deferred pensioners, as well as being difficult to administer given deferred pensioners may opt for a cash settlement at retirement under the new UK pension freedom legislation.
By maintaining the longevity risk of deferred pensioners, pension schemes are exposed to the risk that the cost of Swaps or annuities increases due to re-acceleration of mortality improvements. Alternatively, they could mitigate this risk efficiently using index-based longevity hedges that reference general population or pension fund indices.
In his recent paper – “Pension Fun ALM: Can pension funds stabilize funding levels and improve long-term return by hedging longevity risk?” – David Schrager, Senior Partner of Longitude Solutions, analysed the impact of hedging longevity risk on a pension fund’s funding ratio volatility and ALM strategy. He demonstrated that, for a given risk budget, mitigating longevity risk can:
- Enable a higher allocation to return seeking assets;
- Improve the pension funds Sharpe Ratio; and,
- Increase excess return net of the cost of longevity hedges.
Pension buy-out providers have thus far avoided the regulatory complexity of developing internal models for basis risk, leading most to avoid issuing index-based hedges directly. This may change quickly if the pricing or capacity from reinsurers deteriorates.
Private equity firms are increasingly keen to deploy capital in life insurance which may result in them creating new entrants in buy-out markets. These new players may seek to use index-based hedges as an innovative technique to create a competitive advantage over incumbents.
Reinsurers are perhaps the most natural parties to develop the routes to capital markets. They already have models based on multiple geographies and multiple risks which contain many correlation calculations just as complex as longevity basis risk.
Not all reinsurers have significant mortality risk against which to set longevity risk, meaning that longevity trend risk does not diversify as well for them. For these reinsurers, developing a route to the capital markets allows them to play in the longevity reinsurance market without building up an uncomfortable trend risk exposure.
A recent global slowdown in mortality improvement rate makes now an attractive time for increased pension de-risking. The increased demand for pension buy-outs will be met with increased capital charges for longevity risk (at least in the US), placing greater than ever pressure on longevity reinsurance market capacity.
This demand, combined with greater regulatory support for longevity risk transfer, mean longevity markets are poised to boom. Given all of this, new entrants and increased participation from capital markets investors should be both expected and welcomed.
Please reach out to one of our partners if you would like to discuss any of these topics in detail.