Original posted in the Financial Times by Steve Johnson:
Asset managers are gearing up to start trading in longevity risk, potentially opening the way for pension funds to begin hedging one of their biggest risks en masse.
The involvement of specialist longevity and hedge funds offers a lifeline to a market that was in danger of being strangled at birth by a chronic lack of capacity.
The pension schemes of Babcock International and RSA Insurance have already signed deals with investment banks to protect against the risk of their scheme members living longer than expected, an eventuality that would increase their liabilities.
Similar deals covering an estimated £20bn (€23bn, $33bn) of liabilities are in train, yet Watson Wyatt, the consultancy, has estimated that the current market capacity is just £10bn-£20bn because reinsurance companies – which are exposed to the risk of higher mortality via life assurance policies – are the only natural holders of longevity risk for the banks to pass the exposure on to.
“There are £1,000bn of UK pension liabilities. There is nowhere near enough capacity for that,” said Steven Dicker, senior consultant at Watson Wyatt.
“We think £10bn-£20bn of deals will be done in the next two years. After that we are worried about replacement capital. You definitely don’t want to be last in the queue.”
The emergence of investment funds, which are not natural holders of longevity risk but are happy to trade any asset perceived as providing an attractive risk/return trade off, should allow many more pension schemes to lay off this risk.
London-based Centurion Fund Managers has just gained regulatory approval for a Luxembourg-based fund that would specialise in trading the longevity swaps spun off by pension schemes.
A number of London and Geneva-based hedge funds specialising in insurance-linked securities (ILS) are also believed to be in talks with banks about entering the market for both UK and Dutch longevity derivatives.
“Finding new holders of this risk is of paramount importance. We are scratching the surface of the additional capital that is available,” said Eugene Dimitriou, head of alternative risk transfer at Royal Bank of Scotland, which orchestrated a deal by which Aviva, the insurer, laid off some of the longevity risk in its annuity book. “It’s probably safe to say the outstanding capital that is available from non-traditional sources is 100 times larger than the available capacity of the reinsurance industry.”
But pension funds may have to price in higher longevity expectations in order to attract hedge funds.
Andrea Cavalleri, head of life origination at Securis Investment Partners, a London-based ILS hedge fund group, said he believed the deals that had been struck so far had been absorbed entirely by reinsurers because pricing terms were not yet attractive enough for the capital markets.
David Rawson-Mackenzie, chief executive of Centurion, said: “I think we are going to see some of the large hedge funds getting into this space but the big issue is whether the pension funds want to recognise the cost of this extended longevity. From what I understand every pension fund manager would love to do this but they are not prepared to pay the cost of doing it.”
However one banker involved in the sector said pricing was becoming aligned and he expected to see two to three deals a quarter being struck.