Managing Longevity Risk - an analysis of the Swiss Re Kortis Bond

In 2010 Swiss Re issued the Kortis bond,  the world's first "longevity trend bond" designed to enable the transfer of extreme longevity risk to the capital markets. Researchers at Cass Business School have produced the first analysis of the bond, looking at its design, its payoff, and key risk factors for it.

Ever increasing life expectancy, although welcome in every way, does pose risks for pension companies. In response these companies have sought novel methods of managing the risk and as a result the traded market for longevity risk has grown significantly. In 2010, Swiss Re issued the Kortis bond. This was promoted as the world's first longevity trend bond and offered a new way for investors to transfer risk to investors willing to take on and manage it. Recently a team from Cass Business School, City University London modelled and analysed the Kortis bond, the first time it has been subject to such analysis since it was issued. The resultant research paper Modelling longevity bonds: Analysing the Swiss Re Kortis Bond is now available for download.

Co-author of the research, and Director of the Pensions Institute, Professor David Blake said: "The Kortis bond provides a new method of transferring extreme longevity risk from insurers and reinsurers to investors in the capital markets. As the prototype of a new breed of longevity-linked securities, it is important to be able to model and analyse it, so that the entire industry can learn and improve how to transfer these extreme risks more effectively and, so, better support the growing market for pension scheme de-risking."

Professor Blake and Dr Hunt modelled the payoff of the bond using a number of recently developed modelling techniques. They looked at how the structure pioneered by Swiss Re could be adapted to meet the needs of longevity risk in other insurers. The research demonstrates that the underlying bond design is very flexible, and has the potential to be widely replicated and extended to allow more efficient transfer of longevity risk to the capital markets.

The bond was created because Swiss Re reinsured pensions and annuities in the UK and, if these pensioners live longer than expected, the company has to pay out more. Concurrently they cover a lot of younger people for life insurance in the US and if they live longer then they pay out less. The investor buys this principle at risk bond and if mortality rates in England and Wales decrease faster than the US then the investor loses money. If that doesn't happen they get their money back plus a high rate of interest on the bond.

The Kortis bond builds on the structure of catastrophe bonds. These pay out less in the event of an earthquake, hurricane or epidemic, and apply the same design to changes in mortality rates.

Dr Hunt said: "We are the first to model and analyse the bond since it was issued. Our study discusses its design features, models its payoff and analyses the different risk factors present using a number of recently developed techniques that allow for the correlations in mortality rates between different countries, and finally, considers how the Kortis structure can be adapted and extended in future.

With the phenomenal growth of the pensions buy-out, buy-in and longevity swap market - almost £35bn in the UK in 2014 alone (according to Towers Watson's De-risking Report 2015) - there has been a huge transfer of longevity risk - the risk of faster than expected increases in life expectancy - to insurers and reinsurers. In turn, the reinsurance market has started to investigate novel methods for managing this risk."

The success of the pensions de-risking market ultimately depends on the willingness of reinsurers to manage longevity risk. Dr Hunt and Professor Blake believe that issuing further Kortis-type bonds is essential to maintaining the current high rate of growth in the longevity risk transfer market, and the ability of companies to reduce and eventually remove this risk from their pension schemes in future.

A draft version of the research paper is available for download at the link below.


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