Industry Body Looks to Standardize Index-Based Longevity Swaps

Longevity swaps may soon become a trend across Europe, as insurance firms seek to optimize their capital under the Solvency II regime's requirements for buffers in times of stress. With this in mind an industry body is defining population-based standards for this industry to encourage the growth of the longevity swap market.

The Life and Longevity Markets Association (LLMA) was started in 2009 by JP Morgan and Swiss Re. Its members now also include Aviva, Deutsche Bank, Morgan Stanley, Prudential and AXA.

LLMA board member Pretty Sagoo tells Inside Reference Data that as people in Europe become healthier and have access to a better standard of medical care, insurers and pensioners face longevity risk: having to pay out pensions and insurance to populations living longer than expected. Under Solvency II, institutions have to hold capital against extreme instances of this occurring.

"Now, if you do a swap, you will be protected against anything over 20 years [increased lifespan] and this means you don't need to hold as much capital," says Sagoo, who is also director of structured insurance solutions, corporate banking and securities, at Deutsche Bank.

But longevity swaps haven't had much traction in the market up until now, she adds. "JP Morgan had been trying for years and had invested a lot of money in doing swaps on mortality indices."

Mortality indices are tables of data to which pension institutions and the swap providers can refer when quantifying longevity risk in each country and calculating the fixed and variable cashflows involved in the swap.

"But it never got much return on investment in terms of the number of trades that actually happened," says Sagoo.

One reason for this was that JP Morgan was ahead of its time and "people weren't ready to look at indices," she says.

"Another thing that hindered this is that insurers and pensions aren't chuffed about using an index run by a bank. They would rather link a transaction that they may have on their books for years and years to an index that they have some certainty will be there for years and years. Banks have historically been fickle with indices, launching them and then turning them off after a few years."

So it made sense to have an independent organization develop the indices, says Sagoo. JP Morgan handed over their work to the LLMA, which has been working on developing and publishing standard indices in a two-phase project for four countries—Netherlands, UK, Germany and the US.

Phase one of the LLMA's work involved standardization of index-linked swaps—how might this look and how might risk be calculated. But the major part of the work was looking at every single mortality model there is and working out, depending on the size of an institution, the best model for it to use.

"Phase one was basically doing all the nitty gritty modelling to work out the best modelling methodology," Sagoo explains.

In phase two, which is currently under way, the LLMA will apply these models to some real-life examples to ultimately understand how an institution will benefit from reducing its risk using index-based products.

Sagoo says regulators, such as the Prudential Regulation Authority, have shown a lot of interest in the LLMA's efforts. "This is clever of them, because at some point insurance companies are going to ask them, "What do you think of this or that trade?"," she says.