In December 2003, a European insurance company,Swiss Re, issued a 3-year floating-ratebond maturing on January 1, 2007, with a parvalue of US$400 million. The interest-ratepayments were quarterly with a coupon resetformula of 3-month U.S

Question

LIBOR plus 135 basispoints. The principal at maturity was linked toa specifically constructed index of mortalityrates (i.e., mortality index) across five countries(United States, United Kingdom, France, Italy,and Switzerland). The principal schedule at maturitycalled for repayment in full if the mortalityindex does not exceed 1.3 times the 2002 baselevel during any of the three years of the life ofthe bond. However, if the mortality index exceededthat level, there would be an increase of5% for every change in the index by 0.01 .

What was the purpose of Swiss Re issuingthis bond?

Answer 1

The purpose of Swiss Re issuing this bond (an asset) is to cover its maturing liabilities in three years. Due to uncertainties in the liabilities, the bond is arranged to cover risk aspects such as unexpected changes in longevity and inflation. More details are supplied below.

A liability-driven investing (LDI) involves managing the assets and the liabilities. Assets haveinvestment risks and, as we will see, so do liabilities. LDI is used by life insurance companies(like Swiss Re) for several products: annuities, guaranteed investment contracts (GICs), and structuredcontracts that guarantee a minimum rate. It is also used by sponsors of defined benefit (DB)pension plans.Longevity risk is a major risk faced by life insurance companies in pricing insurance policies andby individuals in planning their retirement. To appreciate the significance of longevity risk,consider the change in the expected life over the past 100+ years and the assumption of aretirement age of 65 . In the United States, the average life expectancy at birth for both sexesaccording to mortgage tables breaks down as follows: 1950, 68.2 years; 1960, 69.7 years; 1970,70.8 years; 1980, 73.7 years; 1990, 75.8 years; 2000, 77 years; 2010, 78.7 years. It is expectedto be 79.5 by 2020 . Hence, a plan that used an expected life of 73.7 years in 1980 and thereforea payout of 8.7 years after age 65 would have, on average, to make cash payments forfive additional years (78.7 years minus 73.7 years) by 2010 . As with inflation risk, the sensitivityto changes in the expected life used in the projection of liabilities and the new valuation forthe liabilities based on that expected life can be used to assess the importance of longevity risk.

There are strategies for hedging the interest-rate risk of liabilities such as Swiss Re face. One strategy is referred to as the single-period immunizationstrategy. While not used by DB pension plans to hedge interest-raterisk (because it involves hedging only a single liability payment in the future), this strategyis used by life insurance companies (like Swiss Re) to hedge the interest-rate risk of a popular insuranceproduct: a guaranteed interest contract (GIC). In fact, GIC products are sold by life insurance companies to DB pension plans.

To comprehend the basic principles underlying the immunization of a portfolio againstinterest-rate changes so as to satisfy a single future liability, consider the situation faced bya life insurance company that sells a GIC. Under this policy, for a lump-sum payment, aninsurer guarantees that specified dollars will be paid to the policyholder at a specified futuredate. Or, equivalently, the insurer guarantees a specified rate of return on the payment. A stream of liabilities must also be satisfied for a life insurance company that sells an insurance policy requiring multiple payments to policyholders, such as an annuity policy. Two strategies can be used to satisfy a liability stream: (1) multi-period immunization, and (2) cash flow matching