Longevity Risk As An Asset Class

Includes: MET, PRU
by: Tom Armistead

It's pretty clear we need a new asset class. Just like Huey Lewis and the News, "I want a new drug." Fortunately, longevity is emerging to fill the gap, according to a Prudential (NYSE:PRU) press release.

Dr. David Blake, Professor of Pension Economics and Director of the Pensions Institute at Cass Business School, and chair of the conference, said: “Longevity risk is an increasingly important risk to recognise, quantify and manage for both pension plan and annuity providers, as well as for governments and individuals. Getting the right trend improvements in life expectancy is the key both to managing this risk and to creating an asset class acceptable to investors to buy into.

“However, this has proven to be difficult to realize in the past; even official agencies have systematically underestimated previous mortality improvements. Pension plan and annuity providers are beginning to question whether longevity is a risk they should be assuming on an unhedged basis, and the capital markets are beginning to offer solutions for managing and unloading longevity risk.” (Emphasis added)

Unloading Longevity Risk

It's well known that many pensions are chronically underfunded, both among governments and private industry, particularly in the wake of the financial crisis. However, rather than viewing this as a lack of funding, it may also be viewed more constructively as a problem of longevity. It's not about a lack of money: the problem is, the pensioners may live too long. They may become a bunch of struldbrugs, mumbling incoherently; and even worse, continuing to receive money that could be better used by younger and more relevant citizens.

This problem could be exacerbated by deflation, improved medical technology, or a general slowdown in the pace of economic activity.

Longevity is an important risk, but likely to manifest well in the future, rather than being of immediate concern.

Historical Perspective

The experience in the US with Civil War pensions illustrates some of potential problems. Here's a link and an excerpt:

Both the Federal government and Southern state governments continued to provide pensions for Civil War veterans and their widows well into the middle of the twentieth century. In all, billions of dollars were expended by both sides in an effort to "reward" the survivors of America's costliest war. Because of the high rates of expansion in both the Federal and Confederate systems, critics frequently accused pensioners and officials alike of corruption and fraud. Those pensioners most often labeled as frauds were widows, especially young women who had married veterans much older than themselves, supposed "cowards," and, in the Federal system, black veterans.

The point is, human nature is always and everywhere the same, and some pension obligations may have a tendency to creep upward and drag out interminably.

Converting Risks to Assets

Logically, it may seem difficult to convert risk, which is a kind of ill-defined or hypothetical liability, into an asset. However, our financial alchemists were able to do this in the case of credit default risk, by creating synthetic assets out of CDS.

John Paulson did some very productive work on this, with the assistance of Goldman Sachs (NYSE:GS) and the Fabulous Fabrice, developing Abacus 2007-AC1. Bundling up a bunch of adverse selected CDS, he peddled it to the unsuspecting public, achieving fame and fortune as a savvy and prescient financier.

Very possibly the same can be done with longevity risk. Insurance companies or pension funds that have an excess of longevity risk can create insurance policies to protect and hedge themselves. The policies, which will entail a flow of premiums, can then be sold as assets, with the premiums masquerading as dividends, thereby unloading longevity risk.

Longevity may take a long time to manifest itself. As such, the opportunity of packaging and selling the risk will be ongoing. The so-called assets may exhibit rock solid performance for years.

Investment Implications

As a retail investor, I have no intention of buying any longevity assets, if and when they become available for sale as fixed income securities.

Insurance companies or other financial institutions that hold large amounts of fixed income assets may be drawn into the game. It's always good practice to look at the financials for disclosures of asset type and quality. Just make a mental note, if at some point in the future you see something along the lines of longevity, check it out.

Companies such as MetLife (NYSE:MET) or PRU have a fabulous marketing opportunity in the annuity area. Investors nearing retirement, and badly burned by the financial crisis, will be attracted to guaranteed payments and the ability to offload their longevity risk onto an insurance company. The companies, if they charge adequate premiums, can simply hold the risk. On the other hand, if they can unload it at a profit, they will be able to sell more policies at lower rates. This one could take a while to develop, and might not end well.

Disclosure: I am long PRU, MET.