Korea Capital Market Institute

Longevity risk is a systemic risk in the face of an aging society. As the rate of improvements in life expectancy is very uncertain, the adverse impact this may have on pension plans and annuity providers are potentially huge. Failure to restructure and mitigate longevity risk may increase the likelihood that individuals will run out of financial resources, thereby being forced to lower their living standards when they reach an old age. Despite increasing awareness and concerns about the impact of longevity risk, the financial instruments to hedge against it are currently lacking. Under the circumstances, economic efficiency would be enhanced dramatically if each economic entity, according to each one`s own incentive, could trade the longevity risk in the capital markets. Longevity bonds can help pension funds and prospective investors effectively manage and trade longevity risk in the capital markets. The longevity bonds pay coupons(and sometimes the principal sum) that are linked to population survivorship. Derivatives such as longevity swaps have so far been favored, but the issuance of longevity bonds can attract a much wider investor base. As for how to implement longevity bonds, the issuer can be either the government or the private sector. Despite the controversies over whether the government should be exposed to more longevity risk by issuing longevity bonds, we strongly believe that it is necessary for the government to play a limited role as an issuer for small issues or issues related to super-aging risk. When the government issues longevity bonds, the issuer will bear longevity risk while pension funds and insurers, who are currently taking on those risks, will become investors. A desirable scheme would be for the government to issue longevity bonds with super-long maturities based on the government’s high credit rating. In such a case, the entire population will be the target group to calculate the longevity risk, and the amount of payouts will rise as the survival rate becomes higher than a predetermined expectation. A typical example of bonds carrying such a structure is the EIB/BNP longevity bond. For longevity bonds issued by the private sector, potential issuers are pension funds and insurance companies that are currently taking on longevity risk. Under such a scheme, ideal investors would be sophisticated investors, such as hedge funds, capable of properly managing longevity risk. For this type of bond, short-term issues are desirable, taking account of the credit rating of the issuers. In this case, the target population group for the longevity risk is narrowed down to a particular sub-group of population, whose longevity risk is what the issuer intends to hedge against. The payouts fall as the survival rate increases above a pre-determined expectation. The 2010 Swiss Re longevity- trend bond fits these characteristics. Here, we introduce the fundamental concept as well as actual cases of longevity bonds. Then, we discuss in more detail how to launch longevity bonds in Korea. We hope that anyone looking for policy tools in response to the aging trend will find this paper helpful.