On A Long Enough Timeline…

Articles that talk about risk usually catch my attention.  I recently came across a piece that focused on an often overlooked risk:  longevity.  Risk management is critically important in portfolio structuring.  The following is an excerpt from the Dow Jones column:

New proposals from a group of banks and insurers, the Life and Longevity Markets Association, mark a step towards turning the risk of people living longer into a tradable derivative.  Globally, more than $17 trillion of pension assets are exposed to longevity risk, estimates Swiss Re.

Previous securitization attempts have been unsuccessful. A European Investment Bank ‘longevity bond’ aimed at hedging pension schemes’ and insurers’ longevity exposure was pulled from launch in 2005. Pension schemes complained the price of hedging the risk was too high and the profiles of their individual members differed too much from the bond’s underlying index.

The LLMA believes derivatives could be more successful. It aims to start in the U.K., Europe’s most developed market, but other national indices could follow. Index hedges are more transparent and liquid than bespoke insurance, and they require less capital upfront than bonds. Their lack of correlation with other asset classes makes them potentially attractive to hedge funds.

The problem with hedging longevity risk is that it requires a significant time period to play out.  Things change during the course of that time. Life expectancies change.  Population dynamics change.  Knowledge and science changes.  To “hedge” for the next 78 years—the current life expectancy in the United States—is not hedging, its speculation.  And there is nothing more wrong with speculation than to mistake it for hedging.

Currently, trustees of pension schemes use insurance contracts to hedge this risk (also speculation).  This is a customized process that doesn’t lend itself to future adaptations because continuously repositioning in order to mirror the ongoing population changes is cost prohibitive.  Creating a more liquid market in which hedge funds will take the other side of your “hedge” likely means two things:  you shouldn’t be “hedging” and there is a lot more speculation going on that meets the eye.

I’m not sure you can truly hedge longevity… not for any significant amount of time, anyway.  And that kind of defeats the purpose.  It may just be a risk that we need acknowledge and live with.

Links
http://online.wsj.com/article/SB10001424052748704644404575481410626113330.html

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