Focus: Longevity risk management
2 March 2011
In brief: With a growing number of Australians expected to live beyond the age of 90, many will enjoy a longer retirement than they ever imagined but at what cost? Partner Dean Carrigan and Senior Associate Simon Lewis look at the emerging market for longevity risk management and highlight some recent developments.
- Longevity risk
- Consumer level
- Wholesale level
- Market developments
- Legal and structural issues
How does it affect you?
- With increasing life expectancy comes the risk that assets supporting retirement incomes will be exhausted prematurely. For retirees, this can have a profound impact on their standard of living; for defined-benefit superannuation funds, their sponsoring employers and insurers providing longevity-insured products, it inflates present liabilities and may cause financial stress.
- The management of longevity risk is of increasing interest, particularly to financial institutions. A number of transactions have been completed in the UK and, more recently, Australia, in which these institutions have transferred this risk to insurers and reinsurers.
The greater life expectancy (or 'longevity') of retirees means that they will need to draw an income in retirement for longer, creating several issues for the retirement system. It increases:
- the risk that retirees will exhaust the assets of their defined contribution superannuation funds (and so, will need to call on the Commonwealth age pension);
- the liabilities of defined benefit superannuation funds and, in doing so, increases the need for support from sponsoring employers; and
- the liabilities of issuers of products that provide longevity insurance (for instance, lifetime annuities and some income guaranteed products).
Although all the evidence and projections point to increased longevity for future generations, the fact that we don't know how much more life expectancy will actually increase creates risk in relation to the size of current retirement liabilities (or 'longevity risk').
In the past, a significant number of Australian retirees obtained longevity insurance by joining a defined benefit fund that provided a lifetime pension, or purchased lifetime annuities. Most Australian defined benefit funds are now closed to new members and, currently, the Australian market for lifetime annuities is not significant. So, for the most part, the retiree bears the risk that savings held in defined contribution superannuation funds will be insufficient to meet their retirement needs; albeit with the limited back-stop of the Commonwealth age pension.
Defined benefit superannuation funds and life insurers issuing products with longevity-based payment components take on some of the longevity risk of their members and insureds. These institutions can, in part, control their exposure by varying the level of benefits provided to members; however, payment obligations are usually set at the time the fund is joined, or product issued, which is likely to be many years before the end of a member's retirement, and so may not adequately, or accurately, factor in future improvements in longevity.
British superannuation fund trustees have been able to lay off some, or all, of their longevity risk into primary insurance markets, using buy out/buy in and longevity swap structures. Life insurers may also use these techniques to lay off their risk in reinsurance markets.
In general terms:
- a buy-out involves a trustee transferring the primary liability to a third-party life insurer, in exchange for the payment of a lump sum premium. This is a 'complete' solution, as the trustee is no longer liable to pensioners, and is often used when the trustee is looking to wind up a fund;
- a buy-in involves a third-party life insurer paying a stream of cash flows to the trustee to cover some, or all, of the future payments, in exchange for the payment of a periodic premium; and
- a longevity swap involves a third party, usually a life insurer, paying to a trustee the actual cash flow due to annuitants each month (or a quota share thereof) in exchange for a payment fixed in a schedule based upon estimated longevity.
The quantity of global superannuation liabilities subject to longevity risk, estimated by Swiss-Re to be more than US$ 17 trillion1, is likely to exceed the capacity of insurance and reinsurance markets. Several market participants have been working towards developing a tradable market in longevity risk, which may include capital markets instruments. A key proponent is the Life and Longevity Market Association (the LLMA) in the UK, which has recently published technical documentation in relation to pricing of longevity exposure and definition of longevity risk transfer instruments, in order to establish 'market standard' approaches to trading in longevity risk.
The return on longevity-linked capital markets instruments would be determined by the movement of a standard longevity index and would have similarities with the market for insurance-linked securities (eg catastrophe bonds) or securities linked to other risks such as inflation and interest rates.
The longevity improvement reflected in a standard longevity index is unlikely to correspond precisely with the longevity experience of a defined-benefit superannuation fund or life insurer, resulting in a mismatch between the cashflows received by a trustee or insurer under the swap and the cashflows payable to pensioners or annuitants; this is known as 'basis risk'.
Basis risk can be mitigated in a number of ways:
- by increasing the number of pensioners or annuitants to which a trustee or insurer has exposure, resulting in an aggregate exposure that more closely reflects the longevity improvement in the population (insurers have an important role to play here, as they are able to take longevity risk from different sources products, superannuation trustees to create such a diversified 'portfolio' of longevity risk that can then be dispersed using more standardised market instruments); and
- by the creation of a wider range of longevity indices that reflect specific cohorts; for instance, determined by age, gender, geography or occupation.
Due to the greater prevalence of defined contribution funds and the current relative lack of available annuity products, the Australian market for longevity risk management is at an earlier stage of development than are some other overseas markets. However, there are several notable developments.
At a retail level, in the past couple of years there have been a number of products released, such as Macquarie Lifetime Income Guarantee, ING Money for Life and AXA North Protected Retirement, that provide insurance against longevity risk, with greater investment flexibility than a traditional lifetime annuity.
At a wholesale level, Swiss Re has recently announced a number of longevity swap transactions with Australian annuity providers for their in-force lifetime annuity portfolios.2
The 2009 Henry Report on Australia's future tax system considered the challenges posed by increased longevity for individual retirement savings and recommended that the Federal Government support the development of a longevity insurance market in the private sector. The Government gave an initial response to the Henry Report before last year's federal election and is expected to respond in more detail in the future.
There has also been growing academic interest in the area, with the establishment of the Australian Institute for Population Ageing Research at the University of New South Wales; one of the institute's aims is the creation of an Australian Longevity Index.
There are a number of legal issues arising from longevity hedging arrangements, particularly at a wholesale level, including:
Traditionally, buy-in and buy-out arrangements have been structured as life insurance contracts, due to the close nexus with human life. Many longevity swaps have also been structured in this way, though we query if this will always be the case where swap cashflows are referable to improvement in a standardised longevity index, rather than the experience of a particular group of pensioners or annuitants.
The legal characterisation of a longevity hedging arrangement will influence the tax treatment of the arrangement. Ensuring the appropriate tax treatment for both the provider and the client is essential to the efficacy of the arrangement.
The ability to structure longevity hedging arrangements in a way that promotes the efficient deployment of capital by providers is an important determination of the pricing of such arrangements.
The products that give rise to longevity risk, such as defined benefit superannuation funds and annuity products, are long-term arrangements. Trustees and insurers will need to be satisfied with the long-term security of assets that are contributed to support such products.
Longevity hedging instruments have traditionally been bespoke transactions; however, groups such as the LLMA are seeking to create market standard documentation.
There is a growing awareness of the socio-economic challenges caused by increased life expectancy and, in the context of the financial sector, particularly to defined benefit pension funds and life insurers. At a retail level, several new retirement products that provide longevity insurance have been released, which evidences industry interest in and, support for, development in this area. At a wholesale level, there are several insurance-based solutions for defined benefit funds and life insurers looking to lay-off longevity risk, and there is also likely to be an increased focus on standardised market instruments, which may allow access to capital markets as well as insurance and reinsurance markets.
- A short guide to longer lives: Longevity funding issues and potential solutions (2010) Swiss Re: Zurich.
- 'Age shall not weary insurers' Swiss Re, September 2010.
- Simon LewisSenior Associate,
Ph: +61 2 9230 4340
- Jamie WellsPartner,
Ph: +61 7 3334 3268
- Louise JenkinsPartner,
Ph: +61 3 9613 8785