Longevity Swaps: The Next Shoe to Drop?

by: Jim Delaney

Have the horses all escaped? Has the barn door been locked and nailed shut? Has every precaution been taken to ensure that those things that created the last crisis won’t create the next one?

From the parade of TARP and TALF recipients that were forced to endure made for TV congressional hearings put on to allay any fears in those people who believe what they see on TV that those on the dais were really looking out for the good of their constituents and not just campaign funds for the next election, I think we can say yes to all of the above.

Now that we’re all feeling completely safe and secure in the ability of regulation to prevent anything bad from ever happening again, I would like to ask a question: Have you ever heard of a “Longevity Swap”?

Longevity swaps are the latest concoction dreamed up by the same financial engineers that brought you CDOs^3, CBOs and a rash of other products that could be made to look like completely harmless, safe as money in the mattress investments. That is, until they weren’t.

Technically speaking, longevity swaps are a risk transference vehicle used to move the liability that pensioners in a specific pension fund will live longer than the actuarial models say they are supposed to. Now, unlike some of the early proposals in the health care initiatives where Rahm Emmanuel’s brother raised the concept of offing people once they got too old, pension funds are required to pay the allotted amounts for as long as the pensioner lives. By using longevity swaps, the pension fund can remove some of this liability.

The Life and Longevity Market Association came into existence on February 1st of this year with the goal of taking longevity swaps into the “mainstream”. I take this to mean making sure investors around the world buy a whole bunch of them and the products created with them so we can have another complete global meltdown in 10-15 years. John Fitzpatrick, a partner and director of the LLMA, has a slightly different view of the product and said “the group wants to produce ‘standardized products that will attract investors and create liquid market’.”

Jonathan Graham, head of longevity swap pricing at Swiss Re said: Longevity capacity exists within the insurance market at present but there simply isn’t enough to cover the long-term future needs.”

The list of players are names we can all repeat in our sleep by now; Deutsche Bank (NYSE:DB), J.P. Morgan Chase (NYSE:JPM), Royal Bank of Scotland (NYSE:RBS), Axa SA (AXA), Legal & General Group PLC (OTCPK:LGGNY), Pension Corp, Prudential PLC (NYSE:PRU), Swiss Re (OTC:SWCEY) and Credit Suisse (NYSE:CS).

If your next question is 'how far along is this product?', last week BMW off-loaded £3BN ($4.65BN) of U.K. pension risk to Deutsche Bank which was the largest deal to date in Britain.

While this all might seem like the brand spankingest new thing, longevity swaps have existed for some time. France used one in 1997 to reach its 3% of GDP deficit goal to stay within the confines of the Eurozone when it took on the pension liability (off balance sheet) for a €5BN payment (on balance sheet) from France Telecom and Antigone Loudiadis, the woman now known as having arranged the infamous currency swap between Greece and Goldman, is now at another Goldman subsidiary, Rothesay Life, and has been transacting longevity swaps since 2005.

Financial innovation is a great thing and unlike Mr. Volcker, for whom I have the utmost respect, I do not think the ATM was the only new thing to come along in the last 25 years that has value.

I think the real point here is that innovation is as inherent and necessary on Wall St. as evolution is to Darwin’s finches. To believe that risk can be legislated away will put us all right next to the Dodo Bird.

For the most part, the names listed above as participants in the longevity swap market are tracking the current move lower in CDS spreads and higher in stocks that began back on February 8th.

The longevity swap market is still in a nascent stage and as such none of the institutions mentioned have substantial risk to this product. As with most if not all financial innovation, longevity swaps are at the stage where they are addressing an economic need: over-burdened pension plans and an increasingly long lived populace. If any of the lessons of the last crisis have been learned, and I know that is a stretch, than longevity swaps do not necessarily have to be a problem waiting to happen. For that, however, we will have to wait and see.