Longevity Risk and Practical lsolutions George Graziani FSA FCIA Senior Vice President Swiss Re George_Graziani@SwissRe.com Meet Dave Age: 70 Gender : Male Life Expectancy: 16.3 yrs Smoking Status: Non Smoker Diet: Healthy Cholesterol: Low Dave's favorite activities: Swimming, Mountain biking,hiking Chatting with friends on FB Writing poetry for his wife Susan Dave Loves Longevity! 2
Dave's Longevity Poem#1 "Longevity risk is real" Longevity risk is real, like a lava lamp on Jupiter. It has a material financial impact on plan values. 1% change in mortality improvement -> 4% change in plan value There are practical solutions. 3 Dave's Longevity Poem#2 "Longevity risk is large" Longevity risk is large. Global 20T and Canada 1.3T. Reinsurance solutions are popular and practical like an iceberg. Capital market solutions in early development. 4
Dave's Longevity Poem #3 "Longevity insurance improves risk adjusted returns" Longevity insurance improves risk adjusted returns. Sharpe Ratio goes up. Swap uncertain cash flows for certain ones. De Risks Liabilities streamlines Liability Driven investing (LDI) 5 "Longevity Risk is Real" 6
Lava Lamp Canadian life expectancy continues to improve Annual improvements in male mortality rates (Canada) Most average this way when projecting forward, including CIA, ignoring important cohort effects 95 90 85 80 75 70 65 60 55 50 45 40 35 30 25 20 4.0%-5.0% 3.0%-4.0% 2.0%-3.0% 1.0%-2.0% 0.0%-1.0% -1.0%-0.0% For example, sixty year-olds in 2001 showed an improvement of 2-3% This means that, if at the start of 2001, 100 sixty year-olds were expected to die over the year, at the end of 2001, only 97-98 sixty year-olds are expected to die over the year These high levels of improvements can be seen at most ages and cumulatively are material Improvements of 2-3% over a 10 year time horizon mean that after 10 years, 20-30% fewer people are expected to die at the ages in question 1966 1971 1976 1981 1986 1991 1996 2001 2006 Source: Swiss Re calculations Canadian life expectancy has been increasing and increases show no sign of slowing down 7 Causes of longevity trends 300 250 200 150 100 50 0 Canadian Population Mortality Rates for Specific Impairments Cardiovascular - Both Prostate Cancer - Male Breast cancer - Female 2000 2001 2002 2003 2004 2005 2006 vement Mortality Improv 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% Canadian Population Mortality Improvement for Specific Impairments 2001 2002 2003 2004 2005 2006 Data Source Statistics Canada www.statcan.gc.ca Cardiovascular - Both Prostate Cancer - Male Breast Cancer - Female 8
Future potential for mortality improvements Pharmaceutical developments 60 52 New Drug Approvals 45 30 15 39 26 13 R&D Expenditures (Billions of 2008 USD) 0 1963 1968 1973 1978 1983 1988 1993 1998 2003 0 2008 Source: Kaitin, Clin Pharmacol Ther, 2010;87:356-361 9 JUPITER STUDY Rosuvastatin to Prevent Vascular Events in Men and Women with Elevated C-Reactive Protein The New England Journal of Medicine, November 20 2008 JUPITER : Justification for Use of Statins In Prevention: an Intervention Trial Evaluating Rosuvastatin Conclusion In this trial of apparently healthy persons rosuvastatin significantly reduced the incidence of major cardiovascular events. Major Cardiovascular Events Myocardial infarction 46% (Heart Attack) Stroke 52% Unstable Angina 59% Arterial revascularization (By Pass) Hazard Ratio 54% Hazard Ratio = #Taking Rosuvastatin/#Taking Placebo who experienced each major cardiovascular event 120% 100% 80% 60% 40% 20% 0% Hazard Ratio Rosuvastatin Placebo 10
"Material Financial Impact" 11 Financial Impact Sensitivity of Liabilities to Mortality Improvements 16.00% Liability Price Sensitivity to Mortality Improvement Percentage Price Change 12.00% 8.00% 4.00% 0.00% 1% 2% 3% Change in Mortality Improvement p.a. Conclusion: Very Sensitive!! Change in mortality improvement p.a. 1% 2% 3% Price change 4.4% 9.5% 15.5% Life Expectancy change yrs 1.1 2.5 4.2 Base Case: "Dave" Male 70, discount rate 4%, Annual Payments $100,Price $1078.60 Life Expectancy 16.3 yrs 12
Longevity Risk - On Regulators Radar When Who What July 2010 March 2011 Juan Yermo, Head of the Private Pensions Unit within the OECD s Financial Affairs Division OSFI Draft Guideline Stress Testing Guideline for Plans with Defined Benefit Provisions "Regulators should promote the use of asset-liability modeling and require the use of prudent, yet realistic assumptions when calculating liabilities, including up-to-date estimates of longevity risk exposure"1 Longevity listed as a risk factor that may be covered in Stress Testing. "It is important to recognize that some risk factors are highly volatile while others will experience gradual trending or even continual change. " 1. The Impact of the Financial Crisis on Defined Benefit Plans and the Need for Counter-Cyclical Funding Regulations OECD p. 7 July 2010 13 "Practical Solutions" 14
Two Styles of Solution Insurance Solutions Longevity Insurance Complete Longevity Risk Transfer through indemnity coverage. Buy Ins As above with full upfront payment Buy Out Existing Assets and Liabilities are transferred to Insurance company Offered by Insurance/ Reinsurance companies Investment Solutions Longevity Swaps Investments that are negatively correlated with longevity risk embedded in pension liabilities. Index population based - basis risk ISDA / LLMA Cat Bonds, Mortality Bonds, Micro Longevity cash, bespoke, index Insurance Linked Securities (ILS) (where performance is uncorrelated on a buy and hold basis with debt and equity markets) Transfer Liabilities 15 Longevity Insurance Main Features Premiums Reinsurer Claims (=Pension payments) Pension Plan Pension payments Annuitants No cash outlay. Assets stay with Pension Plan Pension Plan maintains relationship with Members Benefits are unaltered Premium amounts are defined in contract at outset Complete longevity risk transfer no basis risk Sits alongside other risk management solutions e.g. LDI Settlement Mechanism mitigates Credit Risk 16
Dave's Longevity Poem#2 "Longevity risk is large" Longevity risk is large. Global 20T and Canada 1.3T. Reinsurance solutions are popular and practical like an iceberg. Capital market solutions in early development. 17 Longevity Transactions as at December 2010 30 28 27.0 25 20 15 13 Deal Count Size ($CAD B) 10 9.3 7.4 8 5 5.0 5 55 5.5 2 0 Insured Buy-Ins Synthetic Buy-Ins Longevity/Insurance Swaps Insured Buy-Outs Total 18
Who takes on longevity risk? Of publicly announced longevity swaps completed during the past two years, more than 85% of longevity risk ended up on reinsurer balance sheets RSA 1.9 bn Investment Bank Reinsurer Royal County of Berkshire 1.0 bn Reinsurer BMW 3.0 bn Investment Bank Reinsurers Babcock International 1.2 bn Investment Bank Reinsurers But reinsurer capacity is limited 19 Iceberg Why do Reinsurers take on longevity risk? - mortality offset If longevity improves faster than expected, Reinsurer pays out greater claims to the pension plan 25 30 35 Example impact on Typical longevity age distribution portfolio of pension fund Age Example impact on a Typical mortality buyers portfolio of life products 40 45 50 55 60 65 70 75 80 85 90 95 Longevity Exposure Mortality Exposure Natural offset However,Reinsurer will also be paying out lower claims on its mortality (life reinsurance) portfolio Although not perfect (due to different age profiles and different geographic distributions) Reinsurer's mortality portfolio provides a natural offset 20
Capital market solutions in early development. 21 Capital market longevity in development stage Life and Longevity Markets Association (LLMA) 1 st February 2010 Promote the development of a liquid traded market in longevity and mortality-related risk The association will support the development of consistent standards, methodologies and benchmarks to help build a liquid trading market, necessary to support the future demand for longevity protection sought by insurers and pension funds Currently there are 12 members, from Banking, Insurance, and Reinsurance sectors Kortis Capital Ltd. Series 2010-I Class E Notes - 2011 Longevity risk transferred to the capital markets Kortis receives payments in the event of large divergence between the mortality improvements experienced between male lives aged 75-85 in England & Wales and male lives aged 55-65 in the US First longevity trend bond programme, return to investors paid as spread over collateral Fully collateralized in AAA assets Awards The Banker Deal of the Year Structured Finance Europe 2011 Trading Risk Life Transaction of the year 2011 22
Dave's Longevity Poem #3 "Longevity insurance improves risk adjusted returns" Longevity insurance improves risk adjusted returns. Sharpe Ratio goes up. Swap uncertain cash flows for certain ones. De Risks Liabilities streamlines Liability Driven investing (LDI) 23 Longevity insurance improves risk adjusted returns. Sharpe Ratio goes up. Objective Investigate the impact on plan performance from a liability De-Risking Strategy Metric : Sharpe Ratio = Risk adjusted return on Equity = (ROE Risk Free) / ROE Volatility where, Equity = Plan Assets Plan Liabilities Result: Sharpe ratio goes up! Case # Name Longevity Insurance Sharpe Ratio 1 Naked No 0.09 2 Hedged Yes 1.99 2.5 2 1.5 1 0.5 0 Naked Sharpe Ratio Hedged Assumptions Assets invested in AA Corp Bonds ; Liabilities valued at AA Corp Bond Yields (avg. = 4.6%) Projection Period = 20 years ; Risk Free rate = 3% Hedge Cost 100bp / annum Additional Mortality Improvement of 0.5% p.a. Sharpe Ratio 24
Longevity changes impact Duration and create headaches for LDI strategies Duration Change Duration Sensitivity to Mortality Improvement 2.5 2.0 15 1.5 1.0 0.5 0.0 1% 2% 3% Change in Mortality Improvement p.a. Conclusion: Very Sensitive!! Change in mortality improvement p.a. 1% 2% 3% Price change 4.4% 9.5% 15.5% Duration (yrs) 8.3 8.9 9.8 Duration Change (yrs) 0.5 1.1 2.0 Base Case: "Dave" Male 70, rate 4%, $100 p.a., Price $1078.60, Life Expectancy 16.3 yrs, Duration 7.8 25 Longevity Impact on LDI Illustrative Example (See Appendix 3 for details ) Liabilities and Assets are key rate duration matched. Hedged (through Longevity insurance) is immune to mortality improvements. Un-hedged liabilities are compromised by mortality improvements and move into deficit. Position Entry Hedged Un-hedged Mortality Improved Short Liabilities 100 105 109 Long Fixed Income 100 105 109 Short Cash 60 65 69 Long Equity 60 60 60 Net 0-5 -9 Un-hedged Mortality Improved Again 26
Recap and Take Aways 27 Dave's Longevity Poem#1 "Longevity risk is real" Longevity risk is real. Like a Lava Lamp on Jupiter. It has a material financial impact on plan values. 1% change in mortality improvement -> 4% change in plan value There are practical solutions. 28
Dave's Longevity Poem#2 "Longevity risk is large" Longevity risk is large. Global 20T and Canada 1.3T. Reinsurance solutions are popular and practical like an iceberg. Capital market solutions in early development. 29 Dave's Longevity Poem #3 "Longevity insurance improves risk adjusted returns" Longevity insurance improves risk adjusted returns. Sharpe Ratio goes up. Swap uncertain cash flows for certain ones. De Risks Liabilities streamlines Liability Driven investing (LDI) 30
Thank you Appendix 1 Jupiter Study details Justification for Use of Statins In Prevention: an Intervention Trial Evaluating Rosuvastatin 32
JUPITER STUDY Rosuvastatin to Prevent Vascular Events in Men and Women with Elevated C-Reactive Protein The New England Journal of Medicine, November 20 2008 JUPITER : Justification for Use of Statins In Prevention: an Intervention Trial Evaluating Rosuvastatin Background Current ttreatment t tfor the prevention of fcardiovascular events recommend statin ti therapy for patients t with established vascular disease, diabetes, and overt hyperlipidemia. However, half of all Heart Attacks and strokes occur among apparently healthy people with levels of low-density lipoprotein (LDL) cholesterol that are below currently recommended thresholds for treatment. Study Elements Size 17,802 Healthy Men and Women Type Randomized, d Double-blind bli Control Placebo Controlled Location Multi centre Sites 315 Countries 26 33 JUPITER RESULTS Conclusion In this trial of apparently healthy persons rosuvastatin significantly reduced the incidence of major cardiovascular events. Major Cardiovascular Events Myocardial infarction 46% (Heart Attack) Stroke 52% Unstable Angina 59% Arterial revascularization (By Pass) Hazard Ratio 54% Hazard Ratio = #Taking Rosuvastatin/#Taking Placebo who experienced each major cardiovascular event 120% 100% 80% 60% 40% 20% 0% Hazard Ratio Rosuvastatin Placebo 34
Appendix 2 Longevity Solutions compared 35 Index vs. Indemnity Solutions Indemnity longevity insurance Index longevity swaps Payment trigger Own portfolio Index-based (usually national population) Risk capacity Significant for pensioners More limited for non-retirees At present smaller than indemnity market No material capital market for longevity Most index capacity comes from reinsurers Non retired Yes, but capacity limited Tenors are too short to properly cover members non retireds. Valuation hedge possible but substantially model dependant Transaction size Minimum size due to the higher Small sizes possible maintenance costs Basis risk Yes No. Complex to analyse and understand transferred? Credit risk Can be collaterised Can be collaterised Liquidity No liquid market. Exit terms need to reflect actual risk so potentially greater negotiation at exit No liquid market. As a standardised risk the exit terms are simpler to agree Indemnity solutions offer greater risk transfer and should be the preferred option for pension plans 36
Sources of Basis Risk With Index Solutions Basis risk means the extent to which the payoff from the product or its valuation does not correspond with the cash impact or valuation impact on the pension plan s liabilities from a change in longevity. There are various sources for this: Structural Actuarial assumptions Valuation Plan vs national population Stochastic Limited range of ages and terms for parametric solutions in the market Use of q-forwards rather than S-forwards Assumptions are used to determine the portfolio of ages, terms and genders purchased Pension plan liabilities and value of the national index product depend on the actuary s assumptions. Valuation basis risk arises if these assumptions don't move in tandem How the pension plan s mortality experience actually develops vs the national population Risk that the individuals with the higher pensions by chance happen to be the ones that live longer than expectations 37 Appendix 3 Longevity and Liability Driven Investing (LDI) 38
Longevity Impact on LDI Illustrative Example Stage 1 Feeling Good Liabilities and Assets are key rate duration matched. Positioned for yield pick-up on Equity Short Cash is less risky than Short Bonds Equity/ Fixed Income = 60/ 40 just like everyone else Position Entry Value Notes Short Liabilities 100 What was that about Longevity Insurance? Long Fixed Income 100 Key Rate Duration Matched with Liabilities Short Cash 60 Rates are low, and less volatility than short bonds Long Equity 60 Great managers. Homework done. Fingers crossed Net 0 Balanced 39 Longevity Impact on LDI Illustrative Example Mortality improves Stage Two I thought we were de risked? Mortality Improved Liabilities are now 5% more. Fixed Income portfolio needs to change because Liability Durations changed. How should we do this? Rebalance Bond Portfolio sell and buy liquidity risk, market risk Layer with derivatives - friction costs, op, liquidity, market risk Need additional cash increase cash short? Sell equity? Both? Equity performed well Position Entry Value Notes Short Liabilities 105 Mortality improvement of 1% - need to think more about Longevity Insurance Long Fixed Income 105 Rebalanced and needed cash to buy more long bonds Short Cash 65 Increasing leverage Long Equity 60 Good Asset Performance Net -5 Deficit 40
Longevity Impact on LDI Illustrative Example Mortality improves and interest rates increase Stage Three This is getting complicated Mortality Improved Liabilities are now 4% more Fixed income portfolio decreased because interest rates increased Fixed Income portfolio needs to change because Liability Durations changed How should we do this? Rebalance Bond Portfolio s and buy liquidity risk, market risk Layer with derivatives friction costs, op, liquidity, market risk Need additional cash increase cash short? Sell equity? Both? Equity performed well Position Entry Value Notes Short Liabilities 109 Mortality improvement of 1% - enough pain need to get Longevity Insurance Long Fixed Income 109 Rebalanced and needed cash to buy more long bonds Short Cash 69 Increasing leverage Long Equity 60 Good Asset Performance Net -9 Deficit increasing 41 Legal notice 2011 Swiss Re. All rights reserved. You are not permitted to create any modifications or derivatives of this presentation or to use it for commercial or other public purposes without t the prior written permission i of Swiss Re. Although all the information used was taken from reliable sources, Swiss Re does not accept any responsibility for the accuracy or comprehensiveness of the details given. All liability for the accuracy and completeness thereof or for any damage resulting from the use of the information contained in this presentation is expressly excluded. Under no circumstances shall Swiss Re or its Group companies be liable for any financial and/or consequential loss relating to this presentation. 42