London is set to become the centre of a potentially huge new global market in trading so-called "longevity" risk faced by pension funds, industry experts predict.

Leading investment banks and insurance companies are working on the design of new securities expected to be launched next year. The moves come as the pensin industry is frantically looking for ways to meet its growing obligations.

David Blake, professor of pension economics at City University, forecast the new market would eventually outstrip credit derivatives, which has balooned to $26,000bn. "The potential is enormous and it will start to happen very soon." The market is expected to start in London rather than New York partly because of a favourable regulatory regime.

Analysts say prescriptive pensions legislation and the threat of class-action lawsuits make US pension schemes nervous of innovation.

This week, Hank Paulson, US treasury secretary, warned the rule-based approach to regulation in the US was undermining the competitiveness of its capital markets. Partha Dasgupta, head of the UK Pension Protection Fund, the statutory safety net for schemes, said the fund was encouraging investment banks to co-operate in designing the securities.

He is optimistic that a market will develop to allow pension funds to offload some of the risk that their members live longer than expected.

The new securities are likely to include variations of "mortality bonds" (whose value falls if deaths occur earlier than expected) and "longevity bonds" (which move the oppsite way). Banks such as Deutsche Bank and BNP Paribas are working on so-called "mortality derivatives."

Death rates spark the birth of a new market

In this world - as Benjamin Franklin once said - "nothing can be said to be certain except death and taxes".

However, a third feature might be added to this list - the ability of bankers to create profitable arbitrage opportunities from these events. For after years of creating structures to handle tax, the financial industry is now turning its attention to the metter of death.

More specifically, some of the sharpest banking minds in London and New York are engaged in a race to create products that enable investors to place bets or hedge risks on death rates (or, to use the more tasteful phrase, 'longevity risk'.)

There are at least two factors driving this trend. One is that, as Detica consultancy recently noted, "the insurance and derivatives industries are beginning to converge".

Although derivatives were initially developed as a tool to manage interest rate and currency risks, financial engineers are now applying these techniques more broadly.

Deutsche Bank and BNP Paribas, for example, have recently been developing "mortality derivatives", which allow investors to bet on death rates.

Meanwhile, cash instruments are increasingly being used alongside synthetic techniques to spread insurance risk into the capital markets.

In recent years, there has been a wave of issuance of "catastrophe bonds" - a security that essentially allows an insurance group to offload part of the risk of a natural disaster to other investors, such as hedge funds.

And in a subtle modification of this technique, Axa, the French insurer, recently sold up to EUR 1bn ($1.3bn) of "mortality bonds", which reflect the risk of a sudden rise in death rates.

This concept was first pioneered by Swiss Re but the Axa deal marks the first time that a primary insurance group has sold such instruments to investors.

However, the second factor driving the "longevity" innovation, is the pension industry's urgent need for better ways of handling risk.

With people in the Western world living longer - and conventional investment returns falling - many pension funds face a growing mismatch between assets and liabilities.

Some are trying to address this by raising their investment in long-dated fixed income instruments. In one sign of this, banks said they wanted more issuance of long-dated gilts in their latest consultation with the UK Debt Management Office.

This has affected asset prices. "As [pension fund managers] started to understand the [risk] issues, the prices of the instruments they needed to buy became extremely high earlier in the year," says Keith Jecks, head of the pensions unit at ABN Amro, who points out that recent gains in equity markets have neverthless changed the picture recently.

This also prompts many bankers to look for alternative ways of managing risk. If a pension fund buys mortality bonds, for example, it can use this to hedge itself against the risk of an unexpected rise in the longevity of its pensioners.

Other "longevity bonds" are likely to be launched next year, which would have a similar effect in reverse.

Investment bankers are also scrambling to offer bespoke derivatives solutions to those running pension schemes, such as trustees (the officials overseeing a pnesion scheme).

"The trigger puller [for buying a product] is the Trustee. We can and indeed do speak to sponsors, but ultimately the trustee must be happy that any solutions work for the interests of the beneficiaries," says Richard Boardman, head of Liability Driven Investments at UBS, which - like its rivals - is trying to sell its innovative ideas to trustees and pension consultants.

This sales job is not easy: trustees tend - as one banker notes - to "be very conservative" and thus wary of the derivatives world. As a result, earlier attempts to launch longevity bonds have failed (see below).

In spite of the challenges, some bankers say it is inevitable that the capital markets will play a big role in taking on longevity risk.

Caitlin Long, head of the insurance solutions group at Credit Suisse, says: "Capital markets to trade longevity and mortality risk will develop soon. There is simply not enough capital in the life insurance industry to absorb the entire longevity exposure in pension plans."

Meanwhile, David Blake, professor of pension economics at City University's Cass Business School, who has been one of the most vocal proponents of longevity bonds, believes the market will start to take off in 2007.

"I've been saying this for five years. But it really is going to happen very soon," he says.

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Changing Attitudes Mean There is More Life Left in Longevity Bonds

The concept of longevity bonds is not new: bankers at BNP Paribas first launched the idea in 2004, after more than a year of working on the scheme.

The main difficulty in meeting the longevity risk in this BNP Paribas plan was finding a counterparty that would take it on. The £550m of 25-year bonds were to have been issued by the top-rated European Investment Bank.

Annual coupon payments would be reduced over time from the base of £50m, reflecting the percentage of the population aged 65 in 2003 who had died by the coupon date.

So why didn't they sell? One key reason seems to have been the price. The cost of the longevity hedge, coupled with the top AAA rating of the borrower, meant the bonds yielded the equivalent of 35 basis points below London interbank offered rates.

Moreover, one banker who worked on the deal says the bond was launched at a time when many pension funds were still assessing their strategies. And many appear to have decided against using funded instruments such as longevity or index-linked bonds to hedge their risk.

Instead they were pursuing strategies that use unfunded hedges, such as interst rate and swaps, and then seeking higher returns with the funded portions of their portfolios.

Nevertheless, the timing for longevity and mortality bonds may now look better, as shown by the recent successful sale of the EUR345m Axa bond.

Pension funds are becoming more knowledgable and more willing to embrace innovation and there is also rising appetite for purchasing new risk products from the ever-expanding pool of hedge funds.

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