Life Expectancy, Pension Funds, and the Longevity Risk in Between
Longevity Risk is defined as “… any potential risk attached to the increasing life expectancy of pensioners and policy holders, which can eventually result in higher pay-out ratios than expected for many pension funds and insurance companies.”
Life expectancy has nearly doubled in the past century — from 47.3 years of age in the US in 1902 to 76.8 in 2000. In 2020, it is expected to reach 79.5 years of age. In addition to living longer, a growing proportion of the population is reaching retirement age: the population of 65-and-older is set to reach 20% of the population in 2030 and will more than double from 2010–2050! With medical technology, diagnostics and treatment making leaps and bounds along with people leading healthier lifestyles, these numbers are only expected to rise.
Growing Challenges for Life/Pension Funds
Life expectancy steadily growing poses a huge challenge for life/pension funds and related financial institutions. Insurers are forced to keep large amounts of capital available for the increasing number of payouts. The Solvency II regime together with rising governmental regulation on life and pension products, further obligate insurers to hold capital. This stresses insurer solvency ratios, greatly increasing reserves, liabilities and risk.
The Longevity Risk that life/pension funds are exposed to is evaluated at over $30 trillion USD worldwide. This exposure is currently rising at a rate of 3–5%, while longevity reinsurance penetration is still under 1%. Furthermore, For each additional year of unanticipated life expectancy at age 65, pension liabilities grow by 4–5%.
Naturally, life/pension funds are looking to transfer this risk onwards, and have increasingly been looking for solutions to their longevity risk problem, creating a new emerging market for Longevity Risk Transfer (LRT). LRT solutions exist on the market, mostly in the form of market-based risk transfer solutions, but they are not nearly as developed as in the P&C space. This is changing rapidly, as the need for risk transfer swiftly grows.
Longevity Risk Transfer: Buy-out, Buy-in, Swap or Capital Markets?
There are a few methods in which insurers/pension providers can transfer risk in the Longevity Risk Market: Buy-out, Buy-in, longevity swap and by issuing securities and/or bonds to capital markets.
- Buy-out: In a buy-out, the insurer or pension provider sell and transfer all of their assets and liabilities to the longevity risk protection provider (insurer or bank) in return for a single premium payment. The buyer then has complete control of the underlying assets, but is open to the risk involved.
- Buy-in: In this case, the insurer or pension providers holds on to the underlying assets, but pays a single premium in exchange for periodic payments that match the pension payouts needed from a reinsurer. This is a partial risk transfer, as the pension provider still retains the liability involved in pension payouts.
- Longevity Swap: In a swap, pension providers pay fixed periodic premiums based on mortality assumptions to the longevity risk protection provider (investment bank or reinsurer). The longevity risk protection provider pays a floating premium to the pension fund. This premium is calculated by the difference between the actual and expected mortality rate.
- Transfer to Capital Markets: Hedging against longevity risk using capital markets is the newest and most flexible risk transfer method. Pension funds or insurers can issue longevity bonds which are correlated to an index of a specific population. Buyers of these bonds, in turn, can limit the longevity risk they take on by offloading the risk themselves — either on capital markets, or to other insurers. New online platforms have greatly simplified this process in comparison with the previous methods, providing quick solvency relief for life/pension funds.
Fast Growth Predicted for the Longevity Risk Market
Needless to say, the Longevity Risk Market is undergoing an exciting boom. According to the 2018 LCP Pensions Buyout report, for example, nearly 150 billion GBP (!) worth of risk transfers have been written since 2007 in the UK alone. 2018 was a record-breaking year in the longevity risk transfer market, with demand only rising. If the markets hold, 2019 is expected to exceed 2018.
With the growing need for ways for pension/life insurers to limit longevity-related risk and liabilities, the market can only expand. Due to their flexibility and immediacy, solutions providing options to transfer risk to capital markets are on the rise, with new opportunities offered to insurers, reinsurers, investment banks as well as individual investors. The next few years will be very interesting in the life/pension insurance space, so keep your eyes peeled for new innovation and creative ways to hedge longevity risks.
*This post was originally published on medium.com.
Vesttoo has developed advanced technologies for data-driven risk management, transferring actuarial risk to financial risk through the capital markets. Vesttoo specializes in risk modeling and alternative risk transfer for the Life and P&C insurance markets, providing insurers with a low-cost strategic risk management solution for immediate capital relief, value enhancement and liability hedging.