EUROPEAN PAPERS ON THE NEW WELFARE

Longevity, Systemic Models and Business Risk

12. Reinsurance

Reinsurance is a traditional tool of the insurance market, especially in accident insurance, in some ways comparable to capital owned by third parties, which in the case of longevity seems to have suffered and still be suffering from a sharp lack of supply.
We believe that some of the points made in the present analysis may be valid also for reinsurers and that the development of a reinsurance market is vital also in relation to the topic dealt with below.
The first step — which was insufficient albeit daring — accompanying the 2004 attempted issue of longevity bonds by the European Investment Bank — and above all the fascinating idea of a longevity market, as shown below — raises hopes of possible medium-term developments also in this field.
Limiting the duration of the expected lifetime of the contract and anchoring it to an index and not a given population seem to be the steps required from reinsurers for the development of reinsurance relations. The world of unpaired annuities — where the expected life of those insured is shorter — is also about to enjoy the benefits of a reinsurance approach.
Much is required from reinsurers in terms of research and development of new solutions: perhaps competition in a sufficiently developed longevity market might stimulate the players in this sector.
In contrast, unfortunately, we think that the management of traditional assets does not look as promising as a source of cover, since it is hard to identify direct investment tools which increase revenue so as to deal with possible losses generated by the longevity risk.
For example, direct investment in the care for the aged would be exposed to other forms of risk which are neither diversifiable nor immunisable, i.e. all the other risks typical of this sector of operation.
The same holds true of investments in pharmaceutical shares, and of the topics discussed below: direct hedging through the purchase of shares issued by pharmaceutical companies is unfeasible, since investors would be exposed to undesired incremental risks which could annul the effects of cover.
To conclude this short analysis, we believe that all the tools described here, considered jointly, can make the risk reasonably manageable so long as they are included in an adequate organisational context which, as already acknowledged in the case of other risk sources, plays a fundamental role in developing the correct cultural and suitable operational mechanisms. We stress the adverb jointly because longevity is not and never will be a world of ‘killer applications’, which are after all rather simple, not to say banal, solutions. The longevity risk can be effectively managed only through an articulated ‘blend’ of skills and technical approaches on the one hand and managerial vision and tools on the other.
An adequate but sustainable strategy of contingency loading, flexible articulated products included in suitable supply packages may be the correct approach to potentially profitable risk management on the part of insurance companies, the natural bearers of the risk and professional interface with the client. However, when longevity becomes an issue of general interest and epoch-making importance, we cannot manage without the contribution provided by the possibility of opening a widespread market.

13. The hypothesis of a longevity market

The hypothesis of creating a longevity market, i.e. a virtual place where operators originally not involved in the issue start investing and take on the risk, is fascinating and systemically necessary and is a great challenge. All those who for any reason participate in the world of longevity should feel stimulated by it.
Of course there are significant obstacles, but the correct intellectual and operational attitude is needed to face them.
Isn’t there sufficient available data? It can be created gradually by calling upon all the players involved.
Isn’t there a revenue culture in both supply and demand?
This goal can be achieved slowly, but continuously and determinedly.
Don’t investors demand why longevity investments are not included in management mandates and benchmarks? The solution entails highlighting the possible value of a group of assets completely unrelated to traditional financial variables, which in general are widely appreciated by certain kinds of investors.
Do the first attempts fail? They will be useful lessons for the future and not unappealable sentences.
After all, the history of the derivatives market is riddled with operational segments and experiences which proved successful over time by overcoming obstacles or very real failures which seemed insurmountable and final.
The natural ‘prime mover’ syndrome must be overcome, since the perception is that risks are more numerous than benefits for those in the vanguard in a world full of repetition.
An interesting scientific literature on the subject of longevity bonds has begun to emerge, a fundamental prerequisite for the development of derivatives markets, as is shown by experience of the Black and Scholes model — now an integral part of the history of economics and economic theory and the birth of which as a reference scheme was crucial to the development of derivative shares.
We refer in particular to the recent work by Blake and his co-authors17, who consolidated older research and identified a series of derivatives connected to longevity, though not necessarily related to cash shares, following the model of traditionally well-known shares: swaps, futures, options, caps, floors etc.
Literature is beginning to appear in more weighty and widely circulated magazines18, and this is also an encouraging — if somewhat timid — sign.
As regards issuers, we believe that a fundamental role can be played by operators who profit from an increasing life expectancy, i.e. all those who have a customer life time value strongly sensitive to the increasing life expectancy. The importance of the role played by such operators, who might be termed longevity risk ‘natural hedgers’ lies in the fact that they could contribute to the overcoming of the chronic lack of reinsurance supply, and could even be a natural competitor marked by a competitive edge which cannot be replicated.
At this point, mention should be made of the pharmaceutical industry for which:
• presumably there exists a complex but steady long-term functional correlation between ageing of the population and the value that can be created by the industry;
• the relation works in two ways: not only is ageing the precondition for the creation of value, but it is also partially the result of the value that was created: according to some researchers, approximately 40% of the years in an average life gained between 1986 and 2000 in the US may be traced to the introduction of new medicines;
• the invested capital is significant, tends to grow, covers long time spans and debt obviously useful as a source of funding, if only to streamline the capital structure;
• the size, reliability and sophistication of businesses are noteworthy and are an important factor in the creation of potentially large markets.
It is well known that the consumption of medicines grows exponentially among the elderly: in Italy, in 2004 a patient of over 75 years of age, assisted by the national health service cost 11 times as much as a person between the ages of 25 and 3419.

17 E.g. “Living with mortality”, which was cited above.
18 E.g. “Life and pensions”.
19 Source: Italian Higher Health Care Authority.


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