Pension Advisory Group

Longevity and mortality risk management

q-Forwards:
Derivatives for transferring longevity
and mortality risk

• q-forwards are simple capital markets instruments for transferring longevity

and mortality risk. They are derivatives involving the exchange of the real-
ized mortality rate of a population at some future date, in return for a fixed
mortality rate agreed at inception
• q-forwards form the basic building blocks from which many other more com-
plex derivatives can be constructed July 2, 2007
• A portfolio of q-forwards can be used to provide an effective hedge of the
mortality risk of a life assurance portfolio, or of the longevity risk of a pen- Guy Coughlan
(44-20) 7777-1857
sion plan or annuity book guy.coughlan@jpmorgan.com
• Because investors require a premium to take on longevity risk, the mortality ALM & Longevity Structuring
forward rates at which q-forwards transact will be below the expected, or Pension Advisory Group
JPMorgan Chase Bank NA
"best estimate" mortality rates
• To create a liquid market requires, in the early stages, a limited number of David Epstein
standardized contracts in which liquidity can be concentrated. A set of q- (44-20) 7777-3805
forwards that settle based on the LifeMetrics Index could fulfill this role david.uk.epstein@jpmorgan.com
ALM & Longevity Structuring
• JPMorgan is committed to developing a market in LifeMetrics q-forwards
Pension Advisory Group
JPMorgan Chase Bank NA

Amit Sinha
(1-212) 834-4119
amit.sinha@jpmorgan.com
Introduction Pension Advisory Group
JPMorgan Chase Bank NA
Longevity and mortality derivatives are financial contracts that allow market par-
ticipants to either take exposure, or hedge exposure, to the longevity and mortal- Paul Honig
ity experience of a given population of individuals. For example, they enable pen- (1-212) 834-4589
paul.honig@jpmorgan.com
sion plans to hedge against increasing life expectancy of their members and life
Exotics & Hybrids Trading
insurers to protect themselves against significant increases in the mortality of poli- JPMorgan Chase Bank NA
cyholders. They also enable these risks to be transferred to financial investors.

Despite referencing an underlying exposure more commonly associated with the

life insurance industry, longevity and mortality derivatives are not contracts of
insurance. They are capital markets instruments which, in common with other
financial derivatives, have payoffs linked to the level of an index — in this case a www.lifemetrics.com
longevity, or mortality, index. Bloomberg: LFMT <GO>

This report has been prepared by the Pension Advisory Group, and not by any research department of JPMorgan.
Pension Advisory Group
q-Forwards: Derivatives for transferring longevity and mortality risk
The indices referenced in longevity and mortality deriva-
tives and securities could be either customized or stand-
ardized. Customized indices reflect the actual experience
of individuals associated with a particular exposure, such
as the policyholders of a life assurance book or the mem-
bers of a defined benefit pension plan. By contrast, stand-
ardized indices, in particular the LifeMetrics Index 1
(Coughlan et al. 2007), reflect the experience of a larger
population (e.g., the national population) and are calcu-
lated according to consistent and well documented meth-
ods.
q-forwards as building blocks
The simplest type of longevity and mortality derivative is a
mortality forward rate contract, which we call a "q-for-
ward". It is so named because the letter "q" is the symbol
used by actuaries to denote mortality rates2.
q-forwards are important because they form basic building
blocks from which other, more complex, life-related deriva-
tives can be constructed. In particular, a portfolio of q-
forwards, appropriately designed, can be used to replicate
and to hedge the longevity exposure of an annuity book or
a pension plan. Similarly, an appropriately designed portfo-
lio of q-forwards can be used to hedge the mortality expo-
sure of a life assurance book. In addition, portfolios of q-
forwards can hedge many of the life-contingent risks asso-
ciated with life settlement investments and reverse (or eq-
uity release) mortgages.
Definition of a q-forward
A q-forward is an agreement between two parties to ex-
change at a future date (the maturity of the contract) an
amount proportional to the realized mortality rate of a given
population (or subpopulation), in return for an amount pro-
portional to a fixed mortality rate that has been mutually
agreed at inception. In other words, a q-forward is a zero-
coupon swap that exchanges fixed mortality for realized
mortality at maturity. This is illustrated in Figure 1. The
reference rate for settling the contract is the realized
mortality rate as determined by the appropriate index, such
as the LifeMetrics Index.
In a fair market, the fixed mortality rate at which the trans-
action takes place defines the "forward mortality rate" for
the population (or subpopulation) in question. If the q-for-
1
Available at www.lifemetrics.com
2
More precisely qx denotes the probability of an individual aged x
dying within the next year.
2
July 2, 2007
Guy Coughlan
David Epstein
Amit Sinha
Paul Honig
Figure 1: A q-forward exchanges fixed mortality for
realized mortality at maturity of the contract
At maturity: Notional x 100
x fixed mortality rate
Counterparty A Counterparty B
(fixed rate payer) (fixed rate receiver)
Notional x 100
x realized mortality rate
ward is fairly priced, no payment changes hands at the
inception of the trade. At maturity, however, a net pay-
ment will be made by one counterparty or the other.
Table 1 gives an example term sheet for a q-forward trans-
action, where the reference population corresponds to
65-year-old males in England & Wales. The q-forward payout
is determined by the value of the LifeMetrics Index for this
subpopulation at the maturity of the contract.
This transaction is a 10-year q-forward contract initiated
on 31 December 2006 and maturing on 31 December 2016. It
reflects part of a longevity hedge provided to a UK pension
plan. At maturity the hedge provider (the fixed-rate payer)
pays to the pension plan an amount proportional to a fixed
mortality rate of 1.2000%. In return the pension plan pays
to the hedge provider an amount determined by the refer-
ence rate at maturity, which corresponds to the most re-
cent value of the LifeMetrics Index reflecting the realized
mortality rate for 65-year-old males in England & Wales. Be-
cause of the ten-month lag in the availability of official data,
settlement on 31 December 2016 will be based on the
LifeMetrics Index level for the reference year 2015.
The settlement that takes place at maturity is based on the
net amount payable and is proportional to the difference
between the fixed mortality rate (the transacted forward
rate) and the realized reference rate. Table 2 shows the
settlement calculation for different potential outcomes for
the realized reference rate. If the reference rate in the
reference year is below the fixed rate (i.e., lower mortal-
ity) then the settlement is positive, and the pension plan
receives the settlement payment to offset the increase in
its liability value. If, on the other hand, the reference rate
is above the fixed rate (i.e., higher mortality) then the set-
tlement is negative and the pension plan pays the settle-
ment payment to the hedge provider, which will be offset
by the fall in the value of its liabilities.
Pension Advisory Group July 2, 2007
q-Forwards: Derivatives for transferring longevity and mortality risk Guy Coughlan
David Epstein
Amit Sinha
Paul Honig

Table1: An illustrative term sheet for a single q-forward to Hedging longevity risk with q-forwards
hedge longevity risk
Longevity risk is the opposite of mortality risk, namely, the
Notional Amount GBP 50,000,000 risk that people survive longer than expected, because re-
alized mortality rates are lower than expected. This is the
Trade Date 31 Dec 2006
risk faced by pension plans, annuity providers, life settle-
Effective Date 31 Dec 2006 ment investors, etc. To hedge the longevity risk of its pen-
Maturity Date 31 Dec 2016
sion liabilities a pension plan could enter into a portfolio of
q-forward contracts in which it receives fixed mortality rates
Reference year 2015
and pays realized mortality rates (see Figure 3). This portfo-
Fixed Rate 1.2000 % lio would involve q-forwards referencing both males and
Fixed Amount Payer JPMorgan females across a range of different ages and maturities.

Fixed Amount Notional Amount x Fixed Rate x 100

Why does receiving a fixed mortality rate and paying a real-
Reference Rate LifeMetrics graduated initial mortality rate for 65-
ized mortality rate provide a hedge of longevity risk? Since a
year-old males in the reference year for England &
Wales national population pension plan must pay out pension benefits to its members
Bloomberg ticker: LMQMEW65 Index <GO> on the basis of realized longevity, the obvious hedge is a
Floating Amount XYZ Pension derivative contract in which the pension plan receives a
Payer
realized survival rate and pays a fixed survival rate. But not-
Floating Amount Notional Amount x Reference Rate x 100
ing that one-year survival rates are given by 1−q, then it is
Settlement Net settlement = Fixed amount − Floating amount evident that paying fixed survival (essentially paying 1−qfixed)
is equivalent to receiving fixed mortality (essentially receiv-
ing qfixed).

Table2: An illustration of q-forward settlement for various

At maturity, the hedge will pay out to the pension plan an
outcomes of the realized reference rate. A positive
(negative) settlement means the fixed-rate receiver amount that increases as mortality rates fall to offset the
receives (pays) the net settlement amount. correspondingly higher value of pension liabilities. So, a
pension plan wishing to hedge longevity risk would receive
Reference Rate fixed (and pay realized) mortality in a q-forward contract.
(Realized Rate) Fixed Rate Notional Settlement
1.0000 % 1.2000 % 50,000,000 10,000,000 A portfolio of q-forwards provides a value hedge for pension
1.1000 % 1.2000 % 50,000,000 5,000,000 liabilities. In other words, it stabilizes the value of pension
1.2000 % 1.2000 % 50,000,000 0 liabilities at some future date (the hedging horizon) with
1.3000 % 1.2000 % 50,000,000 -5,000,000 respect to changes in mortality rates (and hence longev-
ity). The hedging portfolio's value will increase as realized
mortality falls over the horizon. By carefully calibrating the
hedging portfolio it can provide an effective hedge of the
pension liabilities due to:
Hedging mortality risk with q-forwards
Mortality risk reflects the potential for mortality rates to • The realized survival rate over the period being different
be higher than expected. This is the risk faced by life insur- from expectations
ance companies. In particular, if mortality rates are higher • Changes in expectations about future trend improvements
than expected then a life insurer must pay out a larger in mortality rates beyond the hedging horizon, due to
amount than expected in death benefits. To hedge this risk the realized mortality experience over the horizon
the insurer could enter into q-forward contracts in which
it pays fixed mortality rates and receives realized mortality
rates. At maturity, the hedging contract will therefore pay Population basis risk
out to the insurer an amount that increases as mortality In any situation involving the hedging of mortality and lon-
rates rise to offset the correspondingly higher payout on gevity exposure, there is the potential for a residual basis
the life portfolio. This is illustrated in Figure 2. risk due to the mismatch in the populations of the expo-

3
Pension Advisory Group July 2, 2007
q-Forwards: Derivatives for transferring longevity and mortality risk Guy Coughlan
David Epstein
Amit Sinha
Paul Honig

Figure 2: A q-forward contract to hedge the mortality risk Figure 3: A q-forward contract to hedge the longevity risk
of a life insurer. of a pension plan (or an annuity book).

Notional x 100 Notional x 100

x fixed mortality rate x realized mortality rate

Life Insurer JPMorgan Pension Plan JPMorgan

Notional x 100 Notional x 100

x realized mortality rate x fixed mortality rate

sure and the hedge. This basis risk reflects the difference
in longevity/mortality experience between the population
of individuals associated with the hedging instrument and
the population of individuals associated with the underly-
ing exposure. Note that basis risk does not necessarily mean
that the hedge is ineffective: indeed the effectiveness of
the hedge can still be very high. Basis risk can be managed
and minimized by careful design and calibration of the hedge.
Pricing q-forwards
The pricing of q-forwards is similar to the pricing of other
forward-rate contracts, such as interest-rate forwards or
foreign exchange forwards. Because investors require com-
pensation in the form of a risk premium to take on longevity
risk, the mortality forward rate at which q-forwards will
trade will lie below the expected, or "best estimate", mor-
tality rate. This spread reflects the expected return to
investors and needs to be sufficient to provide a return-to-
risk ratio which is comparable with other assets.
The expected return for an investor, and the correspond-
ing cost to the hedger, of a q-forward is essentially just the
present value of the spread between the forward rate and
the best estimate rate at the maturity of the contract.
as an unbiased reference by all participants for the trans-
fer of mortality and longevity risk.
• In the early stages of the market's development restrict-
ing transactions to a limited number of standardized con-
tracts in which liquidity can be concentrated.
q-forwards based on the LifeMetrics Index can meet these
requirements for standardization, and at the same time pro-
vide sufficient flexibility to be effective hedges of the ac-
tual longevity and mortality exposure of specific pension
plans, annuity portfolios and life assurance books.
For example, a small set of standardized q-forward con-
tracts referencing the LifeMetrics Index can provide enough
flexibility to hedge a variety of different life contingent
portfolios. This set of standardized contracts has the fol-
lowing characteristics:
• A specific maturity (e.g., 10 years)
• Split by gender (Male, Female)
• Four age groups (50-59, 60-69, 70-79, 80-89)
Note that with just these eight contracts, it is possible to
provide an effective long-term hedge of the longevity risk
of a pension plan or annuity portfolio.

Liquidity and standardization References

An essential requirement for creating any new liquid mar- Coughlan, G.D. et al. (2007). LifeMetrics: A toolkit for meas-
ket is standardization. For longevity and mortality risk transfer uring and managing longevity and mortality risks. Techni-
this means two things: cal Document (JPMorgan: London, March 13, 2007).

• Having a standardized index (such as the LifeMetrics In- Loeys, J., Panigirtzoglou, N., Ribeiro, R.M. (2007). Longev-
dex) which is objective and transparent, and can be used ity: A market in the making. (JPMorgan Research Publica-
tion: London, July 2, 2007).

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