Editor’s Letter

This special issue of The Journal of Alternative Investments is mostly devoted to longevity risk, and I am grateful to Bob Swarup, the Special Issue Editor, for helping to create it. I wish to express my deep appreciation to the authors whose articles appear here for sharing their expertise with the readers of JAI.

One of the byproducts of advances in medical technologies and declining health risks is increased life expectancy. Longevity risk is the risk that populations could live longer than expected. Although increased longevity is beneficial to those who live longer and to society as a whole, it poses serious financial risk to governments and defined-benefit pension funds.

According to a 2013 Bank of International Settlements (BIS [2013]), total longevity risk is significant when measured from a financial perspective, with each additional year of life expectancy adding about 3%–4% to the present value of the liabilities of a typical defined-benefit pension fund. Estimates of the total global amount of annuity- and pension-related longevity risk exposure ranges from $15 trillion to $25 trillion (CRO Forum [2010] and Biffis and Blake [2012]). Hence, a one-year longevity underestimation will cost risk holders, in aggregate, from $450 billion to $1 trillion.

To manage this risk, pension funds in some countries are increasingly looking to transfer their longevity risk. Three basic types of transactions are being used to transfer longevity risk, which differ in terms of the types of risk transferred and the types of risk created:

• • A buyout transaction transfers all of a pension plan’s assets and liabilities to an insurer in return for an up-front premium.

• • In a buy-in, the pension plan sponsor retains the assets and liabilities but pays an up-front premium to an insurer to receive periodic payments that match the pension payments.

• • In a longevity swap transaction, periodic fixed payments are made to the swap counterparty (or (re)insurer) in exchange for periodic payments based on the difference between the actual and expected pension or annuity mortality experience.

Bob Swarup, the editor for this special issue, provides an overview of critical issues in understanding and managing longevity risk in the lead article, “The Little Problem of Longevity: Searching for Answers to Uncertainty.” He discusses historical and future trends in life expectancy across the world and argues that the expected increases in longevity are likely to have significant implications for the structure of pension systems in the future. In response to this risk, individuals, businesses, and governments have already undertaken certain actions such as working longer, closing defined-benefit pension schemes, and introducing reforms to state pension systems. Swarup argues that future longevity trends are uncertain, which make it more difficult to allocate longevity risk efficiently and fairly across different economic agents.

The article by Avery Michaelson and Jeff Mulholland, “Strategy for Increasing the Global Capacity for Longevity Risk Transfer: Developing Transactions That Attract Capital Markets Investors,” argues that relative to the size of global longevity risk, the present capital base of the insurance and reinsurance industry is insufficient to bear a meaningful portion of this enormous systemic risk. The only sources of capital capable of assuming a risk of this magnitude are the global capital markets—and, as such, they must be mobilized to do so. The authors describe one strategy for accomplishing the diverse objectives of the various stakeholders in the longevity risk value chain, with the objectives of increasing the global capacity for longevity risk transfer and enhancing the stability of retirement systems by spreading this systemic risk.

The article by Neil Cunha-Gomes “Introducing Alternative Capital to Longevity Risk Transfer,” considers the potential role of alternative capital in the longevity risk transfer space. The author argues that over the past two decades, the catastrophe bond market has generated considerable interest from a variety of capital markets investors, such as endowments, sovereign wealth funds, and family offices. By drawing on lessons from the development of the catastrophe bond market and from the few successful longevity transactions with capital markets investors, the author considers a format in which longevity risk can be transferred into the capital markets.

In “Longevity Risk and the Stability of Retirement Systems: The Chilean Longevity Bond Case,” Ivan Zelenko writes that an unexpected increase in life expectancy is a potential source of insolvency for all economic entities managing defined-benefit retirements, public and private sector alike. Governments are currently dealing with this risk through regulation, by imposing larger, and more risk-based, capital requirements. At a country level, this is akin to a self-insurance strategy, relying on the constitution of savings. The alternative would be to insure. This article studies the case of Chile, a country confronted with the possibility of buying insurance from markets in the form of a longevity bond. In 2009, a team from the World Bank Treasury, together with a bank (J.P. Morgan) and a reinsurer (Munich Re), worked in partnership with the Chilean authorities to create the conditions for a longevity bond issue—potentially the first of series—as a longevity hedge and an alternative to capital requirements for life insurance companies. The article tells the story and draws lessons from it.

Peter Nakada, Chris Breaux, Mehrdad Honarkhah, Chris Hornsby, Dean Tolla, and Rebecca Vessenes provide an overview in “The Fundamentals of Longevity Risk.” They write that investors new to catastrophe-linked securities seek their advice to answer several fundamental questions: What does the historical record tell me? How can I account for future risks that are not in the historical record? How does the risk relate to my intuition around real-world developments? Am I on the wrong side of an information asymmetry? The authors aim to answer these questions for investors new to the asset class. The article starts by reviewing the historical record to provide context for the statistics of interest: life expectancy and mortality improvement. In doing so, the authors discuss various causes of death and how societal and technological advances have impacted these measures, as well as how they differ among countries. The authors address the financial impact of these indicators on annuities and other assets, such as the stock market. With the historical record as a guide, the article discusses approaches to projecting longevity.

This issue of The Journal of Alternative Investments includes two additional articles, on real assets. In “Gold and Systemic Risk,” Chih-Chieh (Jason) Chiu and Mitchell Ratner test gold as a hedge and safe haven asset against systemic risk in 21 emerging and developed countries from 1979 to 2012. Generalized autoregressive conditional heteroskedasticity (GARCH) dynamic conditional correlation analysis indicates that gold serves as an effective hedge against systemic risk. Their results indicate that gold also provides a safe haven in times of extreme market volatility and during periods of financial crises in most countries.

“An Investor-Oriented Metric for the Art Market,” introduces a new financial metric for the art market. The metric, which authors Ventura Charlin and Arturo Cifuentes call artistic power value (APV), is based on the price per unit of area (dollars per square centimeter) and is applicable to two-dimensional art objects, such as paintings. In addition to its intuitive appeal and ease of computation, this metric has several advantages from the investor’s viewpoint. It makes it easy to estimate price ranges for different artists; perform comparisons among them; follow the evolution of the artists’ creativity cycle over time; and compare, for a single artist, paintings with different subjects or different geometric properties. Additionally, the APV facilitates the process of estimating total returns. Finally, due to its transparency, the APV can be used to design derivatives-like instruments that can appeal to both investors and speculators. Several examples validate this metric and demonstrate its usefulness.

TOPIC: Real assets/alternative investments/private equity

Hossein Kazemi

Editor-in-Chief

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