Leave it to Wall Street to come up with a new product that solves the “problem” of longer life spans. Sovereign wealth funds, educational endowments and ultrahigh-net-worth individuals are the target investors for longevity derivatives, which package the risk that retirees drawing annuities will outlive actuarial expectations.
The roots of this nascent market date back to 2006, when small monoline insurance companies such as U.K.-based Lucida (purchased by Legal & General in June 2013) and Paternoster (bought by Goldman Sachs Group in 2011) began taking longevity risk off European pension funds through bulk annuity buyouts. These buyouts entail a company selling pension assets earmarked for all or some of its plan participants. The assets are converted to annuities that the sponsor can keep on its books or off-load to the insurer.
Big European insurers like Aegon and Prudential followed suit. After the 2012 pension risk transfer megadeals involving U.S.-based Verizon Communications and General Motors Co. ($7.5 billion and $29 billion, respectively), the industry needed to boost its capacity. With about $4 trillion in total assets in Europe and the U.S. and a regulatory obligation to cover 99 percent of their liabilities, insurance companies are looking to the $200 trillion global capital markets for cash. So far, investment banks Deutsche Bank and Société Générale have stepped up with derivatives products geared to the risk hedger (insurers) and buyer (investors). Both parties are needed to close a deal.
“This is a desirable product to add to a diversified growth portfolio,” says Guy Coughlan, London-based chief risk and analytics officer of Pacific Global Advisors, a U.S. consulting and professional asset manager for pension funds and other institutions. “While the market is still quite immature, it offers potential for returns different than other asset classes.”
Banks build longevity derivatives products using risk models provided by firms like Newark, California–based Risk Management Solutions (RMS). They’ve closed a dozen such deals, but the customized structure can be tough for investors to grasp. Deutsche Bank is focused on creating a path into the capital markets, according to Paul Puleo, global head of pension and insurance risk markets in New York.
In December 2013, Deutsche created longevity experience options, or LEOs, a more standardized product tailored to capital markets participants. Longevity derivatives resemble the older catastrophe bond, or insurance-linked security (ILS), market, which packages insurance against natural disasters. A key difference between longevity insurance derivatives and cat bonds is that there are now a number of hedge funds dedicated to the ILS market.
To date, the purchasers of these derivatives have been life insurers, whose policies offset them, or specialty ILS managers. Although it’s been difficult for capital markets participants to compete with such natural buyers, long-term investors like sovereign wealth funds may find the portfolio diversification attractive. Ultrahigh-net-worth investors might also be interested, says Peter Nakada, Hoboken, New Jersey–based head of the life risks and capital markets units at RMS. These products can be viewed as a social good because they provide insurance for people who may not have enough cash in retirement, Nakada posits: A wealthy individual makes good money now by purchasing them; in the unlikely event that retirees exhaust their annuities, the monetary outlay can provide financial relief to the needy elderly.
It may take time for investors to warm to longevity derivatives. Michael Hall, a Seattle-based consultant with investment consulting firm Towers Watson, doesn’t think U.S. pension liabilities are big enough to warrant dabbling in the derivatives market. “The structured products at investment banks have historically not been attractive,” Hall cautions. “It’s likely the case Wall Street won’t sell this stuff cheap.” • •
Follow Frances Denmark on Twitter at @francesdenmark.