It was a fairly routine item about an accomplished executive changing jobs in the asset management industry, but it caught my eye.
A March 2017 news item said that Andrew Reid, until recently the head of corporate pension origination at Deutsche Bank, had left that post to work with Insight Investment, a specialist in liability driven investments.
What caught my eye? The reported explanation for II’s interest in Reid: his expertise in longevity risk. Before he was at DB he was head guru on longevity at Credit Suisse and, before that, at Willis Towers.
Thus, Reid’s job change called up a fascinating and important subject. It’s important because populations are aging in much of the world, and that presents pressures for many institutions via their annuity and pension obligations. One estimated minimum for the total global amount of this risk exposure is $15 trillion. It’s fascinating because while there are market opportunities for the transfer of this risk (as through swap transactions) the markets for such transfers are as yet under-analyzed and are still hardly a blip on the screen of scholars of financial economics.
Back in August 2013 the Basel Committee on Banking Supervision published a “consultative document” on Longevity Risk Transfer Markets that still rewards study.
A Consultative Document
The Basel Committee’s review of the subject began with the fact that three large transactions of the preceding year (2012) had helped internationalize the subject. Until that time, almost all LRT activity had taken place within the U.K. But in 2012:
- General Motors transferred all of its pension plan’s assets and liabilities to Prudential Insurance;
- Verizon did likewise, also to Prudential; and
- Aegon, a life insurance company headquartered in The Hague, arranged a swap with Deutsche Bank, involving € 12 billion in underlying assets.
The Aegon-DB swap has a 20-year maturity and a close-out mechanism that determined the final product, and a longevity index based on publicly available data that is to drive the cash flows.
Despite such high-profile transactions, the Basel Committee report observed that “total LRT volumes are as yet a small fraction of total pension fund and (re)insurer longevity risk exposure.” Then it asked the question: Why? What have been the impediments to the growth of this market?
The Basel report focuses on three answers: there is the asymmetric “lemon” risk; the impact of regulations; and the dearth of critical information.
Suppose you’re walking down a residential street. You see a car out on someone’s front lawn with a sign on its hood that says, “For $1,000 AS IS, cash needed by Tuesday.” From its initial appearance, you suspect that the car might be worth considerably more than $1,000.
This is a situation in which you really ought to consider how asymmetric the transaction will be. The seller knows the car a good deal better than you do. He has obviously made the decision that the car is worth less than $1,000. Further, in contrast to an actual dealership, the seller of the car sitting on his own front yard has no reputational interest at stake. He doesn’t really care whether you end up resenting him and telling your friends that he sold you a lemon. And in our case, he’s given you a short deadline, which may leave you with no time to get under the hood yourself.
The analogy is imperfect, but an insurer might well concern itself with the possibility that pension fund managers are more familiar with how healthy their pensioners are than the insurer is or can realistically become. Further, it seems likely that only those fund managers with long-lived pensioners would want to hedge longevity risk, just as only motorists who find themselves with lemons put the above-described sign on the car and the car on the lawn.
This problem could be addressed by the use of standardized cohorts, as tracked by government statistical agencies, as a proxy for the actual data on pensioners. The Basel report also suggests that such a shift would improve market liquidity.
As an example of the regulatory restrictions on the growth of the LRT market, the report observes that in the U.S., pension plan sponsors have to co-exist with the Department of Labor Interpretive Bulletin No. 95-1, with its “safest available annuity” standards. This amounts to the imposition of high due diligence costs on anyone who might want to play a part in hedging that risks and bearing those costs may be “feasible for only the largest firms” as the Basel report puts it.
Not Enough Information
The lack of reliable and sufficiently detailed information about longevity and changes therein may certainly be hindering market development. As the Basel report says, “Life tables are not updated frequently and are only available for relatively aggregated groups in the population. Sophisticated longevity risk management and transfer would benefit from much more disaggregated demographic data (including, for example, by postal code and cause of death), which can reduce basis risk; indexes of such data would facilitate the design and trading of LRT instruments.”
Though efforts will surely be made to remove these impediments and so to grow the market, there is no free lunch.
“Techniques to broaden LRT markets,” we are cautioned, “tend to expose longevity risk sellers to new risks that may be substantial.”