When it came to creating a bond to tackle the thorny issue of longevity risk that pension funds face, BNP Paribas drew on the broad talents and outlook of its global risk solutions team, as Geraldine Lambe explains.
The world’s great engineering projects have solved what seemed like intractable problems: for example, the Suez Canal changed the course – literally – of world trade. Financial engineering has to be no less ingenious. Finished products must match the needs and whet the appetite of all financial markets participants if they are to gain traction. And, while all banks pride themselves on being creative, being first to market does not always make that balance easy to achieve.
BNP Paribas’s longevity bond bears all the hallmarks of innovative engineering, not least because it is tuned to one of the most thorny issues facing the developed world: the pensions crisis. Not only are many pension funds underfunded, but also trustees face growing longevity risk. As the life expectancy of fund beneficiaries increases, so does the problem of adequately funding their retirement. According to the UK’s Office for National Statistics (ONS), life expectancy for men aged over 65 has, in some groups, risen by up to 30% since the late 1970s.
Mirroring liability
The financial markets have developed solutions for interest rate and inflation risk, market risk and currency risk. Now, with the design of a longevity bond, BNP Paribas reckons it has completed another part of the puzzle. The bond’s cash flows are designed to mirror a pension fund’s liabilities for a specific group of its members – namely, the 65-year-olds who will retire in a given year and payouts are determined by that group’s mortality rate.
As with any great engineering project, the development of the longevity bond has had to draw on multiple skills. The solution was only possible, says Denis Autier, head of global risk solutions (GRS) at BNP Paribas, because of the make-up and no-holds-barred approach of the bank’s risk team – whose members include financiers, insurance specialists, accountants, actuaries, and tax and regulatory experts. “Many of today’s issues go beyond product silos. This solution emerged because our team is not constrained by a narrow mandate,” he says.
Using indices as a basis
Because assessing longevity risk is based on the measurement of mortality, previous schools of thought have centred on insurance-based solutions. BNP Paribas’s ‘eureka’ moment came when GRS team member Tim Cox (a life reinsurer before going into banking 13 years ago) realised that pension longevity risk could be hedged without using indemnity insurance. Instead, the bank has based its solution on two annual indices: the expected mortality rates produced by the Government Actuary’s Department (GAD) and the actual mortality rates published by the ONS.
“We have taken an insurance-type risk and have translated it to the form of an index. Once you are measuring against a publicly available index, you are able to build financial products. The longevity bond utilises both banking and insurance expertise,” says Mr Cox.
The performance of the “mortality index” determines investors’ returns: coupon payments are, in this case, pegged to the cumulative survival rate published each April by the ONS (where the figures released in 2005, for example, will show the actual death rate for calendar year 2003).
In the first year, investors – pension funds – receive payments that reflect the actual mortality rate, so if 1.5% of 65-year-old pensioners die, the coupon payment in year one will be 98.5% of a fixed annuity determined from the GAD’s expectation of future mortality. If the death rate slows, the coupon payments will be higher and go on for longer, just as pension schemes’ payments will be higher and go on for longer.
Framed in this way, it appears to be a simple solution, so why has no-one thought of it before? Mark Azzopardi, head of insurance and pensions in the GRS team, says it is a matter of certain industries working with the technologies with which they are comfortable. “It is the insurance industry that has the skills to measure and collect the necessary data, and it has traditionally worked with indemnity-based models. It was not used to thinking in terms of an index methodology.”
Different basis risk
Although the longevity bond has a similar effect to that of an indemnity solution, there are differences, particularly in terms of basis risk – the chance that the hedge will not perfectly match the underlying risk. In this case, it is the difference between the mortality rates of pension fund beneficiaries and that of the UK government’s figures, which is a measure of the entire population. Evidence suggests that the people most likely to take out pensions tend to live longer than the country’s population as a whole.
“The amount of basis risk depends on the make-up of each fund’s portfolio,” says Mr Azzopardi. “But because the index essentially maps a trend, as long as the trend [in other words, the mortality curve] is relatively close to that in the portfolio, then it is a pretty good hedge.”
While the longevity bond is a clever solution to one of the pension industry’s ills, there are some significant hurdles to be overcome before it can get off the ground. The size of the first issue, which is to be carried out on behalf of the European Investment Bank to help it comply with the EU’s recommendation that it play a role in alleviating Europe’s pensions crisis, is a clear indication of one problem: the apparent lack of capacity for absorbing this type of risk. In this instance, BNP Paribas is hedging its longevity risk through PartnerRe, a Bermuda-based reinsurer. But, at Ł550m, the first longevity bond represents only a drop in the ocean of the UK’s outstanding pension liabilities.
The market welcomes any attempt to address longevity issues but most participants are sceptical that sufficient capacity can be found to absorb the risk in this way; some have also suggested that a means must be found to disperse the risk throughout the financial system rather than concentrate it with a reinsurer.
BNP Paribas acknowledges that capacity has been one of the biggest hurdles in developing the product. “Finding the capacity has been one of the most difficult challenges,” says Mr Cox. “It took us about one year to find PartnerRe but they liked the idea straight away. We have spent about six months working on the structure. Then it was just a question of how much capacity PartnerRe would provide and at what price.”
BNP Paribas is unsure where future capacity will come from or how much is out there. But the bank is certain that bringing such a product to market will stimulate debate and help to jog companies out of their inertia. “This bond is a marker for the future,” says Mr Autier.
Additionally, the bond has three characteristics that should at least pique longevity capacity providers’ interest. First, because there is less volatility in the index of the population as a whole, firms have to set aside less capital. Similarly, it is cheaper for an insurance company to analyse an index once a year than to reference an entire portfolio, therefore an index-based solution is cheaper to provide. “And if a company doesn’t have a foothold in a particular insurance market, then this sort of product provides a relatively quick entry,” says Mr Azzopardi.
Complex marketing
If perfecting the design of the product and sourcing the risk appetite were not enough, the bank still had to sell the idea to the pension schemes it was designed to help. First, says Mr Cox, this is made more complicated by the actual size of the issue.
“This is partly because pension funds assess the product on the material impact it will have on their portfolios and the first issue is only Ł550m, so can only have a limited effect,” he says.
The marketing process is also made more complex because there are four constituencies to whom BNP Paribas has to sell the idea. “The fund’s trustees make the investment decisions but are not financial specialists, so they rely on the second constituency: the actuarial consultants. We also have to talk to the fund manager and the company whose pension scheme it is,” says Mr Cox.
It is not just BNP Paribas that has had to think “out of the box”, says Mr Autier. “This is a very evolutionary product and it doesn’t fit neatly into any box. The bond investors have to possess various different skills in order to assess this product and investment in it may not be allowed under the terms of the mandate. Funds may therefore need to change the structure of their mandates in order to invest in a longevity bond.”
The marketing effort is still under way and the team is still talking to possible investors – it hopes to go to market in early 2005.
“We have spoken to about 100 companies so far, and they are now in the process of assessing the bond’s potential,” says Mr Autier. “We are still on the road most of the time.” And it has been a long road, indeed.
