Longevity Risk from the Perspective of the ILS Markets

LANE FINANCIAL L.L.C.

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Longevity Risk from the Perspective ofthe ILS Markets

Morton N Lane Ph. D.

Director, M Sc in Financial Engineering,University of Illinois

President, Lane Financial LLC

Sixth International Longevity Risk and Capital Markets Solutions ConferenceSeptember 9,10th, 2010Swiss-Grand resort and Spa, Bondi Beach, Sydney, Australia


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Longevity Risk from an ILS Perspective - Size

The Natural Catastrophe Market is tiny compared to Life

Accumulated Issuance* in the past 15 years is $30 - $40 Billion

$12 Billion is currently outstanding

About 10% of the issuance has been in Extreme Mortality

* The universe under consideration is all bonds that contain a risk analysis, i.e. where there is an Expected Loss


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Longevity Risk from an ILS Perspective; Exchange, Origins

The ILS market started with the Loss from Hurricane Andrew in 1992. A market born out of disaster and commercial necessity

Its first incarnation was an Exchanged Traded Option (at CBoT)

The CBoT market died after 5 Years (Soft Market)

Since then, Exchanges have been tried in New York, Bermuda London and again in Chicago. All would have enabled public access.

None has (robustly) succeeded

The wrong Economics? Auctions?


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Longevity Risk from an ILS Perspective - Indices

The following loss measures have been used on the Exchanges,

Loss ratios

PCS Industry Numbers (by region and proportionate to loss)

Guy Carpenter (customizable) loss ratios

PCS Industry Numbers (by region and binary event)

Hurricane Index formula (based on storm Intensity)


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Longevity Risk from an ILS Perspective - Indices

Private transactions have used all the preceding loss indicesplus, Sigma, Munich Nat Cat Services, plus

PCS Industry Numbers (modeled to book), PERILS

Parametric earthquake measures, Wind speedsParadex, AIR, Modeled Loss, Computer modeled replications of cedants book

To paraphrase Lance Armstrong, Its not about the IndexIts about the need – or opportunity If the need is there, almost any index will do – Cat in the Box

Better Indices are good, but will not provide the tipping point.20-30% of annual issuance remains indemnity based.


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Longevity Risk from an ILS Perspective – Event Driven

The development of Cat bond has been event driven more than anything else.

What are the extreme events that will drive Longevity risk?

Two that I believe stimulated the first mortality bonds were,Terrorism (dirty bombs) and Pandemics

Swiss Re issued the first Mortality Bond the year after theSARS outbreak and a little over 2 years after 9/11


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Longevity Risk from an ILS Perspective – Event Driven

Nearly 90% of all Cat ILS are Occurrence based

Aggregate covers, even erodible thresholds are not popular

They are subject to greater secondary market fluctuation

What are the “Occurrence” event risks that need be transferredby annuity/pension providers?

Cure for Cancer, Diabetes Pill, Shifts in Trend?


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Longevity Risk from an ILS Perspective – Capital or Risk?

If the longevity risk has to be transferred because of mandateor a desire to write or hold a bigger book

A sidecar, or quota share to a more appropriate analog than ILS

Sidecars have worked well to increase capacity in a hard market. They do not serve to reduce risk in the retained book

Sidecars are not wanted when capital is plentiful (even to generate fees)

Swaps which substitute fixed for floating seem like finite reinsurance?


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Longevity Risk from an ILS Perspective – Bonds or Swaps

Most ILS issuance has been done in the form of Bonds not SwapsBonds allow for distribution to many investors; Swaps tend to be private 1:1 transactions or club transactions

Swaps depend on the rating of the counterparty, not the swap itself.Also, if they need to be reversed, its usually the same counterparty

Bonds Ratings make for wider investor based distributionSeparately rated tranches also allow access to conservative and more risk taking investors. Specialist and opportunistic investors

Rated Bonds also allows secondary market trading – necessary for hedge fund valuationsLiquidity for all investors is in very high demand


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Longevity Risk from an ILS Perspective – Bonds or Swaps

ILS structures have eschewed swaps since the Lehman Default

90% of all issues since the end of 2008 have avoided swaps (priorto 2008, 90% contained swaps)

Where swaps are used they heavily collateralized and managed

ILS investors at present do not want counterparty credit risk


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Longevity Risk from an ILS Perspective - Term

ILS investors and issuers like short terms – the average maturity is between 2 and 3 years. Investors also dislikelong development period. This is a necessary component of indemnity- based bonds, even PCS.

The longest ILS issued was 10 years. One three year bond took sixyears to close – without an ultimate loss. Dead Capital, frozen collateral.

Notwithstanding, the ILS market has been established, participants behave rationally through the cycle

Maturities are extended in soft markets, shortened in hard onesTerms and conditions tighten in hard markets , get more relaxed in soft markets. e.g. more perils added


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Longevity Risk from an ILS Perspective - Price

ILS investors require a high price to accept a risk, even adiversifying one

Multiples of expected loss range from 2 to 20 times

Multiples will be higher in hard markets

Are cedant’s prepared to pay?


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0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10

Mul

tiple

Expected Loss at Issue

Multiple of Expected Loss on all ILS Issuesvs.

Expected Loss

2004 to Q2, 2010



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Total Issuance Ext Mrt

Emb Val

Issue Sprd

Sprd EV EL Mrt

Multiple

20022003 $400,000 $400,000 1.35% 0.02%20042005 $952,000 $362,000 $590,000 1.45% 0.71% 0.06% 22.62006 $852,424 $852,424 1.82% 0.13% 14.52007 $629,152 $629,152 0.30% 0.03% 9.02008 $100,000 $100,000 1.35% 0.05%2009 $75,000 $75,000 6.50% 0.46% 14.12010 $50,000 $50,000 5.25%

Total Issuance $3,058,576 $2,468,576 $590,000 1.50% 0.71% 0.08% 18.7



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-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

Perc

enta

ge R

etur

ns (M

onth

ly)

Monthly All CAT ILS and Life Total Return Performance

2002 - Q2/2010All CAT Total Return Avg 0.668% Std Dev 0.759%Life Total Return Avg 0.370% Std Dev 0..470%

Annual EquivalentsAvg 8.02% Std Dev 2.628%Avg 4.439% Std Dev 1.628%

All CAT Total Return

LIFE Total Return



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-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%


Perc

enta

ge R

etur

ns (M

onth

ly)

Monthly All CAT ILS vs. Life Finance Return Performance

2004 - Q2/2010All CAT Finance Return Avg 0.242% Std Dev 0.244%Life Finance Return Avg 0.248% Std Dev 0.146%


Floating Rate (LIBOR and/or Money Rate) (includes Price Loss on 4 Bonds which had Lehman as TRS Counterparty)

Life Financing



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-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%


Perc

enta

ge R

etur

ns (M

onth

ly)

Monthly All CAT ILS vs. Life Insurance Return Performance

2004 - Q2/2010All CAT Insurance Return Avg 0.426% Std Dev 0.682%Life Insurance Return Avg 0.116% Std Dev 0.523%


All CAT Insurance Return

LIFE Insurance Return



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-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%


Perc

enta

ge R

etur

ns (M

onth

ly)

Monthly All CAT ILS vs. Life Insurance Return Performance

2004 - Q2/2010All CAT Insurance Return Avg 0.426% Std Dev 0.682%Life Insurance Return Avg 0.116% Std Dev 0.523%


All CAT Insurance Return

LIFE Insurance Return



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Mortality Bonds Trade with the Market

Absent Financing Rates Cat has Higher Returns

Most Cat bonds are Issued in the BB range

Most Extreme Mortality Bonds issued AA Range

Total Returns for CAT are therefore Double Life Returns

Deduct Financing - the “Insurance” Return is 4 times

Broadly the Bonds move in tandem –whether CAT or Life

Katrina affected Life and ILS – Hard Market

Lehman - both CAT and Life succumbed to Liquidity and CDS

Independent Life Behavior observed with H1N1 concerns


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END

[email protected]@illinois.edu


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Documents

Longevity Risk from the Perspective of the ILS Markets