Longevity risk is one of the burning topics in the world of investment. Pension funds would dearly love to protect themselves against it. Investment banks have laboured for years to devise such protection. So far, nothing much has emerged.

Yet it is easy enough to envisage how such a market might work. All it takes is enough liquidity to form market prices, so that investors can buy and sell in the usual way. The question is how to kick-start the whole process.

To illustrate the difficulty, let us look at how some existing classes of derivatives work, and how longevity might fit in. In each case, the crucial question is how the provider of protection hedges the risk.

Class I: An investment bank offers protection on a security or an index, such as the FTSE 100. It then hedges its position through the cash market. In longevity, there is no cash market.

Class II: The bank offers protection against moves in interest rates, and hedges in the interest rate futures market. There is no longevity futures market. In theory, one could be formed – but only once the derivatives market was running.

Class III: The bank offers protection against inflation. To hedge this, it gets access to an inflation-proofed cash flow, for instance from a utility. There are no longevity-proofed cash flows.

Class IV: The bank finds natural buyers and sellers of the same class of risk and brings them together, as with weather derivatives. A Florida orange grower is nervous of frost, while a neighbouring electricity supplier is nervous of a warm spell. So one pays the other if the temperature is above or below a specified level. The two risks cancel out.

On the face of it, Class IV sounds promising. Pension funds and life insurers face longevity risk of opposite kinds. In bald terms, life insurers want you to die old, while pension funds want you to die young.

Therefore, some argue, they are a natural match. Others are less sure. The steep falls in mortality rates in recent decades have been primarily among the old. Younger people still drive cars too fast, or face novel threats such as Aids. These are risks which concern the life insurers but do not affect pension funds.

Conversely, the pension funds have to worry about people living further into their eighties, but many of them will have collected on their life insurance already. So the two classes of risk are not so well matched as they look. Nevertheless, the thought is worth holding on to. The question, remember, is not how to match buyers and sellers in a developed market. It is how to develop the market in the first place.

Meanwhile, one interesting new arrival is the longevity swap, apparently on offer from some investment banks. This works in a way analogous to interest rate swaps, whereby a fixed rate is swapped for a floating one.

The fixed rate here is an agreed projection – say, over 25 years – of the annual mortality rate. The floating rate is the actual outcome. Both parties agree that – for instance – of 100,000 65-year olds, 2,000 should die in year one and so forth. If the figure turns out higher, one party has to put up collateral, and vice versa.

The mortality projections used are the result of complex actuarial calculations – in other words, a model. But all such markets start that way. As they develop, the model becomes redundant.

Thus, the weather derivatives market in the US, being only a decade old, still relies partly on actuarial models. But in interest rate futures, all that matters is the market price, which embodies all the models in use and strikes the balance between them.

If such a developed market existed for longevity, all kinds of advantages might follow. The various traded instruments could be packaged together, as with credit derivatives, then sliced and diced variously.

The package could be divided up by age groups, to suit individual pension funds’ exposure. Or by geography, so that a fund with members in an area with low life expectancy, such as Glasgow, could do deals with high expectancy areas such as the south coast of England.

That brings us back to our start. Establishing this market will be formidably difficult. But given the brain-power and potential profits, and the scale and variety of pent-up demand, it could happen sooner than we think.

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