Longevity Risk Transfer Provides Solvency Relief & Hedges Risk Exposure
In the 1950s and 1960s there was a huge post-war economic boom in the United States. The insurance market was no exception - during that period, US life and non-life premiums saw a 6 to 10-fold increase. While profits skyrocketed, many insurers broadened coverage and benefits without really understanding the risks involved.
As all good things naturally come to an end, the economic boom stalled in the 70s and 80s and the liability insurance market got a serious wake up call. In order to keep up with the fierce competition, insurers offered unrealistically low premium rates, causing huge financial strain on businesses and their insurers, eventually creating heavy losses for reinsurers and other players in the liability insurance market.
Searching for Alternatives
That crisis pushed insurance-seekers to search for different ways to mitigate their risk other than traditional reinsurance, and Alternative Risk Transfer was born. Alternative Risk Transfer is “the use of techniques other than traditional insurance and reinsurance to provide risk-bearing entities with coverage or protection;” namely, reducing risk exposure by transferring it to capital markets through securitization. In the securitization process, the insurance company or pension fund sells assets or liabilities to third parties through tradable securities, or in this case, Insurance-linked Securities (ILS).
In our previous post, we discussed the Longevity Risk Market and the huge challenge life insurance and pension providers face due to increasing life expectancy. We stated that the risk life and pension funds are exposed to is evaluated at over $30 trillion USD, with exposure rising at a rate of 3-5%. Some evaluate the risk as even higher - reaching $60-80 trillion USD (!). Due to inaccurate longevity forecasting methods, this sum could balloon even further.
Traditional Reinsurance Is Limited and Slow
Such a staggering sum has the potential to topple pension schemes worldwide, so a solution to the longevity risk problem is desperately needed. Many argue that traditional reinsurance methods simply don’t have the capacity to mitigate the Longevity Risk, and that more modern methods of risk transfer are needed. Furthermore, traditional risk transfer methods are slow, inefficient and difficult to access, leading to the current longevity reinsurance penetration of under 1%.
Alternative Risk Transfer to capital markets via new innovative technologies and solutions is the answer the Longevity Risk Market is looking for. Capital markets are much larger than the insurance markets and can provide the capital needed, offloading the enormous risk life/pension insurance providers are facing with the growing ageing population and providing the solvency relief needed.
What Types of Securitization Are There?
Currently, there are various types of ILS for life insurance and pension plans, but as Alternative Risk Transfer Market grows, more methods and financial instruments will surely appear in the future:
- Mortality Catastrophe Bonds (CATM bonds): CATM bonds, the oldest in the group, are securities which are linked to a mortality index. These bonds help reduce the insurers’ exposure to a catastrophic event that leads to extreme mortality. Investors purchase these bonds for a specific catastrophe and get a return on their investment. If this catastrophe takes place, investors will lose part or all of their investment on behalf of the insurance company to reduce its loss. If the catastrophe doesn’t occur, investors get their money back at the end of the term and benefit from high returns during bond lifetime. CATM bond issuing is historically costly and complex, so they have their limitations.
- Mortality Swaps/Survivor Swaps: These are derivative securities, in which the parties agree to swap a series of payments in the future based on at least one random survivor or mortality index. These are similar to traditional reinsurance as both of them exchange anticipated payments with actual ones, but they legally follow security requirements as opposed to insurance legal requirements. In addition, the randomality element of these swaps also separate it from traditional reinsurance. On one hand, they are more flexible because of the simpler legal requirements and simpler structuring due to the randomality, but on the other hand they are limited in the capacity of the risk they can offload and have limited lifetimes.
- Mortality Forwards/Mortality Futures: Mortality forwards are derivatives that involve the buying or selling of the future mortality rate of a given population in return for a fixed mortality rate at a price agreed upon signing. Mortality futures (q-futures) are mortality forward contracts standardized to be marketable on exchanges. These are also limited in the capacity of the risk they can offload and tend to have large tail liabilities.
- Longevity Bonds/Survivor Bonds: There are several types of longevity bonds. The common goal of all of them is to protect insurance/pension providers from an unexpected increase in lifespan of their insured parties. Longevity bond payoffs depend on a set survivor index, or the percentage of surviving population at a set time in the future. These bonds provide regular floating payments that depend on the survivors compared to the index. Longevity bonds usually have a much longer term, (20 years vs. 10 years, for example), and therefore can transfer more risk to the capital markets, providing greater solvency relief.
In summary, traditional insurance methods will not be able to cover the ever-growing risk in the Longevity Risk Market. Life expectancy is growing quickly, and current longevity reinsurance is extremely low. Traditional risk transfer methods are inefficient, slow and very difficult to access, further stressing the need for alternative ways to transfer longevity risk off company balance sheets. New and innovative ways to transfer risk to the capital markets via risk securities can provide the solution the Longevity Risk Market desperately needs.
Vesttoo, has developed advanced technologies for data-driven risk management, transferring actuarial risk to financial risk through the capital markets. Vesttoo specializes in risk modeling and alternative risk transfer for the Life and P&C insurance markets, providing insurers with a low-cost strategic risk management solution for immediate capital relief, value enhancement and liability hedging.