In the previous article, we have already seen how pension funds have been adversely affected by an increasing amount of longevity risk.

The increase in the average lifespan of people is definitely a positive development. However, it has an adverse impact on the financial situation of most pension funds.

In order to mitigate longevity risks, pension funds across the world have started relying on financial innovation. Longevity bonds and longevity derivatives are financial instruments that allow pension funds to transfer the financial risk from the institution to individuals.

The details regarding the functioning of longevity bonds and longevity derivatives have been explained below:

What are Longevity Bonds?

Longevity bonds are a type of financial instrument in which the coupon rate to be paid is not fixed. Instead, the coupon rate to be paid is variable and depends upon the life expectancy of a group of people.

Since the life expectancy of a group is not easy to measure, the issuers of these bonds create an index for this purpose. This value of this index changes based on the demographic data which is being released by the population. At the same time, the value of this index is the basis for coupon payments being made. As the value of the index keeps on increasing, it means that the mortality rate of a given population is also increasing.

If the mortality rate increases, the coupon payments are also correspondingly reduced. This means that there is an inverse correlation between the mortality rate and coupon payments. As the mortality rate keeps increasing, the coupon payments go on reducing. Finally, when there are no members of the demographic group left, the coupon payments go to zero.

It needs to be understood that these bonds actually function as an annuity. This is because the principal amount on these coupon bonds is never returned. Instead, the investor trades a lump sum for a series of small payments.

What are Longevity Derivatives?

Longevity derivatives are very similar to longevity bonds. In fact, a lot of the time, longevity derivatives are based on longevity bonds. The concept of longevity derivatives includes all types of instruments viz. forwards, options, and swaps.

Longevity derivatives are still quite unique. Hence, there are traded over the counter and not on an exchange. For example, two parties may swap their cashflows based on the value of the mortality rate in the demographic index.

Who Trades in Longevity Derivatives?

Now, the question is why would investors and financial institutions want to invest based on the mortality rate. There are several reasons why investors find longevity derivatives to be useful. Some of these reasons have been mentioned below:

1. Pension funds, annuity providers, and such other financial institutions are directly affected by longevity risk. If they buy longevity bonds, they have to invest a large amount of capital. Longevity derivatives are a cheaper way to mitigate the same risk.

   For instance, a pension fund may pay a relatively small premium to insure itself against the risk that its customer population will live longer than expected. This will help them match their cash flows to their liabilities and transfer the risks to a third party.

2. Longevity derivatives are also attractive to mutual funds and other financial institutions. This is because the fact these derivatives have a very low correlation with other asset classes. Hence, the addition of longevity derivatives to a portfolio helps in increasing the amount of diversification. This in turn helps in lowering the overall risk of their portfolio.

3. Speculators have also found longevity derivatives to be an attractive option. They have increased trading in these instruments after the uncertainty added by the coronavirus pandemic has led to increased volatility. Increased volatility translates to higher possibilities of profit and hence tends to attract speculators to the market.

Disadvantages of Longevity Bonds and Longevity Derivatives

Financial institutions and investors have found the concept of longevity bonds to be appealing to some extent. However, they have not invested large sums of money in this idea. Hence, longevity bonds are still not very prevalent in the market. There are some significant disadvantages related to longevity derivatives. Some of these disadvantages have been mentioned below:

1. Longevity bonds are said to be highly illiquid. Most of these financial instruments are sold over the counter. Hence, there isn’t an active market where these instruments are traded. It is therefore difficult to find a counterparty if these instruments have to be liquidated before maturity.

2. Another important issue with longevity instruments is the fact that they can be difficult to price. There is no standardized model in place to price these instruments. Hence, investors find it difficult to find the acquisition or trading price of these instruments.

   In the absence of a market and standardized pricing mechanisms, it can be very difficult to price such instruments. Therefore, investors can never really be sure if they are buying the instruments at the right price.

3. Also, the market for longevity-based financial instruments is a bit lopsided. There are many parties that want to let go of their longevity risks. However, there are few parties that actually want to take on that risk. This leads to the mispricing of these financial instruments. Hence, depth needs to be added to the market for these instruments before they can be used on a large scale.

The bottom line is that longevity bonds and longevity derivatives are still in the nascent stage. They are very promising when it comes to risk management in pension funds. However, the market is yet to be fully developed.