Aggregating Longevity Risk for the Capital Markets A Necessary First Step 5 th International Longevity Risk & Capital Markets Solutions Conference JP Morgan

Aggregating Longevity Risk for the Capital MarketsA Necessary First Step

5th International Longevity Risk & Capital Markets Solutions ConferenceJP Morgan Chase Auditorium, 270 Park Avenue, New York25 September 2009

John H. FitzpatrickPartner and Director, Pension Corporation

Copyright © 2009 Pension Corporation LLP. All rights reserved. 2

Agenda

Current forces affecting the size and ownership of longevity risk

Why the risk is moving from the pension funds to professional pension insurers now

The result: a new and growing market for the professional pension insurers

Longevity risk: why it will move from pension insurers to investors

Longevity risk: pensioner characteristics favourable for investors

Likely issuers, why they will sell and what they will have to offer

Some constraints to address to increase volume of issuance

Summary and conclusions

Appendix


Current Forces Affecting the Size and Ownership of Longevity Risk

The Mosaic Today

Retirement population growing

Longevity risk moving from corporates to individuals

Cost of longevity significant and rising

Inflation could exacerbate longevity costs

Longevity extending

Credit Crunch moving longevity risk arguably to

Government

The UK population of retirees (i.e. people 65+) is set to increase by 60% by 2032 from 10 million to 16 million due mainly to the ageing of the baby boom generation

Longevity continues to increase for UK retirees at historically high rates against largely fixed retirement / entitlement dates

The current cost of life extension in the UK is estimated at £12.5 to £24.7 billion per year if GAD / ONS best estimate and high projections prove accurate

Current fiscal and monetary policy may be sowing the seeds of high inflation and expectations of inflation

Strong forces are causing corporates to close existing Defined Benefit (DB) schemes and transition to Defined Contribution / Personal Account schemes

The Credit Crunch is causing a significant increase in DB pensioner risk to move to the Pension Protection Fund (PPF)


The Four Forces:Why the Risk will Move from the Pension Funds to Pension Insurers

UK Pension Funds

Pensions Regulato

r –

Greater Powers

Pension Pro

tection

Fund

Investment Market

Volatility

Powers that have been granted, exercised and proposed continually raise bar for trustees, administrators and sponsors

Stock market performance has reopened deficits

Lower gilt yields Corporate bond spreads

Levy calculation on pension funds revised upwards and more risk-based

Recent proposal by ASB would raise liability value to ‘market value’

With market volatility, this becomes even more significant

Accounting – not just

FRS17 and IAS19


Pension Insurance Market: A Growing Market in the UK

0

20

40

60

80

100

120

140

160

180

2006 2007 2008 2009 2010 2011 2012

Year

GB

P b

n

Cumulative Projected Development of the UK Pensions Buyout and Longevity Insurance Market

Total of £1,000bn of private defined benefit pension liabilities in the UK

Rate of transfer to pension aggregators will continue to accelerate

– £3.5bn in 2007

– £8bn in 2008

– £11bn projected for 2009

Large schemes have turned to longevity hedging in 2009

20% to 25% of companies expect to enter into a buyout by 2012

25% of defined benefit plans to end accruals

Sources: (i) Lane, Clark & Peacock report, “Pension Buyouts 2008”; (ii) Watson Wyatt (March 2008) survey of 100 UK company pension sponsors; (iii) PwC Pensions Survey of 193 UK-based companies (October 2007); Pension Corporation estimates (iv) Snapshot survey of 100 companies by the National Association of Pension Funds (January 2009) (v) Pension Corporation

The Likely Path


Why Longevity Risk Needs to Move

Longevity: Unrewarded, historically underestimated and unmanaged, a material risk for pension funds

‘Natural or original’ owners of a risk are not the ‘best owners’

‘Best owners’ of longevity risk are the pension insurers and reinsurers / capital markets

– Spread risk around larger number of markets and participants

Risk flows to those best able to manage it

Pension Funds Capital Markets/ReinsurersPension Insurers

Original owners of longevity Underwrite price specific pension fund risk

Create large risk portfolios

Carry basis risk

Longevity not correlated to non-life, credit and market risks

Natural hedge (albeit not perfect) against mortality risk

Buy longevity indices on the population and specific portfolios


Longevity Risk is Starting to Move to Reinsurers / Capital Markets

Reinsurers

Have bought insured annuity risk

Now writing coverage for pension insurers

As improvement factors increase, reinsurer appetite increases

Capital Markets

Investment banks have recently arranged for longevity risk of insured annuities to be

distributed to investors, most recently in a reinsurer-led transaction for £0.5 billion

Investors buy $18 billion of Traded Life Policies / Life Settlements per year (longevity risk on

wealthy Americans)

Populations indexes have been created on which derivatives will develop

Capacity is growing but at a slow pace


Moving Longevity Risk:Recent Transactions (Europe)

Date Risk OwnerSize (GBP millions)

Type of Longevity Risk

Risk Recipient

January 2008 Lucida Not disclosed Life annuitantsCapital markets

investors

July 2008 Canada Life £500 Life annuitantsCapital markets

investors

February 2009 Abbey Life £1,500 Life annuitants Reinsurers

March 2009 Aviva £475 Life annuitantsReinsurers and capital markets

investors

June 2009Babcock

International£500 – £750 Pensioners Reinsurers

July 2009 RSA £1,900 PensionersPension insurer and reinsurers

September 2009 (announcement)

Royal County of Berkshire

[£500 – £750] Pensioners [Pension insurer]

Total (Jan 08 – Sep 09)

£5,375 – £5,875


Longevity Risk:Favourable Characteristics for Investors

No known correlation of longevity risk to credit, market, interest rate, or inflation risk

A new asset class providing diversification to ILS and other fixed income portfolios

Not “binary” as in hurricane, earthquake or extreme mortality securities

Could be used as a hedge to life insurance risk (risk of early death) securities

Long-dated securities


Longevity Risk of PensionersQualitative Advantages for Investors

Anti-Selection risk

– None: pensioners are members of pension fund based on prior association as employees

Access to historical mortality experience data for pension funds

– Allows for analysis of past experience and enables more accurate mortality projections

Pension portfolios possess homogeneous populations

– Low average pension amounts (<$5,000 payment p.a. per life)

– Geographical and socio-economic diversity

– Life expectancy of a large pool of pensioners will be more closely linked to the overall population

Number of lives in a portfolio

– Pension book of $500m may cover as many as 10,000 pensioners

– Volatility reduces for larger populations (“Law of Large Numbers”)


Investment in Longevity of Pensioners Through a Swap

Expected Pension Payments + Fee

Time

TimeHeavier Mortality

Actual Pension Payments

Swap defines an expected “cash flow line” based on agreed mortality basis and assumptions for future improvements

Investor pays to Pension Insurance Corporation the Actual Pension Payments due to the pensioners in return for the Expected Pension Payments plus a Fee

Expected Pension Payments(“Fixed Leg”) + Fee

Actual Pension Payments(“Variable Leg”)

Pension Insurer

Investor

Transaction Mechanics

Key Features

High return (8%-10%)

Low volatility (due to “Law of Large Numbers”)

Initial collateral payment by investor

Mark-to-Model payments, if required, by investor (on extension of longevity)

Payment of fees plus remainder of Expected Pension Payments plus return of collateral to investor (on death of covered lives)


Longevity Risk of PensionersLikely Issuers, What They Can Sell and Timing

Professional pension insurers

– Large portfolios of pensioners, well diversified pools

– In a standardised Index form (i.e. pension insurers can retain basis risk) or reflecting large actual pension portfolios

Insurers with annuity blocks

– Has anti-selection risk, but this can be priced

Large corporates with sophisticated risk management functions and large enough pension funds

– Unlikely to transact directly with the capital markets on longevity risk in large volumes

Timing: Given the current size and growth of the professional pension insurance market, risk is available now


Longevity Risk Transfer:Current Constraints with Capital Markets

Risk Owner

Pension Insurers

Full longevity risk transfer

Partial risk transfer

Reasons for capital markets constraints

Potential Solutions

Limited quality and quantity of information

Granular data

Capital markets reporting standards

Use of specific sizeable portfolios

Redemption rights

Desire to trade out

Medium term solution: long-term investment i.e. no-redemption structures

Long term solution: liquid longevity market

Pension Insurers

Capital Markets

Indemnity basis risk

Index-based cover

Duration basis risk

Limited duration

cover


Summary & Conclusion

Longevity Risk is growing fast, due to demographics, lifespan extension, and developing long-term inflation trends

Pension Funds have been significantly increasing their assumptions for longevity, enabling pension portfolios to become insured

Longevity Risk is moving to Pension Insurers and other aggregators, a necessary first step for distribution to Capital Markets

Aggregators of longevity risk bridge the gap between the needs of the pension funds and the requirements of the capital markets investors

Analysis of longevity data, historical and current, has substantially improved in recent years, aiding all market participants, with forward-looking medical-based models being developed

Investors should employ methodologies to analyse longevity risk: geographic, socio-economic factors

Volatility should be very low for large portfolios of homogenous pensioner longevity risk, even though longer duration than many ILS products

Appendix


The UK Population of Retirees is Increasing

The share of people aged 65 years and over or 85 years and over in total population has and will continue to increase substantially

The combination of increases in life expectancy and the fact that more people reach old age is expected to have a profound impact on society

The UK population of retirees (i.e. people 65+) is set to increase by 60% by 2032 from 10 million to 16 million due mainly to the ageing of the baby boom generation

Chart 5: Number of people aged 65+ and 85+ (millions)

0

2

4

6

8

10

12

14

16

18

20

1982 1992 2002 2012 2022 2032 2042

Source: GAD, 2006-based principal population projections and ONS population statistics.

65+ 85+


Increasing Longevity is Here to Stay

Longevity continues to increase for UK retirees at historically high rates against largely fixed retirement / entitlement dates

Source: GAD, 2006-based principal population projections and ONS population statistics

Period expectation of life at age 65, E&W

5

10

15

20

25

1850 1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Year

Exp

ecta

tion

of li

fe (

year

s)

Males

Females


The Cost of Longevity Extension to Corporates / DB Schemes, Governments and Individuals

Membership(1) Liability(1) Cost (p.a.) if LE extends (2)

(no. of people)

by ½ year every 5 yrs

by 1 year every 5 yrs

Corporate sponsors of Defined Benefit schemes 15m £850bn £3.0bn £6.0bn

Government

- Public sector schemes

- State benefits

20m

45m

£1,100bn

£1,400bn

£3.9bn

£4.9bn

£7.7bn

£9.8bn

Insurance Companies

- As issuers of annuities

- As pension insurers

6m

< 0.3m

£160bn

£12bn

£0.6bn

£0.1bn

£1.1bn

£0.1bn

Total £3,519bn £12.5bn £24.7bn

UK GDP £1,400bn 0.9% 1.8%

1. Source: The Purple Book 2008; PIC estimates. 2. PIC assumption: liability increases by 3.5% for every year of longevity extension.

Current cost of life extension is estimated at £12.5 to £24.7 billion per year if GAD / ONS best estimate and high projections prove accurate


Realities are Forcing Longevity Risk to Move from Corporates to Pension Insurers, Individuals and Governments

Current fiscal and monetary policy may be sowing the seeds of high inflation and expectations of

inflation. Most pension benefits are indexed to inflation (although portions are limited to 0% - 5%

p.a.) which may increase cost of life extension

Strong forces are causing corporates to close existing Defined Benefit (DB) schemes and

transition to Defined Contribution / Personal Account schemes, causing longevity risk to shift from

corporates back to individuals

The Credit Crunch is causing a significant increase in DB pensioner risk to move to the Pension

Protection Fund (PPF). While it can be argued that the longevity risk stays in the solvent DB world

through the levy, the PPF becomes a large bearer of longevity and other risks, which may not be

sustainable


How Can Policy Actions Adapt to Increased Longevity to Create the Pension System of Tomorrow?

Government

As with state pensions, gradually move retirement age to correspond to increasing longevity

for all public sector schemes

HM Treasury should consider issuing long-dated longevity linked gilts

Work rules regarding mandatory retirement / flexible work incentives need to be looked at

Fiscal expenditure needs to be controlled to create room for future pension expenditures

ONS - Continue to improve the quality of data relative to longevity

The Pension Regulator – promote the improvement of data quality, sound funding practices

Can lead the discussion and creation of the pension system of tomorrow


How Can Policy Actions Adapt to Increased Longevity to Create the Pension System of Tomorrow? (Cont’d)

Individuals

Increase savings rates into DC / Personal Accounts to accommodate higher longevity

Prepare to work part-time in later life

The question of whether they are the best holders of longevity risk needs to be re-examined

Businesses

Businesses increasingly close DB schemes but should they consider hybrid DB / DC schemes?

Continue to transfer legacy liabilities to pension insurers

Examine ways of hedging future liability growth, e.g. longevity insurance

Index future retirement accrual to longevity

Insurers / Capital Markets

Providers

Continue to innovate the transfer of longevity risk to the capital markets

Work with modelling firms to develop a forward-looking, medical-based longevity model

Key to the conversion of asset pools to secure retirement income streams for the population

Must develop a method to efficiently re-pool the longevity risk from individuals to insurers / capital markets


Pension Corporation is a focused financial services organisation that has been established to provide innovative and affordable solutions to pension funds and their sponsors

Pension Corporation offers both full insurance and other pension risk transfer products

Pension Corporation has a large and strong investor base including the Royal Bank of Scotland, JC Flowers, Swiss Re, Sampo Life, Istithmar World and a number of other institutional investors

JP Morgan became an investor during November 2008

Pension Corporation provides increased levels of security and stability for scheme members through Pension Insurance Corporation, a fully authorised and FSA-regulated insurance company

Pension Corporation has £5.3bn of pension fund liabilities, £3.1bn as sponsoring employer and £2.2bn as insurer

Pension Corporation has the largest equity capital of any provider in the sector – close to £1bn

Pension Corporation InvestmentsCorporate Solutions Pension Security Investment Corporation

Guernsey-regulated (Re-) Insurer

Pension Insurance CorporationFSA-regulated Insurer

Insurance SolutionsCorporate Solutions

Pension Corporation:Overview


Pension Corporation Management and Board:Unrivalled Expertise in the Pension Insurance Arena

John CoomberChief Executive Officer

Director and former Chief Executive Officer of Swiss Re; Fellow of the Institute of Actuaries

Sir Mark WeinbergChairman

President of St James's Place plc, co-founder in 1991 of St James's Place Wealth Management Group;

Co-Founder of Hambro Life (Allied Dunbar) in 1969

Edmund TruellDirector

Founder of Duke Street Capital; 22 years experience in building up private equity business; built largest leveraged loan investor in

Europe from start-up to sale

Executive Officers Directors

Edward GieraHead of Global Pensions Advisory Business at

JP Morgan. Previously head of Debt Capital Markets Leveraged Finance

and Structured Finance

Bob ScottFormer Group CEO of Aviva plc and former

Chairman of the Association of British Insurers; Director at Jardine Lloyd Thompson

and Swiss Re

Ravi SinhaHead of Europe and Managing Director of

J C Flowers & Co LLC; former Managing Director Goldman Sachs

John AmatoChief Investment Officer, Istithmar;

formerly at Lehman Brothers

John LovelessFormer Head of Trust and Private Banking,

SG Hambros

John H. FitzpatrickFormer CFO of Swiss Re; former CEO of

Swiss Re Life & Health; 28 years of insurance and financial management

Sir Nicholas MontaguFormer Chairman of HM Inland Revenue

Kari StadighGroup Deputy CEO Sampo plc. Chairman of P&C Insurance Holding Ltd and Sampo Life

Insurance and the Federation of Finnish Insurance Companies

Nick ParkerFormer Managing Partner at

PricewaterhouseCoopers for Project Finance and Privatisations

Danny TruellChief Investment Officer, Wellcome Trust;

former co-head of Global Investment Strategiesat Goldman Sachs Asset Management

Graham CooperFellow of the Institute of Actuaries; founded New

Bridge Street Consultants pension and actuarial practice in 1986

Philip MooreGroup Finance Partner

Former Group Chief Executive and Group Finance Director of Friends Provident plc (2003 – 2007); was Director of

F&C Asset Management plc and Board Member of the Association of British Insurers. Previously Partner at PricewaterhouseCoopers

leading insurance consulting practice in South-East Asia

Rob SewellChief Financial Officer

Former UK Finance Director for Legal & General. Former CEO and CFO for National Westminster life assurance.

17 years financial service experience

Sir Martin JacombFormer Chairman of Prudential plc;

former Deputy Chairman of Barclays Bank and Director of the Bank of England


Disclaimer

This information is issued by Pension Corporation LLP (“Pension Corporation”), a limited liability partnership registered in England (registration number OC316968) with its registered office at 14 Cornhill, London EC3V 3ND. This document is confidential and proprietary to us and is being provided solely for your use and is not intended for any further dissemination. In particular (and without prejudice to the generality of the foregoing), this document may not be reproduced, distributed, passed on, or the contents otherwise divulged, directly or indirectly into any country, territory or possession where to do so may contravene local law or regulation. This document remains our property and, on request, must be returned to us. In addition, on request any copies made must be destroyed and written confirmation provided to us that this has occurred. Nothing in this document should be construed as legal, tax or investment advice. Unless otherwise agreed in writing, Pension Corporation and its affiliates are not acting as your financial adviser or fiduciary. This document is for information purposes only and does not constitute an invitation or inducement or an offer or commitment, a solicitation of an offer or commitment, or any advice or recommendation, to conclude any transaction.

While information herein has been obtained from sources believed to be reliable, no liability is accepted if this is not the case. Accordingly, we do not represent it to be accurate or complete. The information contained herein includes illustrations, estimates and projections and involves significant elements of subjective judgment, assumptions and analysis. Any views or opinions (including illustrations, estimates, statements or forecasts) constitute our judgment as of the date indicated and are subject to change without notice. No representation is made as to the accuracy of such illustrations, estimates or projections or that all assumptions relating to them have been considered or stated or that such projections or returns will be realised. The returns or performance results may be lower than estimated herein. The information contained herein does not purport to contain all of the information that may be required to evaluate such solutions and you are encouraged to conduct independent analysis of the data referred to herein. We do not undertake to update this document.

Before you enter into any transaction, you should ensure that you fully understand the potential risks and rewards of that transaction and you should consult with such advisers as you deem necessary to assist you in making these determinations. No reliance should be placed on any representation or undertaking inconsistent with the above paragraphs. Notwithstanding the confidential nature of this document and its contents, if required by any applicable law or regulation we may disclose to any and all persons, without limitation of any kind, the tax treatment and tax structure of the transaction(s) contemplated herein and all materials of any kind that are provided to you relating to such tax treatment and tax structure. This document is not intended to be and must not alone be taken as the basis for a decision to enter into any transaction which may be described herein.

By accepting delivery of this document, the recipient agrees not to reproduce or distribute this document in whole or in part and not to disclose any of its contents (other than to obtain advice on it from a legal, business, investment or tax advisor) without the prior written consent of Pension Corporation.

No person has been authorised by Pension Corporation to give any information or make any representation concerning any transaction that may be described herein other than the information contained in this document and if given or made, such information or representation must not be relied upon as having been so authorised.

Recipients of this document should not treat its contents as advice relating to legal, taxation or investment matters and are advised to consult their own professional advisers concerning any transaction that may be described herein.

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Aggregating Longevity Risk for the Capital Markets A Necessary First Step 5 th International Longevity Risk & Capital Markets Solutions Conference JP Morgan