Alternative Risk Transfer:

The Convergence of The Insurance and Capital Markets A Three Part Series
By: Christopher Kampa, Director of Research ISI | August 11th, 2010

Part III Utilization of Life

Insurance-Linked Securities Abstract
Insurance-linked securities, once considered to be an alternative form This is Part Three in a three-part series on the Convergence of
of risk transfer, have become a mainstream method of transferring risk the Insurance and Capital Markets (“I/C Convergence Series”).
from insurers to the capital markets. With greater attention being paid
to risk at the institutional level and the search for portfolio diversification Part I of the I/C Convergence Series, “A Broad Overview,”
at the investment level, insurance-linked securities seem poised to further provides a macro-level analysis of the insurance-linked security
facilitate the convergence between the capital and insurance markets asset class. It discusses the maturation of insurance-linked
securities as an asset class and the history surrounding their
Part III Contents: emergence. Insurance-linked securities are a type of alternative
1. Utilization of Life Insurance-Linked Securities by: risk transfer that utilizes capital market techniques other than
Life Insurers, Annuity Writers, Pension Schemes, Life insurance or reinsurance to provide risk-bearing entities with
Settlement Managers, Reverse Mortgage Managers, and
Long-Term Care Providers risk protection. Insurers turned to alternative risk transfer
strategies following several catastrophic events in the 1990s,
2. Life Insurers Utilize Securitization to Hedge Early Mortality when reinsurance capacity shrunk and prices became more
Risks and to Increase Business Capital
volatile. The first insurance-linked security was structured as a
A. Embedded Value or Value-in-Force (“VIF”) Securitizations catastrophe bond, but the market has since grown to include
B. Reserve Funding Securitizations: Regulation XXX and AXXX many forms of securitization on both non-life and life insurance
C. Extreme Mortality Securitizations assets. Since their inception, issuances of insurance-linked
securities have caught on at a rapid pace, growing 40-50% a
3. The Need for the Securitization of Longevity and Mortality
year since 1997 with $50 billion in risk capital outstanding in
A. Longevity Risk Does not Have Access to Forward Pricing 2008.1
Markets
B. Longevity Bonds Can be Used to Hedge Mortality and Interest Part II of the I/C Convergence Series, “Non-Life Utilization of
Rates Insurance-Linked Securities,” delves into non-life insurance-
C. Survivor Indices and Mortality Tables Used for Securitization linked securities. The first non-life utilization of insurance-
have Limitations
linked securities was in the form of a catastrophe bond,
D. Uncertainties Surrounding Mortality Improvement
Underscore the Need to Hedge and Trade Longevity/ which served as the foundation for all other insurance-linked
Mortality Risk securities to follow. Catastrophe bonds serve as a check against
4. Longevity/Mortality Risks Beyond the Traditional Insurance rising reinsurance costs and have weathered the effects of the
Sectors global financial crisis quite well. After the asset-based market
A. Individuals are also Affected by Longevity/Mortality Risk was established, derivative and other synthetic securities soon
B. Annuities, Life Settlements, Annuity Settlements, Reverse emerged. This opened up a wide avenue of risk management
Mortgages, and Long-Term Care all Share Longevity Risk techniques and allowed hedging of risks that were previously
Concerns
thought to be uninsurable.
5. Bulk Annuity Buyouts Evolve from Asset-Based Part III of the I/C Convergence Series, “Utilization of Life
Transactions
Insurance-Linked Securities,” investigates securitization of
A. Bulk Annuities are an Attractive, Albeit Capital Intensive, Risk
Transfer Tool longevity/mortality risks for life insurance-linked securities.
B. Longevity/Mortality Swaps Offer Promising New Alternative
Individuals, financial entities, and government agencies have
for De-Risking exposure to longevity/mortality risk. Historically, managing
such risk has been limited to a few avenues. However, the
6. Life Settlement Securitizations are Needed to Provide
Insured with Fair Value Compensation convergence between the insurance and capital markets over
the last decade has produced many innovative methods for
7. Financial Reform and Regulation will have a Significant managing longevity/mortality risk. These new methods benefit
Impact on the Longevity Market
individuals, life insurers, annuity writers, pension providers, life
A. Financial Reform Changes Risk Management Practices and settlement managers, reverse mortgage managers, long-term
Forces Members of the Longevity Market to Adapt to New
Standards care providers, and others.
B. The GAO and SEC Call for Greater Regulation of the Life
Insurance Settlement Market

8. Summary

©2010 Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III page 1
1 Utilization of Life Insurance-Linked Securities by:
Life Insurers, Annuity Writers, Pension Schemes,
Life Settlement Managers, Reverse Mortgage
Managers, and Long-Term Care Providers
Until recently, longevity/mortality (“L/M”) risk was one of the contagion and asset impairment, along with the collapse of
few remaining major risk categories that had not benefited the monoline insurance market,6 disrupted the growth of life-
from capital market structures for hedging and transferring risk. insurance linked securities.
But many new and exciting alternative risk transfer strategies
The total amount of outstanding life securitizations stood
are evolving that can benefit both risk-assuming entities and
at $22.2 billion at the end of 2009, as shown in Table 1: Life
investors. Traditional hedging strategies for L/M risk involved
Securitization Outstanding. The bulk of securitizations were
participating annuities, life insurance policies with guarantees,
comprised of either embedded value or XXX/AXXX bonds
actuarial management of insurer surplus capital and
(roughly 42% each). The remaining included extreme mortality
policyholder expectations.2 More recently, hedging strategies
bonds and other securitizations, such as life settlements.7
include cash flow risks and debt servicing risks resulting from
L/M risks in life settlement portfolios. Since 2001, the market Historically, 80% of all life insurance-linked securities have
for life insurance-linked securities has grown significantly, with been structured with a credit-enhancement wrap provided
more than $15 billion of securities issued to capital market by monoline insurers. Monoline insurers provide insurance
investors and another $20 billion of private placements between protection in the form of guarantees on fixed-income
insurers and banks.3 The convergence of the insurance and securities. The collapse of the housing market exposed the
capital markets has created alternative channels for insurers to financial weaknesses of the monoline insurance industry, as it
manage risks and raise capital while providing investors with was heavily invested in subprime assets. As losses continued
new forms of investment opportunities. to mount, many monoline insurers lacked the ability to fulfill
their obligations, which lead to deep discounting of the value
The fundamental risk underlying life insurance-linked securities
of the guarantees.
is related to longevity or mortality. Longevity is the risk that
members of a population will live longer than expected. The current disruption of credit and lack of liquidity in the
Conversely, mortality is the risk that members of a population financial markets should be expected to hinder the growth
will die sooner than expected. Longevity/mortality can cause of life insurance-linked securities in the near future, but the
substantial risk where performance of large liabilities is tied long-term potential remains promising. Some experts estimate
to the accuracy of these projections. Reinsurance coverage the market potential for life securitizations at $500 billion for
for L/M has been sparse and expensive. The first operational value-in-force securitizations, and $35 billion of Regulation XXX
mortality-linked bond was issued by Swiss Re in 2003.4 Before excess reserve securitizations alone.8
that, longevity risk had never been securitized.5 In the last
few years, many innovative financial instruments have been Table 1: Life Securitization Outstanding
introduced, the most prominent being longevity bonds. These
are securities with payments tied to the matching of actual
mortality with expected mortality of an underlying reference
pool or portfolio. Some life reinsurers are entering this space.
The life insurance sector, which accounts for 40% of the total
insurance-linked securities outstanding, has not proven to be as
resilient to the financial crisis as the non-life insurance security
sector. The global financial crisis revealed that many alternative
asset classes, supposedly uncorrelated to the financial markets,
had substantial systemic risk exposure. Specifically, insurance-
linked securities were found to not be completely immune to
the systemic nature of market risk, especially during times of
financial distress. The collapse of the subprime CDOs caused a
disruptive impact on all structured products, which included
securitizations backed by life insurance risk. Substantial credit source: Swiss Re Capital Markets

©2010 Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III page 2
2 Life Insurers Utilize Securitization to Hedge Early
Mortality Risks and to Increase Business Capital
Limitations of the reinsurance market plague the life insurance
industry in much the same manner as it afflicts property and
casualty insurance. Lack of reinsurance capacity and increasing
reinsurance costs, along with concerns over credit risk, have
given life insurers incentive to seek alternative solutions and
sources of capital. The market for life insurance securitization
is relatively immature, but is evolving rapidly.9 In the U.S.
market, the most common types of life insurer securitization
include: Embedded Value (Value-in-Force) Securitizations,
Reserve Funding Securitizations, and Extreme Mortality
Securitizations.
A. Embedded Value or Value-in-Force Securitizations
Embedded Value (“EV”) or Value-in-Force (“VIF”) securitizations
allow insurers to monetize future profits of an insurance
portfolio. VIF transactions involve the securitization of a
block of insurance or annuity policies to achieve various
business objectives: to raise capital; capitalize prepaid
acquisition expenses; or to support a demutualization.10 EV/
VIF securitizations enable insurers to realize future profits in
the present, and reinvest the money into business lines that
have higher expected returns. Future profits are affected by
longevity/mortality risk, investment risk, and policy-persistency
risk.
These securitizations tend to have high volatility, exposing
investors to the risk that cash flows will not be sufficient to cover
interest and principal obligations. Therefore, securitizations
are typically structured with a series of tranches to attract a
wide breadth of investors with differing risk-return profiles.
The varying tranches of standardized EV/VIF securitizations
provide different layers of protection and a cushion against
adverse deviations of future cash flows. Most tranches have
been enhanced with wrapped guarantees issued by financial
guarantors, or monoline insurers. Under a wrapped structure,
the monoline insurer guarantees the underlying security which
removes the investment risk, but it leaves the credit risk that
the monoline insurer may default. Before the credit crisis,
the possibility of this happening was thought to be remote.
Following the financial fallout in 2008, new issuances of
embedded value securitizations fell sharply to $1 billion, down
from $6 billion in 2007.11
When monoline insurers’ credit ratings were downgraded in
2008-2009, all of the underlying risks were also downgraded.
Accounting standards, both in the U.S. and internationally,
forced holders of such assets to write them down to fair value.
The downgrades, along with the server market turmoil, led to
large liquidations that depressed the demand for asset-backed
securities across all sectors. Hedge funds were large investors
in the equity tranches of structured products, and many were
heavily leveraged. The downgrades of many structured products
led to margin calls resulting in massive forced sales.12
©2010 Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III
However, the common use of financial guarantees was the
major force behind the declining issuances of life securitizations;
which was a repercussion of the subprime collapse and not
the quality of the life assets. The capital base of many insurers
has been severely impacted by the financial crisis, which has
increased the demand for embedded value securitizations.
In the near future, securitizations may be limited without
the protection of financial guarantees. Until future credit
enhancement instruments are created, investors in embedded
value securitizations will be exposed to longevity/mortality
risk, investment risk, and policy persistency risk. The increased
risk and lack of standardization will likely limit embedded value
securitizations to the private placement market.
The Insurance Studies Institute
ISI is a non-profit research think-tank focused
on: a) researching and analyzing challenges and
opportunities within the many paradigms of
insurance based risk management; b) publishing
research findings on industry relevant topics; c)
educating industry stakeholders, public policy makers
and consumers in insurance based risk management,
and advancing related scholarship; and, d) promoting
dialogue to foster industry advancements, fair public
policy and greater risk protection for consumers.
Learn More
www.InsuranceStudies.org
B. Reserve Funding Securitization: Regulation XXX and AXXX
In the year 2000, a new statutory reserve requirement, known
as Regulation XXX, was passed. Regulation XXX imposes
conservative valuation methodologies for determining the
level of reserves insurers must hold, under statutory accounting
principles, for term life insurance policies.13 A similar guideline
known as AXXX requires increased reserves for universal life
policies that contained no lapse guarantees. The conservative
nature of Regulation XXX resulted in significantly higher reserve
levels for term and universal life insurance than was required
before the regulation was enacted. Effectively, this forced life
insurers to hold more capital in reserve, thus limiting their
ability to invest in new lines of business.
Life insurers, unwilling to be stymied by the increased capital
requirements, developed XXX and AXXX securitizations.
These reserve funding structures allow insurers to issue debt
securities against their capital reserve requirements, and to use
the securities to supplement the amount of capital required to
be held in reserve.
page 3
2 Continued
The issuances of XXX/AXXX slowed in 2007 after the credit
markets began to tighten due to pressure on asset-backed
securities, and the collapse of the monoline insurers. As global
financial markets recover, reserve funding securitizations are
expected to return to previous growth estimates. At the end of
2009, the total amount outstanding of XXX/AXXX securitizations
was valued at $11 billion, with estimates of a $35 billion total
market potential.14
C. Extreme Mortality Securitization
Extreme mortality securitization is a form of alternative risk
transfer designed to shift peak mortality risk to capital market
investors. Extreme mortality securitizations allow life insurers to
3 The Need for the Securitization of Longevity and Mortality
hedge against pandemics or sharp increases in longevity. These
bonds are similar to catastrophe bonds in that they transfer
extreme risks to the capital markets. If mortality develops as
expected, investors receive the prescribed interest and a full
return of principal at maturity. Conversely, if mortality increases
substantially, triggering the bond, investors can suffer a loss of
interest, principal, or both.
Before the financial crisis, extreme mortality securitizations
were structured much like catastrophe bonds. The proceeds
raised from investors were deposited into an SPV, which
entered into a total return swap (“TRS”) with an investment
bank. These structures were thought to remove the credit risk,
leaving investors exposed only to insurance risk, along with little
or no correlation to the broader financial markets. However,
the financial crisis demonstrated that these transactions
were not free from credit risk. After the Lehman Brothers
collapse in 2008 -- which was a large swap counterparty in
many transactions -- many securities experienced severe price
deterioration.15
The collapse of Lehman Brothers demonstrated that the TRS
mechanism was not sufficient to protect investors from credit
risk. Following the Lehman Brothers’ bankruptcy, the structure
of extreme mortality bonds has been improved. Newly issued
extreme mortality bonds invest proceeds in treasury bills,
thereby providing a return of treasuries plus the insurance
spread.16 With the collateral invested in government debt,
maturities of extreme mortality bonds are shorter in order to
avoid asset/liability duration mismatch. The improved structure
provides investors with more security than was provided with
the total return swaps. However, the newer structure exposes
investors to credit risks that were previously thought to not be
present.
Securitization of extreme mortality risk should continue to
expand as large global life insurers and reinsurers turn to the
capital markets to hedge against large deviations in mortality.
The combined volume of extreme mortality bonds issued thus
far stands at $2.2 billion.17 However, since insurers securitize
their exposure to extreme mortality risk, and not the entirety
of their mortality exposure, quantifying the size of the market is
difficult. However, Swiss Re estimates that the market potential
will range somewhere between $5 and $20 billion by 2019.18
©2010 Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III
Longevity/Mortality risk exists due to uncertainties surrounding
life expectancy trends. Large divergences can have severe
effects on the profitability of insurers, annuity writers,
pension schemes, life settlement managers, reverse mortgage
managers, long-term care providers, and any other entity that
has exposure to longevity/mortality risk. Securitization of this
risk allows such entities to raise capital, reduce their cost of
funds, reduce asset-liability mismatches, lock in profits, and
transfer risks to the capital markets. Investors of insurance-
linked securities benefit by adding diversity to their investment
portfolios.
A. Longevity Risk Does not Have Access to Forward Pricing
Markets
Hedging of longevity risk stems from the financial impact of
developments in the long-term trend of survival probabilities.19
Mortality improvement is typically a continual process
spanning over decades, although issues such as medical
advancements in the cure of diseases or health epidemics
can have immediate impacts on mortality trends. Expected
increases in longevity can be modeled with historical modeling
and actuarial analysis. However, the pricing of longevity is not
as fluid. Typically forward market contracts are used as an
instrument to hedge risk and to price assets.20 But at present
time, there is no matured forward market for longevity risk.
This adds to the uncertainty of future mortality improvement
pricing, but some of the large investment banks are making
attempts to create a liquid market.
The emergence of a well-diversified forward market would
allow for greater price discovery and innovation for new
risk management products. A forward market would
provide transparency to expected or more normal mortality
improvement pricing, but would be insufficient for pricing the
more extreme mortality changes, such as a cure for cancer.
Swaps and reinsurance are better suited for hedging these
extreme mortality changes. Even though the reinsurance
markets are designed to cover these risks, to date they have
been unwilling to do so. The reinsurance industry has been
concerned about the amount of capital required to hedge
large, extreme, and unexpected mortality changes. Therefore,
securitizations and other capital market solutions stand out as
the natural course of action for management of these risks.21
page 4
3 Continued
B. Longevity Bonds Can be Used to Hedge Mortality and
Interest Rates
Longevity bonds offer a promising new option for managing
longevity/mortality risk. Longevity bonds provide insurers,
annuity writers, pension schemes, life settlement managers,
reverse mortgage managers, long-term care providers, and
other financial entities with a highly flexible means of hedging
mortality and interest-rate risk. Longevity bonds can also
be attractive to capital market investors who are looking for
an asset class with low correlation to traditional financial
markets.
An advantage to longevity bonds, as with catastrophe bonds,
is that there is little or no credit risk because the bond is
completely collateralized through an SPV. However, because of
the lack of a forward market, the valuation of such bonds is
difficult. Further, survivor indices used to price the bonds may
not completely match the reference pool of the covered asset
pool. Several forms of longevity bonds exist:22

Traditional Longevity Bonds with fixed maturities were designed to

protect against longevity risk. The holder of such a bond gains if the
pool of covered lives on which the bond was underwritten extends
longer than expected, and the bond issuer loses. Greater than
expected cash flows, resulting from the bond’s extended maturity,
serve as a hedge against the holder’s increased liabilities and costs of
the pool of covered lives. The issuer gains if the reference pool lives
shorter than expected. In this scenario, the holder loses money on the
bond but saves money on the decreased liabilities and costs of the
underlying pool of lives.
Longevity Zero Bonds are similar to conventional zero-coupon bonds
or traditional longevity bonds, where the return of principal and
compounded interest is paid at the maturity of the bond.
Survivor Bonds payout for as long as there are survivors remaining
in the reference pool. These bonds are attractive because they are
open-ended, and they can provide an adequate longevity hedge for a
fund or portfolio with a comparable reference population. The open-
ended nature of these bonds allows annuity writers and pension
schemes to match their own liabilities.
Principal-at-risk Bonds have coupon payments fixed or tied to
interest rates, but the principal repayments are based on the survivor
index, meaning that the repayment of principal is dependent on the
divergence between expected and actual mortality.
Mortality Bonds are the opposite of traditional longevity bonds, i.e.,
the payout increases if the reference pool lives shorter than expected.
These bonds serve as a hedge against mortality risk.
Collateralized Longevity Obligations (“CLOs”) are similar to conventional
collateralized debt obligations (CDOs). In the same way that a CDO
tranches a pool of debt instruments a CLO tranches a pool of longevity
bonds. Different tranches have different exposures to longevity risk,
and therefore different return and risk and exposures. Investors in
the more senior tranches would be paid before those in subordinate
tranches. Payment would be based on how the actual mortality
experience compares to the expected mortality experience.
C. Survivor Indices and Mortality Tables Used for
Securitizations have Limitations
The choice of a survivor index or mortality table is critical to
the success of longevity bonds. Longevity bonds expose the
holder to basis risk because the bond is tied to an index and not
the issuer’s actual losses. The objective is to choose a survivor
index that closely matches the longevity characteristics of the
holder’s pool of lives. If the actual longevity of the survivor
index does not closely match the holder’s pool of lives, the
cash flows of the bond will not serve as an adequate hedge
against longevity risk.
Survivor indices and mortality tables are also limited by the
methods used to construct them. Mortality data is published
infrequently and subject to incurred-but-not-reported errors.
Further, methods used to track mortality have changed
with time, and tables and indices suffer when differing
methodologies are used to combine historical data.
If the integrity of the underlying survivor index of a longevity
securitization is in question, investors may be weary of
investing in such structures. Investors may also be susceptible
to moral hazard risks.23 If, for example, issuers have access to
information that investors don’t, or have access much sooner,
they can act on this information at the expense of investors.
Moral hazard can also exist where there is a possibility that
data can be manipulated, thus creating an incentive for the
benefiting party to misrepresent mortality statistics to influence
the value of the index.

©2010 Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III page 5
3 Continued
D. Uncertainties Surrounding Mortality Improvement
Underscore the Need to Hedge and Trade Longevity/
4 Longevity/Mortality Risks Beyond the Traditional
Mortality Risk
If future mortality improves relative to current expectations, the
liabilities of life insurers decrease because death benefits will
be paid out further into the future. Conversely, annuity writers,
pension funds, life settlement pools, annuity settlement pools,
reverse mortgage pools and long-term care providers will
be adversely affected because they will have to pay benefits
and costs for a longer period of time. Current mortality
improvement trends suggest that global life expectancies will
continue to increase, but socio-economic trends indicate that
mortality improvement may be localized and less predictable.24
For example, in the United States, some experts suggest that
the nation may experience declining life expectancies for the
first time in history due to excessive obesity. Uncertainties
surrounding mortality improvement underscore the need
for robust trading platforms to hedge and trade longevity/
mortality risk.
Although improvements in mortality can adversely impact
asset pools sensitive to longevity risks, the effects can be
managed when they are anticipated. Annuity writers and
long-term care providers could raise the premiums needed for
future products, and pension funds could increase required
contributions or make the pensioners work longer. Life
settlement aggregators, annuity settlement aggregators, and
reverse mortgage aggregators can lower the prices paid for
such assets and set more capital aside for expense reserves.
These implementations may not be popular, but they would
improve the solvency of systems under pressure.
Expected mortality improvement can be managed; it is the
unexpected shocks that are problematic. Uncertainty of
anticipated changes in mortality rates are the essence of
longevity/mortality risk. Actuaries create mortality tables that
insurers and annuity writers use to price their related products.
Pension funds and government programs such as social security
use mortality tables to calculate their liabilities. Mortality
tables include some form of mortality improvement based
on historical experience and actuarial expertise. However,
mortality improvement is just an educated prediction of future
mortality rates; they are not certain. Deviations from expected
mortality can severely impact the bottom line of industry
profits.
It is for these reasons that institutions and investors in assets
having longevity risk need market structures to hedge and
trade longevity/mortality risks.
©2010 Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III
Insurance Sectors
Life insurance was established as a form of financial protection
against the risk of dying too soon. But as populations around
the world experience increases in life expectancies, individuals
look for services to ensure sufficient funds to survive their
retirement years.
A. Individuals are also Affected by Longevity/Mortality Risk
The major assets held by individuals in developed countries
around the world are retirement savings and the family home.
Retirement savings typically consist of pensions, social security,
and investment savings. Individuals typically insure their own
mortality/longevity risks with products such as life insurance or
annuities. As life expectancies in developed countries around
the world continue to lengthen, individuals are more avidly
seeking products to provide financial protection during their
retirement years.
“By providing financial protection against the major 18th and 19th
century risk of dying too soon, life assurance [insurance] became the
biggest financial industry … providing financial protection against
the new risk of not dying soon enough may well become the next
century’s major and most profitable industry.” – Peter Drucker
Many longevity based products involve financial risks related
to individual assets used to fund individual retirement income
streams. Reverse mortgages combine housing market risk
and longevity risk. Life settlements stem from arbitrages
between longevity risks and mortality risks. Likewise, the
more recent development of annuity settlements also stems
from the arbitrage between longevity risks and mortality risks.
Long-term care programs face both longevity risk and risk of
increasing care costs. However, these risks currently have
no active wholesale market for hedging or pricing. Financial
innovation to manage longevity risk at the institutional level
will require participation by the capital markets to provide
protection against these risks.
The Insurance Studies Institute
ISI is a non-profit research think-tank focused on: a)
researching and analyzing challenges and opportunities
within the many paradigms of insurance based risk
management; b) publishing research findings on industry
relevant topics; c) educating industry stakeholders, public
policy makers and consumers in insurance based risk
management, and advancing related scholarship; and, d)
promoting dialogue to foster industry advancements, fair
public policy and greater risk protection for consumers.
Learn More
www.InsuranceStudies.org
page 6
 5 Bulk Annuity Buyouts Evolve from Asset-Based
4 Continued
B. Annuities, Life Settlements, Annuity Settlements, Reverse
Mortgages, and Long-Term Care All Share Longevity Risk
Concerns
As populations of the developed world continue to age, annuity
writers, pension administrators, life settlement managers,
reverse mortgage managers, and long-term care providers
are under pressure to develop new products and tools to
compete for capital. Like other insurance-linked securities,
this asset class provides investors with the higher yields and
diversification of securities that aren’t correlated to economic
events affecting traditional financial markets. Investors can gain
exposure to these asset classes through a variety of structures,
including: closed or open-ended funds or securities backed
by the underlying life insurance policies; annuities; or real
estate. As securitizations become more prominent for these
asset classes, the resulting increases in liquidity and investor
appetite will benefit seniors by raising the prices paid for their
assets
©2010 Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III
Transactions
The risk of mortality improvement has become increasingly
capital intensive and challenging to manage for pension funds,
annuity writers, and other financial entities.. Longevity risk
has been systematically underestimated, leaving exposed
firms vulnerable to unexpected increases in liabilities.25 Large
institutions are partnering with capital market investors to
manage this risk.
A. Bulk Annuities are an Attractive, Albeit Capital Intensive,
Risk Transfer Tool
A looming problem for many defined-benefit pension funds
is that they are underfunded, and the increased legacy costs
are forcing them to switch from defined-benefit to defined-
contribution schemes. This costly process takes the form of a
bulk annuity buy-out, where the pension fund pays an insurer
to replace the pension liability with annuities to the pensioners.
In these transactions, the insurer takes on both reinvestment
risk and longevity risk associated with the pension assets. In
Europe, one of the first methods of managing longevity risk by
annuity writers and pension funds was to sell the liability via
an insurance or reinsurance contract known as a bulk annuity
buy-out.26
Several dozen buyouts have taken place over the past few
years.27 However, buyouts have been limited to smaller
pension fund portfolios. When combined with the shortage
of liquid instruments that enable insurers to hedge against
longevity risk, the capital intensive process of bulk annuities
limits feasibility for large pension funds and is limiting the
market.28
Despite the attractiveness of this option, the premium
required often makes buy-outs too expensive for many pension
schemes. During 2005 and 2006, many new players29 entered
the market because investment banks could borrow funds
cheaply to finance the buy-outs, and equity returns were high.
The conventional wisdom was that returns in the equity market
were more than enough to justify investing in risks associated
with longevity. From 2007 onward, the buyout market enjoyed
a considerable boom, writing $14.6 billion in 2008. Since then,
capital has dried up and the equity markets have stagnated,
and the bulk buy-out option has lost popularity. In 2009,
volume dropped to $6.9 billion.
The market for de-risking is evolving from the more costly asset-
based transactions to less costly structures such as longevity
swaps. Following the deterioration in the global economy,
pension fund trustees have become more concerned about
the financial health of insurance companies, leading them to
search for alternative structures to transfer risk to the capital
markets.30
Another index that was recently launched by Goldman Sachs,
the QxX index, tracks a representative sample of the insured
page 7
5 Continued
US population over the age of 65. The index data is provided
by American Viatical Services and has a reference pool of
50,000 who have participated in life settlement transactions
(see the next section). The pool’s mortality experience is based
on the Social Security Death Index, which focuses on a narrow
segment of the elderly population, and tends to be skewed
towards those with more impaired health. Recently, Goldman
Sachs sold its stake in the index to a Goldman Sachs partner.
B. Longevity/Mortality Swaps Offer Promising New
Alternative for De-Risking
Longevity swaps are a form of de-risking that allows entities
with L/M risk exposure to transfer the risk to capital market
investors looking for diversification benefits. Asset-based
transactions can be costly and capital intensive because they
potentially require a large amount of upfront premiums.
Longevity swaps, on the other hand, can be relatively simple.
Unlike a pension or annuity buyout, longevity swaps do not
require a transfer of assets and the original liabilities remain
with the sponsor. Further, there is no large upfront capital
requirement and other risks, such as asset risk and inflation
risk, can be mitigated.
There are two forms of swap transactions: indemnity swaps are
customized, based on actual experiences or portfolio holdings;
parametric swaps are based on an index. Indemnity swaps can
be customized to the actual portfolio to remove most of the
basis risk. However, it can be difficult to find counter parties for
indemnity swaps and more expensive to construct the swap
because of the monitoring costs. Parametric swaps based on
an index are less expensive but the magnitude of basis risk is
likely to be greater. Parametric index based swaps are generally
more popular because they are simple, more objective and
transparent, and therefore offer greater liquidity.
In Europe, the de-risking market for swaps is starting to develop
but has yet to reach main stream. There have only been a
handful of major swap transactions, as listed below:31
Table 2: Recent Longevity Swap Deals
Sponsor Issuance Year Value ($ Millions)
Canada Life 2008 $990
Lucida 2008 $195
Norwich Union 2009 $689
Babcock 2009 $755
Total $2,629
©2010 Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III
A typical longevity swap involves a party, e.g., a pension fund
that has exposure to increasing mortality improvement and that
wishes to hedge against adverse changes in future mortality.
The pension fund receives a fixed amount from investors, as
determined by the contract, and receives a variable amount
based on either the pension fund’s actual mortality experience
or an index that tracks mortality. Thus, the pension fund locks
in its future liabilities by transforming them into a stream of
fixed payments, and locks in the future mortality improvement
of its pensioners.
As the market for longevity swaps materializes, trading indices
are likely to become more developed. Investment banks
such as JP Morgan and Credit Suisse have developed early
versions of trading platforms built on synthetic pools of lives.
The success of these platforms has been mixed. Although it is
no longer available, the first attempt to develop a longevity/
mortality index was made by Credit Suisse in 2005, which was
based on the US population’s life expectancy statistics. J.P.
Morgan’s LifeMetrics Index, launched in 2007, tracks general
demographic trends and provides publicly available population
data. The advantage of publicly available indices is that the data
is verifiable, cannot be manipulated, and is provided by reliable
public sources. However, transactions based on indices may
expose the issuer to basis risk because of mortality mismatch
between the entire population and population of the issuer.32
The key to success for these platforms will be their ability to
match parties that (1) have opposite exposure to the underlying
longevity/mortality risk and (2) have similar mortality
characteristics in their underlying pools being hedged. As
more capital is invested into the market and more attention
is directed toward building robust actuarial tables, institutions
with exposure to longevity/mortality risk will be able to hedge
more of their risk exposures through standardized indices.
page 8
 5 Continued
Consultant Lane Clark & Peacock predicts that $27.8 of new de-
Table 3: Monthly Funding Status and Surplus/Deficit
risking business will be written in 2010. As of the first quarter,
$7.4 of de-risking business took place, with $5.6 comprised of
the automaker BMW’s longevity swap – the largest longevity
swap to date. The consultant also predicts that prices will rise
as demand for pension scheme de-risking grows.33
The potential for de-risking instruments within the pension
fund market is vast due to the unfunded liabilities facing many
pension schemes (see the table across). Additionally, most
pension schemes are heavily invested in equity markets, and
the ongoing financial crisis has left many of the largest pension
plans with record deficits and unfunded liabilities. Following
the financial crisis, many sponsors are in a weakened position
and can’t inject the cash necessary to transfer pension risks to
an insurer via a buyout. However, if the handful of transactions
source: Milliman 2009 Pension Funding Study
contracted since 2008 are any indication,34 the potential for
the market is very promising.

6 Life Settlement Securitizations are Needed to Provide

Insured with Fair Value Compensation
In 2009, American International Group (AIG) became the first
company to successfully obtain an investment-grade rating
on a life settlement securitization. The offering yielded more
than $2 billion on a pool of policies with a face value of more
than $8.5 billion. AIG used the proceeds to pay off a portion
of its government loan.35 While the market in its current form
has been in existence for over a decade, this is one signal that
the industry is maturing, and as issuers develop more ways to
securitize the life settlement asset, more investors will find this
space attractive. In turn this will create capital to benefit the
life insurance secondary market and benefit seniors needing
funds and liquidity for retirement.
In line with other insurance-linked securities, life settlements
offer a wealth of attractive features that appeal to investors,
including the uncorrelated nature of the returns and higher
yields. An advantage of life settlements is that, unlike most
other insurance-linked securities, they are available to both
institutional and retail investors. This has broadened the
investor base and poses a unique set of opportunities and
challenges.
Like traditional market assets and other insurance-linked
securities, life settlements can be structured in a number of
different financial securities. Notes can be issued against a
pool of life settlements as a pass-through security, i.e., asset-
backed security, and they can be structured with a defined
rate maturity and interest payment. A pass-through will
theoretically have a higher rate of return because the return is
dependent on actual mortality as opposed to a note that offers
a fixed-rate of interest. Life settlements can also be structured
in closed-end or open-end funds. A synthetic market has been
pursued, but has yet to find a foothold among investors.
Although asset-backed securities can be issued with a wide
range of assets, the overall structure is rather generic. Cash
flows generated from a pool of life settlement assets are used
to pay the required rate of return and the principal. A debt
security is issued against the asset pool with a set maturity and
defined rate of return, or actual cash flows from the pool can
be passed on to the investor. In the latter case, if the underlying
asset performs better than expected, the investor is rewarded,
but if the performance of the underlying asset is weaker than
expected, the investor’s return is diminished.
Thus far, most of the financial transactions involving life
settlements have been structured in the form of closed-end
or open-end funds based overseas. Closed-end funds lock the
investor in for a defined period of time, and policies remaining
at the end of the period are typically sold, or the investors are
bought out. Open-end funds operate much like mutual funds
with a net asset value and a unit price. Investors can buy and sell
(redeem) shares as they would in a mutual fund. Some funds
use leverage to increase the expected return while others are a
whole asset transaction. If the portfolio manager is successful
in picking and managing life insurance policies, investors will
benefit with greater returns.

©2010 Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III page 9
7 Financial Reform and Regulation will have a Significant
Impact on the Longevity Market
A. Financial Reform Changes Risk Management Practices and
Forces Members of the Longevity Market to Adapt to New
Standards
The Dodd-Frank Wall Street Reform and Consumer Protection
Act was signed into law by President Barack Obama on July 21,
2010. Re-dubbed the “Restoring American Financial Stability
Act of 2010,” the law is the most significant reform to the US
financial system in the past 77 years. The goal of the act is to
restore confidence, and will impact almost every facet of the
US financial system. It creates a significant regulatory regime
governing financial transactions with consumers. Although
not specifically referenced, the new law will influence the life
insurance settlement and longevity markets.
The bill will continue enforcement of the McCarran-Ferguson
Act, which exempts the business of insurance and other
industry participants from most federal regulation. However,
the bill creates a Federal Insurance Office (FIO) within the exchanges and requires them to be cleared through a clearing
US Treasury Department. The FIO is directed to monitor the house. This will result in increased collateral requirements.
insurance industry and recommend to the newly created
Financial Stability Oversight Council which insurance carriers It remains to be seen how insurers and other financial
should be considered to be systemically important. institutions will adapt to the changes in the OTC market.
Financial institutions benefit from customized derivatives
Within the next 18 months, the FIO is mandated to provide a because it allows them to hedge the risk positions unique to
report to Congress that covers the following: 1) Identify which their firm. The standardization of such contracts may limit
insurance carriers are systemically important. 2) Examine if the ability to successfully manage these risks. Most longevity
state insurance regulation is nationally uniform and analyze swaps and the synthetic life insurance settlement market are
inconsistencies in state regulations. 3) Report on consumer customized transactions; depending on how the financial
protection for insurance products and practices (i.e. the recent reform law is enforced, it will have serious repercussions on
Phoenix Life changes in the cost of insurance). 4) Analysis of the life insurance settlement and longevity markets.37
any gaps in state regulation, the costs and benefits of potential
federal regulation of the insurance industry, and the ability of
B. The GAO and SEC Call for Greater Regulation of the Life
a federal regulator to provide consumer protection to policy Insurance Settlement Market
holders.36 On July 22nd, 2010, at the request of the Senate Special
These mandates may have a positive impact on the life Committee on Aging, the Government Accountability
insurance settlement and longevity markets by helping to Office (GAO) and the Securities Exchange Commission (SEC)
ensure that carriers remain financially healthy and are able to simultaneously released reports regarding the regulation and
pay death benefits. However, some features of the bill could treatment of life insurance settlements. The reports note that
restrict risk management practices and trading in the longevity there is no comprehensive data for life insurance settlements,
markets. The bill requires a security issuer to retain not less but estimate that the market grew rapidly from 1998 until the
than 5% of any securitized asset other than certain qualified recent financial crisis.
residential mortgages. While this retention standard is subject According to the reports, the number of policies settled
to certain exemptions, it could definitely change how longevity declined in 2009. In 2009, over 2,600 policies were settled
securitizations are structured. with a total face value of $7.01 billion. This was down from
Further, the treatment of derivatives has been one of the most over 4,500 policies worth nearly $13 billion in 2008. Over this
controversial portions of the new law. The bill will bring the two year period, policy sellers were paid over $3.2 billion in
over-the-counter (OTC) derivatives market under extensive compensation, $3 billion of which was paid above the surrender
regulation. Banks will be allowed to conduct some permitted amount offered by insurers, and thus this figure represents the
derivative transactions on their balance sheets, while other value provided to policy owners that would not have occurred
derivative transactions will have to be managed through an if not for the life insurance settlement market.
affiliate. The law moves most of the OTC derivative market onto

©2010 Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III page 10
7 Continued
Life insurance settlements are regulated under both state and
federal laws. The “front-end” transaction, which is the sale of
8 Summary
Insurance-linked securities, once considered to be an alternative
form of risk transfer, have become a mainstream method to
a life insurance policy to a provider or investor from the policy transfer risk from insurers to the capital markets. With greater
owner, is regulated under state insurance laws. The “back-end” attention being paid to risk at the institutional level and the
transaction, which is the sale of a life insurance policy to an search for portfolio diversification at the investment level,
investor from the provider, is regulated under state and federal insurance-linked securities seem poised to further facilitate
securities laws. the convergence between the capital and insurance markets.
The SEC and the Financial Industry Regulatory Authority (FINRA) Life insurance-linked securities benefit entities with exposure
have regulatory authority over the sale of variable life insurance to longevity/mortality risk by locking in mortality estimates.
products, but they have also tried to assert themselves in the Investors benefit by gaining access to an asset class that is
regulation of all life insurance settlements. Two federal circuit weakly correlated to the traditional financial markets and
courts have reached opposing decisions, however, regarding yields above average returns. As the market continues to
whether a life insurance settlement is a security or not. grow, the many stakeholders facing longevity/mortality
The GAO states that inconsistencies in state-based regulation risk exposure, and the capital market investors, are gaining
may lead to policy owners in some states receiving greater familiarity and sophistication with respect to the underwriting
protection than those in other states while policy holders in and securitization of longevity/mortality risks.
others states may have more difficulty accessing information. Credit defaults stemming from the financial fallout in 2008
Differences in state laws and court decisions may also prevent uncovered weaknesses in the way some life insurance-linked
investors from gaining access to information that they need securities were structured. Investor demand has begun to
regarding their investments. return, however, indicating that previous concerns were
The SEC concurred with the GAO’s assessment and recommends related to the structuring of the securities, and not the
that Congress clearly define life insurance settlements as underlying assets themselves. As both individuals and entities
“securities,” thus protecting investors in these transactions with longevity/mortality risk exposure search for greater ways
under U.S. securities laws. to protect against adverse longevity/mortality movements, the
The GAO noted that they recently reported that Congress potential for life insurance-linked securities remains strong.
could consider the advantages and disadvantages of providing
a federal charter option for insurance and creating a federal
insurance regulatory entity because of the difficulties in
harmonizing insurance regulation across states through the
NAIC-based structure. The National Association of Insurance
Commissioners (NAIC), however, disagreed with the assertion
that a federal charter for insurance is an appropriate solution
to the challenges highlighted in the report. “Upending the
existing system of state-based insurance regulation in favor
of a federal charter option makes no sense given the success
of the state regulatory system in the face of ongoing financial
crises.”38 The NAIC asserts that state officials have effectively
regulated the insurance market to keep up with the needs of
the modern economy and argues that federal chartering would
harm consumers.
Members of the life insurance settlement industry commend
the GAO on their review of the industry and pledge to work
with the SEC. “We are pleased that GAO recognized life
settlement transactions as a viable option for policy owners,”
said ILMA Managing Director Jack Kelly. Only time will tell
how future regulation is shaped, but greater transparency and >>> www.insurancestudies.org
less-ambiguous regulation may help the maturation of the life
insurance settlement market. One benefit of greater regulation
is that institutional investors may feel more comfortable
committing capital to those that are licensed as securities
intermediaries.

©2010 Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III page 11
 1 A World Economic Forum Report, Convergence of Insurance and Capital Markets, World
Economic Forum, 2008.
2 Michael Sherris and Samuel Wills, Financial Innovation and the Hedging of Longevity Risk,
Australian School of Business, University of New South Wales, Sydney, Australia, 2007.
3 Mathieu Boucher, Developments in the Insurance-Linked Securities (ILS) Life Market, Post
Financial Crisis, 2009 East Asian Actuarial Conference, 2009.
4 David Blake, Andrew Cairns, Kevin Downd, and Richard MacMinn. Longevity Bonds: Financial
Engineering, Valuation and Hedging. 2006.
5 Ibid.
6 An insurance company that provides guarantees for a security to enhance the credit of the
issuer.
7 The Role of Indices in Transferring Insurance Risks to the Capital Markets, Sigma, Swiss Re,
2009.
8 Ernest Eng and Cormac Bradley, Insurance-Linked Securities Reaching Critical Mass, Emphasis,
Towers Perrin, 2009.
9 Duncan M. Briggs, Jonathan Hecht, and Charles Pickup, Life Insurance Securitizations
Expanding, Emphasis, Towers Perrin, 2004.
10 Mathieu Boucher, Developments in the Insurance-Linked Securities (ILS) Life Market, Post
Financial Crisis, 2009 East Asian Actuarial Conference, 2009.
11 Ernest Eng and Cormac Bradley, Insurance-Linked Securities Reaching Critical Mass, Emphasis,
Towers Perrin, 2009.
12 ibid
13 Jeffrey Stern, William Rosenblatt, Bernhardt Naell, and Keith M. Andruschak, Insurance
Securitizations: Coping with Excess Reserve Requirements Under Regulation XXX, Journal of
Taxation and Regulation of Financial Institutions, 2007.
14 Ernest Eng and Cormac Bradley, Insurance-Linked Securities Reaching Critical Mass, Emphasis,
Towers Perrin, 2009.
15 Mathieu Boucher, Developments in the Insurance-Linked Securities (ILS) Life Market, Post
Financial Crisis, 2009 East Asian Actuarial Conference, 2009.
16 Ibid
17 The Role of Indices in Transferring Insurance Risks to the Capital Markets, Sigma, Swiss Re,
2009.
18 Ibid.
19 Michael Sherris and Samuel Wills, Financial Innovation and the Hedging of Longevity Risk,
Australian School of Business, University of New South Wales, Sydney, Australia, 2007.
20 Robert S. Pindyck, The Dynamics of Commodity Spot and Futures Markets: A Primer, The
Energy Journal, 2001.
21 Michael Sherris and Samuel Wills, Financial Innovation and the Hedging of Longevity Risk,
Australian School of Business, University of New South Wales, Sydney, Australia, 2007.
22 David Blake, Andrew Cairns, Kevin Dowd, and Richard MacMinn, Longevity Bonds: Financial
Engineering, Valuation and Hedging, 2006.
23 Occurs when one party transfers risk to another party, and the party ceding the risk has less
incentive to ensure that the risk is managed as efficiently as possible.
24 Source: Office for National Statistics. 2007.
25 Enrico Biffs and David Blake, Mortality-Linked Securities and Derivatives, Pensions Institute,
2009.
26 David Blake, Andrew J.G. Cairns, and Kevin Dowd. The Birth of the Life Market. Pensions
Institute. 2008.
27 Global Market Strategy, Longevity: A Market in the Making, JP Morgan. 2007.
28 Ibid.
29 Gill Wadsworth, Buyouts Take a Backseat, Investment and Pensions Europe, 2009.
30 Ryan Davidson, UK Pension BPA Market to Halve in 2009, Predicts LCP, Risk.net, 2009.
31 AON Benfield, Insurance-Linked Securities, Adapting to an Evolving Market 2009, reDEFINING,
2009.
32 The Role of Indices in Transferring Insurance Risks to the Capital Markets, Sigma, Swiss Re,
2009.
33 Gill Wadsworth, Buyouts Take a Backseat, Investment and Pensions Europe, 2009.
34 As cited in the Table 2
35 Meg Green, AIG Files First Rate Life Settlement Securitization, Trading Markets.com, 2009.
36 Jack Kelly, What will the New Financial Reform Law Mean to the Longevity Markets?, ILMA
Investor Notes, 2010.
37 Ibid.
38 Report to the Special Committee on Aging, U.S. Senate, Life Insurance Settlements,
Regulatory Inconsistencies May Pose a Number of Challenges, United States Government
Accountability Office, 2010.

©2010 Insurance Studies Institute The Convergence of The Insurance and Capital Markets Part III page 12