Société Générale is syndicating the risk of longevity to sovereign wealth funds, insurance companies and reinsurance companies, with a first-of-its-kind, €200 million ($262 million) deal slated to launch in July.
At least one large Asia-based institutional investor is among those taking a slice of this risk, says Jeff Mulholland, managing director and head of insurance and pension solutions in New York. He declined to name the investor.
Mulholland announced the planned transaction last week at a conference organised by SG and by Asia Risk magazine.
The concept is similar to catastrophe bonds, securities that generate money-market returns plus a premium paid by insurance companies to hedge against events such as storms or earthquakes. Because natural phenomena determine the outcome, rather than any human behaviour, cat bonds do not correlate to capital markets.
The cat bond market in the US is about $15 billion and the swaps market for cat bonds in London has $200 billion of notional outstanding.
SG hopes to create a comparable market for longevity risk and is working with Risk Management Solutions, a California-based provider of catastrophe risk models, to develop models around life expectancies, earthquakes of a different sort.
These models index the mortality and longevity averages and means in a given country or market. It looks at historic relationships as well as more dynamic factors that impact mortality rates, such as developments in healthcare or pharmaceuticals that can help people live longer.
Risk takers can use such data to take a view, either to hedge or to enjoy earning a premium from insurers. Risk takers include other insurers and reinsurers that would like to mitigate an existing exposure to mortality, as well as financial investors such as endowments, pension funds, sovereign wealth funds and other insurers that seek high returns with little correlation.
Insurance companies are willing to pay a premium because risk-based capital rules such as Solvency 2 are forcing them to set aside more capital for longevity exposure. They can meet these capital charges via derivative contracts at a much cheaper rate than by raising new equity from the market.
The cat bond market developed about 15 years ago for similar reasons, to help insurance companies remove some risk from their balance sheet (and reduce the capital charges that go with it), and to enable others to load up on high-return, low-correlation exposures in the form of an option premium.
To date, there has been only one instance of a cat bond default, which occurred in 2011 as a result of the Fukushima disaster. These are short-term instruments (typically three years) and so the likelihood of multiple disasters wiping out bondholders is very low.
(Although correlations are not quite as low as bankers claim: in 2008, many market participants treated cat bonds as an ATM because they needed instant liquidity, and this led to a crunch in the bond and swaps market.)
Mulholland says risk takers can receive a high-yielding rate of return, free of market risk. In small doses the total portfolio risk is negligible but the yields can be outsized: up to 7% for a 2.5% risk to capital, assuming insurers pay a 2% premium.
That premium may seem steep, but basis risk – the risk of imperfect hedges using futures – is a bigger issue for many insurers today.
SG’s Mulholland says the bank is making its documentation and systems transparent to counterparties, in the hope of quickly creating standards that allow for more deals to emerge and a secondary market to follow.
He also sees the potential for insurers in Japan, Korea, Taiwan and Hong Kong to syndicate some of their longevity risk to financial markets, as these places have sufficient data to create a model. He claims that, once the inaugural July deal is transacted – it involves Dutch longevity and US mortality exposures – investors will come with bigger ticket sizes.
“We’ve now got a hammer and we’re looking for some nails,” he says.