Longevity Risk Management for Pension Funds and Insurance Companies.
Many studies have continued to provide evidence of improved global life expectancies, with the progress largely attributed to improved nutrition, lower mortality rates and enhanced medical treatments and drugs. Since 1990, statistics show that the average global life expectancy has doubled and is approaching 70 years and in Kenya, for instance, the average life expectancy is now at 66.7 years and getting better. Other factors like greater global awareness on the benefits of a healthy diet and regular exercise means that people are living longer.
Figure 1: An elderly couple sharing a light moment. Photo Courtesy: The Internet.
However, as people live longer, pension plan providers face the risk that retirees might on average live longer than expected. This brings about a substantial risk that affects both the willingness and ability of responsible financial institutions to supply retired households with financial products to manage wealth decumulation in retirement (Blake et al., 2014). This type of risk is known as longevity risk and unlike other types of risks affecting pensions and governments, actuaries and insurers have found it more difficult to accurately project and manage this type of risk (Barrieu et al., n.d.).
Longevity risk can express itself either as an idiosyncratic risk that is unique to each individual, or as an aggregate risk borne by institutions that provide life-long payments such as pension funds, annuity providers and public pension schemes (Bravo & Díaz-Giménez, n.d.). Individuals who self-manage their retirement income through withdrawals from defined contribution plans and other savings schemes face the risk of depleting this wealth at a fast rate – individual longevity risk. For institutions that make payments contingent on how long individuals live, aggregate longevity risk will be the risk that mortality assumptions are not accurate and that on average, retirees live longer than expected.
To manage this risk, pension plans and insurance companies (that offer life insurance) can carry out investigations into their own longevity experience and adapt their mortality tables appropriately (Institutions, 2013). However, this task of accurately projecting how long individuals might live beyond their expected ages requires careful analysis or otherwise the financial health of a pension firm or insurer is compromised due to underestimation of financial liabilities. This magnifies the importance of longevity risk management since the amount of unfunded liabilities increase as the beneficiaries live considerably longer than expected. In addition to adapting their mortality tables appropriately, the following risk management solutions also do exist for pension firms and insurance companies.
- Capital market solutions to risk management
Financial markets are said to have developed an increased appetite for insurance risk through alternative risk transfer and development of insurance linked securities. However, the development of these insurance linked securities has not materialised fully due to most financial markets being illiquid and incomplete.
- Longevity indices
Indices have also been used in management of longevity risk and the most common is the survivor index future. Yang Chang presents a cohort-based value index that can be used by insurers to measure the present value of future obligations. Unlike other longevity indices, this cohort-based value index is able to capture interest rate risk and mortality risk simultaneously.
- Longevity swaps
With a growing equilibrium between the number of years spent at work and the number of years spent in retirement, longevity swaps offer an alternative solution to longevity risk management whereby an insurer transfers longevity risk to a counterparty e.g. an investment bank. The insurer makes a series of fixed payments based on longevity assumptions while the counterparty makes variable payments to the counterparty which are calculated against a longevity index.
As improvements in life expectancy continue to materialize, individual savings have not accelerated as fast enough to make up for the deterioration of retirement benefit plans according to a report by the World Economic Forum. Pension firms and life insurance firms continue to strive to identify the best risk management solutions to managing this longevity risk. In Africa, the most commonly identified products in managing longevity risk are the use of annuities and lump sum pension payments. Annuities are offered preferred since instead of receiving a lump sum pension payment on retirement, the retiree receives some amount of income, periodically, during their sunset days.
However, as briefly mentioned in the article, financial institutions providing life-long payments do have a variety of solutions on managing longevity risk. They should continue to innovate nouveau products for retirees who are now predicted to live longer, while also paying attention to their financials so as not to find themselves with huge unpaid financial liabilities.
Written By Frank Maina Muhoho