08 November 2013

Risk.net: Index-based longevity solutions continue to face challenges, experts say

The so-called longevity experience options (LEOs) are designed to provide firms with protection between two points on an underlying index – essentially a call spread, where hedgers are paid once the underlying moves above a certain strike, but the protection is exhausted once the index breaches another, higher strike.

The 10-year product will reference longevity indexes for England, Wales and the Netherlands, with each index divided into five-year age cohorts defined by age and gender. The product will use standardised terms, based on International Swaps and Derivatives Association documentation.

While several large longevity swaps deals have been transacted over the past four years, the market has struggled to gain traction. For one thing, high-quality accurate data is hard to come by, with publicly available national statistics often slow to update. Some early adopters have attempted to model the mortality experiences of their own pensioners, but the data is very specific and lacks transparency. An alternative is to use an industry index, but hedgers are then exposed to basis risk, as the experience of their own scheme members could differ from a standard benchmark.

Deutsche Bank hopes to address the first of these issues by using indexes developed by the Life and Longevity Markets Association. The splitting of the indexes into five-year age groups for each gender, meanwhile, is an attempt to respond to basis risk concerns – users will be able more closely match the hedge to their liabilities, the bank says.

But experts believe Deutsche Bank will continue to have an uphill struggle to win over potential users. In particular, the firm will have to convince pension schemes the product is a good alternative to buy-in and buyout solutions – where pension funds essentially offload all or part of their pension liabilities to an insurance firm.

On the investor side, it is hoped the simple structure and tradable nature of the LEOs will drive interest. Deutsche Bank hopes to further tempt capital markets participants by striking small deals between £3 million and £5 million at first to slowly build capacity.

Ben Stone, senior manager at PwC in London, says: "The building blocks are there, but I think it will depend on both sides. If capital markets players see pension schemes and insurers' demand rising and get comfortable with this product, then they will respond accordingly. For now, it's a case of wait-and-see.”

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