Is Hedging Longevity Risk About to Get Easier?

(October 29, 2013) — After several false starts, the creation of a capital market where longevity risk can be traded may be about to happen—and other options might be coming online too.

Until now, all swaps that have been carried out by investors hedging this risk have included a reinsurer, but Allianz Global Investors thinks this may be about to change.

“It is hard for a normal investor to invest, as longevity swaps are not standardized, the market isn’t liquid yet and documentation isn’t in place,” Bernhard Brunner of risklab, a subsidiary of Allianz Global Investors, wrote in a recent paper issued by the financial institution. “But the first steps are being taken towards the creation of a liquid capital market.”

Brunner highlighted the 2010 creation of the Life and Longevity Markets Association by several banks and insurers in a bid to speed up transactions via methods such as standardizing documentation.

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In anticipation of a properly functioning longevity market, Allianz Global Investors set out a range of possibilities for investors.

“If more liquidity is introduced into the market, other longevity hedging solutions are likely to emerge in popularity alongside longevity swaps, such as q-forwards and s-forwards, which are currently more theoretical instruments. A q-forward is essentially a mini swap that uses a one-year death probability rate.”

However, the company said investors themselves might be interested in taking the other side of the bet through longevity bonds.

It detailed “principal at risk” longevity bonds, which are hedges against catastrophic mortality risk and “coupon-based” longevity bonds, which link payments to the survival rate of a cohort.

In Brunner’s opinion, longevity swaps hold the advantage over coupon-based bonds. “Bonds involve huge upfront payments, plus they have the issue of how dividend payments are specified,” he wrote. “They are very capital intensive and have basis risk. Swaps, meanwhile, aren’t as capital intensive, don’t drain much capital, and the floating rate can be linked to different ages and cohorts of interest.”

Principal at risk longevity bonds could appeal to investors familiar with Insurance-Linked Securities (ILS), such as catastrophe bonds. The challenge, Allianz Global Investors said, would be to design payments that are both beneficial to the hedgers and appealing to ILS investors.

“By issuing standardized longevity bonds that are index-based on the country’s own population, governments would make prices publicly available,” Brunner said. “These would then be used as reference points for other transactions and assist the growth of a longevity derivatives market, solving the problem of transparency that is also holding back the market in current over-the-counter deals.”

The amount by which longevity shocks can blow a pension fund off course has been outlined by consulting firm Redington.

“Even for schemes with an achievable set of investment objectives and deficit recovery contribution schedule, the magnitude of the moves in longevity assumptions experienced over the last decade can substantially damage the chances of the scheme meeting its investment objectives, “ said Wenyu Bai, a member of the ALM team at Redington.

“Moving from a popular mortality assumption back in 2006 to the most frequently used assumption in 2013, a typical UK pension scheme could see their liability present value increased by 7.2%, and interest rate and inflation hedge ratio reduced by 9%. This means that the scheme will have to increase their required return on assets by 88 basis points, or increase their annual deficit reduction contribution by £6.9 million.”

All investors need now, is to engage governments and regulators.

To read the full Allianz Global Investors paper, click here. For the Redington research, click here.

Nordic strategists and managers say institutional investors’ tendencies to herd, chase past performances, and second-guess decisions have contributed to underperformance.

(October 29, 2013) — Various investors’ behaviors such as herding, performance chasing, and complex committee structures could cause poor manager selection and underperformance, according to attendees at the Opalesque Nordic Roundtable.

A group of five Nordic investment managers, consultants, and strategists identified the three factors as the “three maladies of institutional investing” and might contribute to the less than stellar performance by larger funds.

Peter Seippel, head of quantitative analysis at Optimized Portfolio Management, said this was emphasized particularly with a growing demand for hedge funds by investors.

“From the beginning of the year, fixed income has given negative returns and that is of course a problem for investors relying heavily on bonds,” he said. “That has pushed some clients to reallocate and start increasing allocations towards hedge funds again.”

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As more pensions turn to alternatives and absolute return strategies, a concern for “herding into ideas” escalates, according to Mikael Stenbom, CEO of Risk and Portfolio Management. Because large corporations have a difficult time performing their own analyses of managers and strategies, investors follow the steps of their peers that are making similar investments.

“It seems many of those investors tend to go in the same direction: they typically choose the same managers or the same providers, probably because it feels safer and is perceived as less politically controversial and risky,” Stenbom said.

Innovation, in both strategy and manager selection, was more prevalent among smaller organizations, family offices, or independent asset managers. Nordic investment consultancy Wassum’s Karl Trollborg said these smaller investors were able to perform appropriate due diligence on managers and various funds: “They also tend to be very active investors, keen on following through and deploying their money smartly.”

Another behavioral hindrance was investors’ tendencies to select their investments largely based on performance chasing. Opalesque suggested investors most often invest with a certain manager to chase past rates of return, lacking display of “proper know-how and procedures to invest rationally.”

“You have to do your analytics,” Stenbom said. “You have to visit the managers, you have to do the due diligence, you have to have the experience and the skill, you have to do all the work, and most importantly, you have to understand the manager.”

Understanding the manager is a complex idea—it constitutes understanding why a manager is making or losing money, explaining drawdowns, and being able to formulate “methods and courage to act anti-cyclical,” according to Stenbom.

Complex investment committee structures made up the third malaise. Extensive “second-guessing” by investment teams could cause stress and uncertainty, Stenbom said.

“The frightening thing is that the result that the group comes up with typically underperforms the average of the individual decisions, which is probably not a good case for committee decision making,” said Martin Estlander, founder of Finland-based Estlander & Partners.

Looking ahead, the roundtable concluded there would be increased volatility among a relatively positive outlook for global economies. Estlander projected improvements in both Chinese and US markets, followed by good opportunities for investments.

However, he asserted the difficulty of making accurate projections for asset and risk management.

“Our job is not to forecast the future, rather to respond to what’s happening,” Estlander said. “We just have to face reality from the point of view that when the s**t hits the fan, it’s going to hit all over the place and on every single position and gear our exposure accordingly.”