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Pension Advisory Group Longevity and mortality risk management

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

• 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- sion plan or annuity book

• Because investors require a premium to take on longevity risk, the mortality forward rates at which q-forwards transact will be below the expected, or "best estimate" mortality rates

• To create a liquid market requires, in the early stages, a limited number of standardized contracts in which liquidity can be concentrated. A set of q- forwards that settle based on the LifeMetrics Index could fulfill this role

• JPMorgan is committed to developing a market in LifeMetrics q-forwards

Introduction

Longevity and mortality derivatives are financial contracts that allow market par- ticipants to either take exposure, or hedge exposure, to the longevity and mortal- ity experience of a given population of individuals. For example, they enable pen- sion plans to hedge against increasing life expectancy of their members and life insurers to protect themselves against significant increases in the mortality of poli- 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 longevity, or mortality, index.

an index — in this case a longevity, or mortality, index. July 2, 2007 Guy Coughlan

July 2, 2007

Guy Coughlan

(44-20) 7777-1857 guy.coughlan@jpmorgan.com ALM & Longevity Structuring Pension Advisory Group JPMorgan Chase Bank NA

David Epstein

(44-20) 7777-3805 david.uk.epstein@jpmorgan.com ALM & Longevity Structuring Pension Advisory Group JPMorgan Chase Bank NA

Amit Sinha

(1-212) 834-4119 amit.sinha@jpmorgan.com Pension Advisory Group JPMorgan Chase Bank NA

Paul Honig

(1-212) 834-4589 paul.honig@jpmorgan.com Exotics & Hybrids Trading JPMorgan Chase Bank NA

www.lifemetrics.com Bloomberg: LFMT <GO>

Pension Advisory Group

q-Forwards: Derivatives for transferring longevity and mortality risk

July 2, 2007

Guy Coughlan

David Epstein

Amit Sinha

Paul Honig

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 rates 2 .

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

Figure 1: A q-forward exchanges fixed mortality for realized mortality at maturity of the contract

At maturity: At maturity: Notional x 100 Notional x 100 x x fixed mortality rate
At maturity:
At maturity:
Notional x 100
Notional x 100
x x
fixed mortality rate
fixed mortality rate
Counterparty A
Counterparty A
Counterparty B
Counterparty B
(fixed rate payer)
(fixed rate payer)
(fixed rate receiver)
(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.

pays the settle- ment payment to the hedge provider, which will be offset by the fall

Pension Advisory Group

q-Forwards: Derivatives for transferring longevity and mortality risk

July 2, 2007

Guy Coughlan

David Epstein

Amit Sinha

Paul Honig

Table1: An illustrative term sheet for a single q-forward to hedge longevity risk

Notional Amount

GBP 50,000,000

Trade Date

31

Dec 2006

Effective Date

31

Dec 2006

Maturity Date

31

Dec 2016

Reference year

2015

Fixed Rate

1.2000 %

Fixed Amount Payer

JPMorgan

Fixed Amount

Notional Amount x Fixed Rate x 100

Reference Rate

LifeMetrics graduated initial mortality rate for 65- year-old males in the reference year for England & Wales national population Bloomberg ticker: LMQMEW65 Index <GO>

Floating Amount

XYZ Pension

Payer

Floating Amount

Notional Amount x Reference Rate x 100

Settlement

Net settlement = Fixed amount - Floating amount

Table2: An illustration of q-forward settlement for various outcomes of the realized reference rate. A positive (negative) settlement means the fixed-rate receiver receives (pays) the net settlement amount.

Reference Rate

 

(Realized Rate)

Fixed Rate

Notional

Settlement

1.0000

%

1.2000 %

50,000,000

10,000,000

1.1000

%

1.2000 %

50,000,000

5,000,000

1.2000

%

1.2000 %

50,000,000

0

1.3000

%

1.2000 %

50,000,000

-5,000,000

Hedging mortality risk with q-forwards

Mortality risk reflects the potential for mortality rates to be higher than expected. This is the risk faced by life insur- ance companies. In particular, if mortality rates are higher than expected then a life insurer must pay out a larger amount than expected in death benefits. To hedge this risk 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 out to the insurer an amount that increases as mortality rates rise to offset the correspondingly higher payout on the life portfolio. This is illustrated in Figure 2.

on the life portfolio. This is illustrated in Figure 2. Hedging longevity risk with q-forwards Longevity

Hedging longevity risk with q-forwards

Longevity risk is the opposite of mortality risk, namely, the risk that people survive longer than expected, because re- alized mortality rates are lower than expected. This is the risk faced by pension plans, annuity providers, life settle- ment investors, etc. To hedge the longevity risk of its pen- sion liabilities a pension plan could enter into a portfolio of q-forward contracts in which it receives fixed mortality rates and pays realized mortality rates (see Figure 3). This portfo- lio would involve q-forwards referencing both males and females across a range of different ages and maturities.

Why does receiving a fixed mortality rate and paying a real- ized mortality rate provide a hedge of longevity risk? Since a pension plan must pay out pension benefits to its members on the basis of realized longevity, the obvious hedge is a derivative contract in which the pension plan receives a realized survival rate and pays a fixed survival rate. But not- ing that one-year survival rates are given by 1-q, then it is

evident that paying fixed survival (essentially paying 1-qfixed)

is equivalent to receiving fixed mortality (essentially receiv-

ing qfixed).

At maturity, the hedge will pay out to the pension plan an amount that increases as mortality rates fall to offset the correspondingly higher value of pension liabilities. So, a pension plan wishing to hedge longevity risk would receive fixed (and pay realized) mortality in a q-forward contract.

A portfolio of q-forwards provides a value hedge for pension

liabilities. In other words, it stabilizes the value of pension

liabilities at some future date (the hedging horizon) with 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:

The realized survival rate over the period being different from expectations

Changes in expectations about future trend improvements in mortality rates beyond the hedging horizon, due to the realized mortality experience over the horizon

Population basis risk

In any situation involving the hedging of mortality and lon- gevity exposure, there is the potential for a residual basis risk due to the mismatch in the populations of the expo-

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Pension Advisory Group

q-Forwards: Derivatives for transferring longevity and mortality risk

July 2, 2007

Guy Coughlan

David Epstein

Amit Sinha

Paul Honig

Figure 2: A q-forward contract to hedge the mortality risk of a life insurer.

Notional x 100

Notional x 100

x x

fixed mortality rate

fixed mortality rate

Life Insurer

Life Insurer

JPMorgan

JPMorgan

rate Life Insurer Life Insurer JPMorgan JPMorgan Notional x 100 Notional x 100 x x realized

Notional x 100

Notional x 100

x

x

realized mortality rate

realized 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.

Liquidity and standardization

An essential requirement for creating any new liquid mar- ket is standardization. For longevity and mortality risk transfer this means two things:

Having a standardized index (such as the LifeMetrics In- dex) which is objective and transparent, and can be used

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

Notional x 100

Notional x 100

x x

realized mortality rate

realized mortality rate

Pension Plan

Pension Plan

JPMorgan

JPMorgan

rate Pension Plan Pension Plan JPMorgan JPMorgan Notional x 100 Notional x 100 x fixed mortality

Notional x 100

Notional x 100

x fixed mortality rate

x fixed mortality rate

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.

References

Coughlan, G.D. et al. (2007). LifeMetrics: A toolkit for meas- uring and managing longevity and mortality risks. Techni- cal Document (JPMorgan: London, March 13, 2007).

Loeys, J., Panigirtzoglou, N., Ribeiro, R.M. (2007). Longev- ity: A market in the making. (JPMorgan Research Publica- tion: London, July 2, 2007).

The LifeMetrics SM Index by JPMorgan (the “Index”) has been prepared based on assumptions and parameters that reflect good faith determinations as of a specific time and are subject to change. Those assumptions and parameters are not the only ones that might reasonably have been selected or that could apply in connection with the preparation of the Index or an assessment of a product utilizing the Index or its components. The Index has been obtained from and based upon sources believed by JPMorgan Chase Bank, N.A. (collectively with affiliates, “JPM”) to be reliable, but JPM does not represent or warrant its accuracy or completeness. This material is provided for informational purposes and is not intended as a recommendation or an offer or solicitation for the purchase or sale of any security or financial instrument. Actual results or performance may not match or have any correlation to the Index. The Index is not intended to supplement or replace actuarial data and should not be used as such. JPM has no obligation to take the needs of a party entering into, buying or selling a product utilizing the Index or its components into consideration with respect to the composition or calculation of the Index. In all cases, interested parties should conduct their own investigation and analysis of a product utilizing the Index or its components. Each person viewing the Index should make an independent assessment of the merits of pursuing a transaction or product referencing or otherwise utilizing the Index or its components and should consult his or her own professional advisors. Transactions involving securities and financial instruments mentioned herein may not be suitable for all investors. JPM is not acting in the capacity as a fiduciary or financial advisor. JPM or its employees or affiliates may enter into, buy or sell transactions or products referencing or otherwise utilizing the Index or its components. Clients should execute transactions through a JPM entity qualified in their home jurisdiction unless governing law permits otherwise. © 2007 JPMorgan Chase Bank, N.A.

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entity qualified in their home jurisdiction unless governing law permits otherwise. © 2007 JPMorgan Chase Bank,