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The 3rd International Longevity Risk and Capital
Market Solutions Symposium
Westin Hotel, Taipei, Taiwan
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S T R I C T L Y   P R I V A T E   A N D 
 C O N F I D E N T I A L
GUY COUGHLAN, Managing Director, Global Head of
Pension ALM Advisory, JPMorgan
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A new market is emerging
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Issues in hedging longevity risk
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Longevity risk transfer products in the capital
markets
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Longevity appears to be a good candidate to
become a new market

• Because
• Longevity risk is transferable in principal
• Risk transfer is feasible
• Longevity exposure is economically significant
• gt20 trillion globally
• Longevity exposure cannot be hedged in existing
  markets
• Not highly correlated with other markets
• But market development also requires
• Standardisation to create liquidity
• Standardised Index
• Standardised risk-transfer instruments
• Standardised vocabulary/language
• Education of market participants
• Longevity is an unfamiliar risk

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Potential longevity risk landscape
Buyers of longevity risk protection
Sellers of longevity risk protection
Pension Funds

• Pension liabilities exposed to longevity risk
• Current tables likely underestimate risk
• Beginning to evaluate impact of this risk

• Could write protection to synthetically gain
• exposure to risk
• Have the sophistication to analyse risk return

Annuity Providers

• Exposed to longevity risk through annuity
• policies
• Would look to hedge exposure

Life Insurance Companies

• Exposed to declines in longevity through life
• insurance policies
• Selling longevity risk protection offsets this
  risk

Life Settlement/ Premium Finance Investor

• Exposed to longevity risk through investment
• portfolio
• Buy protection to hedge general trend risk

• Sell protection and earn premium
• Can use existing expertise to evaluate risk
• return

Pension Buyout Funds

• Can use existing expertise to evaluate risk
• return
• May synthetically add exposure

• Buy protection against longevity risks from
• plan acquisition

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ILS Investors

• Provide protection and earn premium

Other Hedge Funds

• Have liquidity and seeking return

Endowments

• Have liquidity and ability to buy hold
• Long term investors
• Innovators

• Could issue debt
• Naturally exposed to declines in longevity

Pharma
Others (eg. Reverse mortgage, healthcare)
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There is capital seeking to be deployed on both
sides of the market
Longevity risk sellers
Longevity risk buyers

• Pension plans and annuity providers
• Several are already looking to hedge at least
  some part of their longevity exposure

• Investors see longevity as a new asset class
  enabling them to
• Earn a risk premium
• Gain exposure to an uncorrelated asset class

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Want customised hedges to maximise
effectiveness
Want standardised investments to maximise
liquidity
Risk transfer products need to balance these
opposing needs
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There are still challenges in developing a traded
market of sufficient liquidity

• Barriers to creating a market
• Low visibility of longevity risk
• Perceived complexity
• Unfamiliar nature of longevity risk
• Lack of common language among different
  participants
• Lack of credible risk transfer instruments
• Addressing these challenges requires
• Indices that are objective and transparent
• Education of market participants
• Standardisation of language
• Appropriate risk transfer products

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This was the motivation behind the development of
LifeMetrics
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LifeMetrics has been developed to promote
effective management of longevity and mortality
risk
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Current and historic data available on website
and Bloomberg

• www.lifemetrics.com
• Increase visibility of
• Current mortality and longevity
• Risk to future mortality and longevity
• Data on
• Crude mortality rates
• Graduated mortality rates
• Period life expectancy
• Broken down by
• Gender
• Age
• Country
• Period

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Framework for longevity/mortality risk management
is fully documented

• Framework described in 100-page LifeMetrics
  Technical Document and 80-page Research
  Discussion Paper
• Technical Document
• Transparent description of the LifeMetrics Index
  and how it is calculated
• Details the approach to measuring and managing
  longevity/mortality risk
• Coughlan et al. (2007)
• Research Paper
• Evaluates and compares different models of
  mortality projection
• Cairns et al. (2007)

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Issues in hedging longevity risk
A new market is emerging
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Longevity risk transfer products in the capital
markets
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There two broad categories of longevity risk
Standardised Longevity Hedge
Customised Longevity Hedge

• Standardised to reflect national population
  longevity experience
• But calibrated to match mortality sensitivity of
  pension
• Structured as a value hedge
• Maturity of Hedge
• E.g. 10 years or 20 years

• Tailored to reflect actual longevity experience
  of the pension plan
• Structured as a cash flow hedge
• Maturity of Hedge
• Until the last member dies

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Hedge Provider
Hedge Provider
Pension Plan
Fixed longevity
Actual longevity
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Advantages and disadvantages of customised vs.
standardised longevity hedges
Disadvantages
Advantages

• Cheaper than customised hedge
• Lower set up and operational costs
• More liquid, can be more easily unwound
• Shorter maturity (generally) so counterparty
  credit risk is limited

• Not a perfectly exact hedge
• Population basis risk
• Roll risk at maturity

Standardised Hedge

• Exact hedge, no residual basis risk
• Set-and-forget hedge, requires minimal monitoring

• More expensive than standardised hedge
• Higher set up and operational costs
• Administration, documentation, monitoring, data
  provision
• Poor liquidity, more difficult to unwind
• Longer maturity leading to larger counterparty
  credit exposure
• Less attractive to investors

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Customised Hedge
Standardised hedge has advantages of simplicity,
liquidity and cost
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Hedge effectiveness is an important concept in
evaluating potential hedges but is poorly
understood

• A hedge can be less than 100 effective and still
  add value
• The reinsurance paradigm for risk transfer means
  that this is not widely acknowledged. Insurance
  risk transfer is generally 100 effective
• Longevity exposure is economically significant
• Most hedges of financial risk are not 100
  effective
• Few stakeholders in the longevity space
  understand hedge effectiveness
• Hedge effectiveness is about risk reduction
• Quantifying how a hedge reduces potential for
  monetary loss

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Hedge effectiveness primer

• Hedge effectiveness depends on objectives
• Time horizon
• Performance metric
• Designated risk being hedged
• Principles
• Isolate the risk being hedged by removing impact
  of other risks
• Define risk evaluation methodology carefully
  metric, data used
• Relationship between hedge effectiveness and
  correlation can be counterintuitive
• E.g. appropriate correlation measurement normal
  distribution
• 80 correlation gt 40 risk reduction
• 90 correlation gt 56 risk reduction
• But a low year-on-year correlation can still lead
  to high hedge effectiveness if correlation is
  measured appropriately

Risk(ExposureHedge)
Risk Reduction 1-
Risk(Exposure)
Risk (mm)
Risk reduction ()
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Source HEAT, Coughlan, Kolb and Emery 2003
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The population basis risk associated with
standardised hedges can be managed
Correlations in mortality improvementsShort-term
correlations EW males aged 65

• Basis risk by age can be managed
• Since mortality improvements are highly
  correlated across age

• Basis risk by socio-economic group can be managed
  
• Short term correlations in mortality improvements
  have a low correlations
• But mortality movements are correlated over the
  long term

Pension value EW males aged 65 CMI population vs
LifeMetrics hedge
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Longevity risk transfer products in the capital
markets
A new market is emerging
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Longevity risk transfer products could be based
on survivorship, life expectancy and/or mortality
rates

• Successful products will best meet needs of all
  economic agents
• Mortality rates are most likely to form the basis
  of liquid products
• Simple building bocks
• Allows creation of smallest number of instruments
• Can be combined in a portfolio to replicate
  survivorship and life expectancy
• Can be used by all hedgers pensions, annuity
  provides, life insurers, etc.

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Survivorship and life expectancy are not likely
to form the basis of a liquid market

• Survivorship has the advantage that it directly
  reflects pension/annuity exposures
• A function of mortality rates at different times
  and ages
• Path dependency
• Depends on starting year There as a many
  survival rates for 65 year olds as there are
  starting years (i.e. 65)
• Inhibits fungibility of different contracts
  relating to same cohort
• Difficult to hedge complex non-annuity exposures
• Period life expectancy has the advantage of being
  more intuitive
• A function of mortality rates for different ages
  at one time
• Requires mortality rates for all ages above the
  age in question
• Difficult to effectively hedge non-annuity
  exposures

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Mortality rates are likely to be a better basis
for a liquid market
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q-Forwards are standardised derivatives for
transferring longevity and mortality risk

• q-Forwards (mortality forwards)
• Simple capital market instruments
• Effectively a zero-coupon mortality swap
• Exchange realised mortality rate in a future
  period for a pre-agreed fixed mortality rate

Term sheet for a single q-forward
Forward rate
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Net settlement at maturity for fixed rate receiver
1.2000
Realised mortality
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q-Forwards can hedge pension/annuity and life
insurance liabilities

• q-Forwards are building blocks
• They can be combined into a portfolio to hedge
• Pension liabilities
• Annuity liabilities
• Life insurance liabilities
• A small set of standardised contracts can provide
  effective hedges
• A specific maturity (e.g. 10 years)
• Split by gender (males females)
• Age groups (40-49, 50-59, 60-69, 70-79, 80-89)

Notional x 100x fixed mortality rate
Life Insurer
Hedge provider
Notional x 100 x realised mortality rate
Notional x 100x realised mortality rate
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Pension Plan/ Annuity book
Hedge provider
Notional x 100 x fixed mortality rate
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Case study Application to hedging a DB pension
plan over a 10 year horizon
Cash flow profile Total (GBP mm)

• Mature plan, fixed benefits
• Impact of unexpected mortality improvements by 2
  per year compounded
• Cash flow impact over horizon
• Larger pension cash flows in years 1-10
• Impact on liability value 0.76
• Value impact in year 10
• Large change in liability value
• 13.2 of 2017 value
• 9.6 due to higher survivorship
• 3.6 due to mortality improvements beyond 10
  years

Increase in cash flow (GBP mm)
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Increase in liability value in 2017 ()
Improvements beyond 2017
Higher survivorship in 2017
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Portfolio of q-Forwards can provide an effective
value and cash flow hedge
Hedge
Impact of Increase in trend of mortality
improvements
13.2
13.2
Pension liability (GBP mm)
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q-Forwards can hedge value and cash flow risk
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How much does it cost?
Mortality rates of 65 year old EW males
(illustrative only)

• Market is net short longevity
• There are more economic agents with short
  longevity positions (pension plans, annuity
  providers, life settlements investors) than with
  a long position ( life insurers)
• So to transfer longevity risk investors will
  require compensation
• Mortality forward rate should be settled below
  the expected mortality rate

Best Estimate or Expected Mortality Curve
Forward Mortality Curve
Risk Premium
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• In the early stages of the market, there will be
  no clear consensus of how to arrive at an agreed
  objective expectation of future mortality rates
• Lee-Carter model? - (relatively) simple and
  transparent
• Official forecasts? - Government, society of
  actuaries

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Conclusions

• Longevity is emerging as a good candidate to
  become a new market
• The development of liquidity requires
• Standardisation
• Education
• Hedgers (pension plans annuity providers) need
  to better understand
• Concepts of hedge effectiveness
• You dont have to transfer 100 of the risk to
  add value
• Basis risk can be managed
• A liquid market requires standardised instruments
• Concentrate liquidity in a small number of
  contracts initially
• q-Forwards are a good candidate for developing a
  liquid market

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