Index-based longevity risk transfer solutions to the capital rescue!

Index-based longevity risk transfer solutions are simpler, cheaper, more flexible and have a larger capacity, allowing cedents to transfer more risk to the capital markets at a lower price
August 23, 2019
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Index-based solutions are cheaper, simpler, more flexible and can transfer more risk to capital markets

The longevity risk transfer market is booming. In the past decade and a half, pension providers and life insurers have had to find different and creative ways to obtain solvency relief and limit their exposure to the ever-growing longevity risk by transferring it onwards - either through traditional reinsurance or through alternative longevity risk transfer to the capital markets.

Unfortunately, pension/life insurance providers aren’t offloading nearly as much risk as they would like. Estimates say that the longevity risk market is worth up to $80 trillion USD, but only ~1% of that risk is transferred onwards. The longevity risk market has a lot of room to grow, and indeed, 2018 was a record-breaking year in the longevity risk transfer market, with 2019 set to exceed 2018.

The majority of longevity risk transactions so far have come in the form of traditional reinsurance. In our last blog post, we explained at length why traditional reinsurance is limited, and why alternative longevity risk transfer has much higher potential to control risk exposure and provide pension/life insurance providers with greatly-needed solvency relief from the capital markets.

Presenting index-based longevity risk transfer solutions

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In this blog post, we will take it a step further, and explain why index-based longevity risk transfer solutions could potentially provide the flexibility the longevity risk transfer market is missing. Index-based longevity risk transfer has the potential to provide higher-capacity solutions, providing more effective risk management at a lower price tag, drawing attention from a variety of financial and non-financial institutions.

Index-based insurance solutions are a relatively new approach that link payments between parties to a predetermined index for loss of assets, primarily working capital, resulting from unexpected events. In the case of the longevity risk market, longevity-linked securities are associated to a previously agreed upon reference or index population, as opposed to the specific insured population.

What are the benefits of using index-based solutions?

Index-based solutions have many benefits over the traditional reinsurance solutions out there. First and foremost, using an objective index simplifies the legal work needed in the securitization process. This greatly lowers legal and administrative costs. Contracts and legal procedures can easily be recycled and reused in the next security issuance, making for quick and simple execution.

Quick execution and lower costs can easily attract more players to the longevity risk market, opening national markets to increased global longevity risk transfer and global capital markets, providing far greater capital and solvency relief for cedents. The more players in the market, the more competition there is between them, which in turn can lower costs even more. Furthermore, Index-based longevity risk transfer to the capital markets is uncorrelated to the performance of the markets, removing volatility risks and allowing more aggressive pricing.

Attracting more players to the market has another important benefit with regulatory agencies. In traditional reinsurance, most longevity transfer was carried out by a small number of financial institutions. This was frowned upon from a regulatory perspective. But with regulatory bodies more eager, securitization can go even more smoothly.

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Index-based risk transfer solutions have a high capacity and can provide large-scale risk management

There are a few small hiccups, but they can be worked around

There are bound to be differences between the index or reference populations and the actual policy holders - these can arise from social-economic differences, demographic differences, group sizes, etc. This is referred to as basis risk. Most index-based longevity risk transfer solutions can only provide partial risk transfer, as they aren’t able to eliminate this basis risk.

This basis risk can be minimized, though, by dividing the insured population into socio-economic and demographic segments and covering large and/or small populations using multi-population models. Using these methods, index-based solutions can transfer up to 80% of the risk of big companies to the capital markets. Basis risk can be further minimized or even eliminated entirely by using new technological platforms that employ artificial intelligence (AI) and machine learning to improve segmentation of the insured population, longevity predictions and index calculation.

Furthermore, there is a gap between bond maturity and the “last man standing” (when the last policy holder passes away) - the embedded tail risk. Pre-defined commutation mechanisms are agreed upon in advance, and adjustments on the collateral principal amounts are made at maturity. This helps lower the tail risk, but doesn’t eliminate it entirely. By using advanced actuarial risk models and cutting edge machine learning and AI algorithms and cross validation models the tail risk shrinks dramatically.

Index-based longevity risk transfer solutions have come a long way in the last few years, but still have a lot of room to grow. If everything goes as expected, the insurance-linked securities market will be seeing a lot more of these solutions, with longer terms and higher risk transfer.

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.

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