EUROPEAN PAPERS ON THE NEW WELFARE

Longevity, Systemic Models and Business Risk

Those older than 65 account for 60% of the expenditure: it is clearly possible to define a reasonably sound quantitative model relating the increase in longevity to the increase in expenditure and, consequently, to earnings.
Moreover, since at present there there is a clear and acknowledged gap between structural supply and demand, those who operate on the supply side may achieve interesting — perhaps temporary — benefits in the form of low financing costs in the long and very long run, i.e. a position in the rate curve which for the private fund-seeker is always difficult to reach and entails high costs.
It was not by chance that in 2004 the EIB tried to issue longevity bonds at a price 20% lower that its usual standard price: it was probably excessive but obviously it will take a long time before a general understanding of fair issue pricing is achieved.
As regards the pharmaceutical industry, it seems clear that one can speak of a real relation between assets and liabilities. In this case, assets are not meant to be specifically identified items in the balance sheet: if one wished one could think of the cost of research and development, which are the primary origin of new medium-term gains.
However, the profits of a business over T+1 time by definition derive from its investments (both tangible and intangible, recorded and unrecorded) in previous T periods, in other words they emerge from the asset side of the statement of assets and liabilities, though they may not be reflected in the accounts prospectus..
Mutatis mutandis, the situation does not look too different from that of inflation connected to public utilities, although in the case of the pharmaceutical industry the assessment of the longevity/proceeds relationship is obviously less clear-cut than that of inflation/utility.
The fact that utilities manage to link their proceeds to inflation provided the management with an important source of products linked to inflation, and risks were eventually allocated to subjects operating with liabilities naturally connected to inflation.
It may be maintained that the inflation-linked market developed precisely when this hedging mechanism was put into motion together with the natural provider of cover. Obviously, not all pharmaceutical companies are the same in terms of their product ranges. The roles they play depend not only on their financial structure and propensity towards running into debts, but also on their corporate core business, since the consumption of certain types of medicines is particulary linked to the extension of human life and consequently to a population structure marked by a higher average age, with a significant incidence of older age groups.
It seems difficult to identify other sectors which are as important and in which the correlation with longevity appears to be as significant. Another interesting example of liabilities, financial in nature though belonging to a niche, naturally linked to the longevity risk could be provided by reverse mortgage. The product has already become common on the Anglo-Saxon markets and allows a person normally of advanced years to take out a loan against real estate, amounting to a share of the real estate’s value. The money is repaid from the sale of the real estate when the beneficiary passes away, or it is repaid by his or her heirs wishing to buy the real estate. Clearly, in this case the total margins of the operation (though not the annual ones) last the length of the beneficiary’s life after the loan has been made; this is economic and not financial hedging.
In contrast to the case of inflation, unfortunately the State is not a natural issuer, although it has ideal characteristics in terms of minimising the credit risk: obviously the state is already overexposed to the longevity risk owing to its implicit and explicit pension burden. In any case, during the initial stage, the state could issue bonds to foster the development of a very important market, if its balance sheet would be only slightly affected.
For the creation of a market, issuers, investors, ‘speculators’ and even arbitragistes, are required or there will be insufficient operational structures and critical mass needed to develop attractive liquid markets: after all the huge power of derivative markets derived from their formidable liquid assets.
Investors operating with groups of assets not linked to the market activity and characterised by beta estimates approaching zero, such as traditional hedge funds for example could be interested parties. We believe that there is room for investments banks, which bear huge risks, to create books (albeit initially small) that are not systematically covered. Since this was the case with inflation, which is a major part of the real economy rather than financial the same could happen with longevity in the future.
Among the first criticisms levelled at longevity bonds is that they are basic risk carriers and, in the light of their duration, they entail a marked credit risk. In developed derivative markets tools are found to manage basic risk, which in any case is a fraction of the total risk, especially in a high correlation environment such as the phenomenon of the extension of human life. Furthermore, the price of cover may adjust and remunerate the risk: if less cover is provided, it must cost less. In contrast, tools for managing credit risk are now almost standard, such as credit default swap and collaterals, which would be useful to support issuing longevity bonds.
The experience of derivative markets teaches us that reaching a ‘critical mass’ in terms of operators and volumes is vital: from that stage onwards the problem lies with controlling development.
In addition to technical aspects — however important they may be — we think that a basic prerequisite can be identified: the mindset of operators should not be such as to lead them to believe that by ‘betting’ against longevity losses are inevitable, regardless of the base value set. In this case, whenever we identify a natural hedger such as the pharmaceutical industry, why should it have to self-finance at a cost that ex post would be perceived to be systematically higher?


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