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Longevity Bond to be issued by the EIB
In November 2004, the European Investment Bank (EIB) unveiled plans to issue the first longevity bond that offers a partial longevity risk hedge to UK pension schemes and life insurers. Though the final pricing of the bond is not yet available, its expected structure is known. The size of the issue is expected to be some £500m.
The bond is intended to match a 25 year fixed term level annuity to pensioners at age 65. The annual payments under the bond are effectively linked to the number of lives in the UK male population reaching age 65 in 2003 and then surviving to each subsequent year. The payments decrease in line with the number of lives surviving, as estimated by the ONS. However, there is a lag between the end of the observation period and the date of payment. Therefore the first payment under the bond, to be made in December 2005, will reflect the number of lives in this cohort surviving after 2003, the
Though the bond is to be issued by the European Investment Bank, it is arranged and managed by BNP Paribas. EIB, in turn, will hedge all the investment and longevity risk on this bond with BNP, who in turn will hedge the longevity risk with Bermuda based PartnerRE through a reinsurance contract. Under this structure, the longevity risk is effectively taken by PartnerRE and the investment risk by BNP but it still allows the bond to enjoy EIB's AAA rating because purchasers of the bond are only exposed to the credit risk of EIB defaulting on the bond.
It is clear that the key single determinant of the future issue of such bonds is the availability of reinsurance capacity. Therefore future issues of longevity bonds are dependent on sufficient reinsurance capacity being available. However, no reinsurer has been willing to provide such large cover within the UK and it is interesting to note that the reinsurance cover is provided by a non-EU reinsurer. This may indicate that the EU's solvency requirements may make offering such reinsurance cover from within the EU prohibitively expense.
There are many advantages to the longevity bond, as detailed below:
- It provides a better match for the liabilities of pension funds and life insurers than other available investments other than purchasing (re)insurance to cover the longevity risk.
- The bond also provides a long term interest rate hedge.
- The longevity index is transparent and EIB has a AAA credit rating.
- Life insurers holding the longevity bond as a hedge may be able to hold lower prudential margins.
However the bond does have some limitations as the hedge is imperfect for the following reasons:
- A small scheme will find it difficult to use this bond to match its liabilities as the variance between actual and expected mortality will be quite large.
- The mortality experience of individual pension funds and life insurers may be different from that of the reference UK population.
- The bond only provides a hedge for the longevity of males. However, pension funds and life insurers will also be exposed to significant longevity risk from females.
- The liabilities for pension funds and life insurers give greater weight to the lives receiving larger pensions. Further, there is evidence that there are significant differences in the mortality of those receiving larger pensions compared to those receiving lower pensions. As the payments under the bond effectively give equal weight to all the lives in the UK population, the already imperfect hedge provided by the longevity bond is worsened.
- The bond only matches cashflow under a level pension while a large portion of the pensions paid by pension funds and life insurers will be increasing at RPI/LPI or some other rate.
- The bond is a progressively worse hedge for pension liabilities related to younger or older cohorts.
The table below compares the merits of purchasing the longevity bond against purchasing insurance cover.
| Longevity Bond |
Annuity |
| Partial hedging of the longevity risk |
Full hedging of longevity risk |
| Low credit risk of EIB (rated AAA) |
Higher credit risk of the insurer but there is additional protection through the FSA compensation scheme |
| Fixed term of 25 years |
Covers the full term of the liability |
| Only level pensions matched |
Different annuities can be used to match non - level pensions |
Though the longevity bond does not provide as good a hedge as insurance, it is the next best matching investment available in the short term to UK pension funds and life insurers. Given this and the perceived lack of longevity insurance capacity in the UK, it is likely that the bond issue will be successful. However, as the bond is likely to be closely held rather than actively traded, it is unlikely to give a proxy for the market's view of longevity risk.
Barnett Waddingham LLP, February 2005.