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The vulture funds of death

Published: May 21, 2011
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Source: SCMP

Goldman Sachs, Deutsche Bank and JPMorgan Chase, which bundled and sold billions of dollars of mortgage loans, now want to help investors bet on people's deaths.
Pension funds sitting on more than US$23 trillion of assets are buying insurance against the risk their members live longer than expected.

Investment banks see this as an opportunity to package that risk into bonds and other securities and create a new market for those willing to bet on life-expectancy rates. If pensioners die sooner than expected, investors profit. If they live longer, investors must compensate the pension fund for the additional costs it faces.

The hard part: finding buyers willing to take on the bets that may take 20 years or more to play out.

"Banks are increasingly looking to offer derivative solutions," said Nardeep Sangha, 43, chief executive officer of Abbey Life Assurance, a London-based Deutsche Bank unit that helps pension funds manage the risk of retirees living longer than expected. "Making the long maturity of the risks palatable for investors, including sovereign wealth funds, private-equity firms and specialist funds, is the challenge."

As insurers reach the limit of how much pension-fund liability they are willing to shoulder, companies such as JPMorgan and Prudential last year set up a group aimed at establishing and standardising a secondary market for so-called longevity risks.

They are also developing indexes that measure mortality rates and securities to let pension funds pay fixed premiums to investors in return for coverage against major deviations from projections.

Swiss Re, the world's second-biggest reinsurer, sold the world's first longevity bond in December in what it called a "test case" to sell risk to the capital markets.

Goldman Sachs and Deutsche Bank have set up insurance companies that promise to pay pensions if retirees live beyond a certain age. They typically receive a portion of the pension plan's assets in return. The banks, along with Morgan Stanley, Credit Suisse and UBS, are looking for ways to offer this risk to investors.

"Ultimately, reinsurance capacity for longevity risks will run dry, and that's why it's imperative that as the market grows and develops it is able to bring in new types of risk-takers," Sangha said.

"The obvious channel is the capital markets."

Medical advances and healthier lifestyles have made predicting life spans more difficult for pension funds. Life expectancy in the United Kingdom is increasing by one to three months every year, according to Dutch insurer Aegon. Every year of additional life expectancy typically adds as much as 4 per cent to future pension requirements, Aegon said in a report in March.

Pension funds can hedge against life-expectancy risk by transferring assets to an insurer or other counterparty that promises to pay some or all of the future liabilities.

Last year, GlaxoSmithKline, the UK's biggest drug maker, became the 10th FTSE 100 firm to buy insurance on about £900 million (HK$11.3 billion), or 15 per cent, of its UK pension obligations. That means Prudential, the UK's largest insurer, rather than the pension fund, will pay some GlaxoSmithKline pensioners should they live longer than expected.

"We're seeing more and more sophisticated mechanisms being offered," said Bill Galvin, CEO of the UK's Pensions Regulator. "From a regulatory perspective, we are concerned to ensure that trustees understand the extent to which longevity risk has been passed from their scheme, and the precise shape of any residual risk."

The UK is the world's biggest market for insuring pension liabilities after a change in accounting rules in 2004 forced companies to include pension plans on their balance sheets, increasing the volatility of earnings.

Since then, £30 billion of liabilities have been insured, about 3 per cent of the total outstanding, according to estimates by Hymans Robertson, a London-based pension consultant.

Banks and insurers completed a record £8.2 billion in longevity-risk transfers last year. Goldman Sachs-owned Rothesay Life sold the most pension-plan insurance in 2010, while Deutsche Bank's Abbey Life completed the biggest swaps deal.

Investors may be attracted to betting on life-expectancy rates because longevity trends are not linked to movements in equities, bonds or commodity markets, said David Blake, director of the pensions institute at Cass Business School in London, who has worked with JPMorgan on the derivatives.

The complexity and risk involved in longevity assets with timelines of more than 20 years means banks are looking to create bonds that offer 5 per cent to 9 per cent in annual returns, according to Guy Coughlan, former head of longevity structuring at JPMorgan. Returns as high as the "mid-teens" are possible, he said.

But not knowing whether a bet on a group of pensioners' life spans is correct for decades prevents some hedge funds, such as London-based Leadenhall Capital Partners, from entering the marketplace. Luca Albertini, CEO of Leadenhall, said the longevity market simply was not liquid enough.

Subprime mortgages sold in the past decade were the genesis of the biggest financial meltdown since the Great Depression. Investment banks passed the risk of borrowers defaulting to the capital markets by packaging, or securitising, the loans into bonds and selling them to investors and one another.

Collateralised debt obligations were sold in such volume that when mortgage holders defaulted, governments in the US and Europe had to bail out the financial system. In much the same way, banks are now looking to securitise the risk of pensioners living longer than expected.

Securities based on life expectancy do not hold the same risks as those linked to subprime mortgages because they are "fully collateralised", minimising the risk from a counterparty failing to meet its obligations, Coughlan said.

However, David McCourt, senior policy adviser at the UK's National Association of Pension Funds, said: "There's a massive counterparty risk. People say insurance companies don't go bust, but they do. We've seen AIG and investment banks going under like Lehman.

"There's a lot of pressure on the trustees to make sure they're comfortable the deal is right because there's no going back."

Rothesay Life, the biggest pension liability insurer in the UK last year, has not joined JPMorgan and Prudential in the new London-based Life & Longevity Markets Association. Managing Director Tom Pearce said it preferred to develop the market alone and did not expect it to be easy.

"Clearly, if there was a capital market solution that would be helpful for the market generally, but there are some challenges," he said. "The biggest is selling these very long-term risks to shorter-dated investors."

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