http://www.soa.org/files/pdf/research-long-risk-quant-rpt.pdf
One of the largest and least understood risks that insurance and reinsurance companies, pension plan sponsors, and the government are exposed to is longevity risk.
Longevity risk from the perspective of an insurance company or defined benefit plan sponsor is the exposure that a company has to unexpected decreases in mortality. This is the opposite of mortality risk, which is exposure to increases in mortality. Longevity risk has developed as experience emerges about the consistent increase in life expectancy, combined with the long term nature of many guarantees that insurance companies have written. It is a risk that is often overlooked, as evidenced by the fact that the current RBC capital formula in the US omits longevity risk from the calculation of insurance risk. Typically, risk discussions only reflect the risk of higher than expected mortality – very rarely is the risk of lower than expected mortality discussed.
Historically, retirement programs in the US shifted much of the responsibility for funding retirement to employer based pension plans. These defined benefit plans promised to pay employees over their entire lifetime; therefore eliminating much of the need for retail based guaranteed income products. However, more recent trends indicate that there are fewer and fewer companies offering defined benefit plans to their employees. Because of this, individuals are turning to the retail market to find available solutions to help them manage their own risk of outliving their assets.
The dynamics of greater life expectancy and fewer employer sponsored guarantees has started to drive the sales of guaranteed income products. This is resulting in insurance companies either knowingly or unknowingly taking on a significant amount of longevity risk. Similarly, due to the increasing life expectancy, employer sponsored pension plans face an increasing risk.
Longevity risk should be examined as two separate components – systematic and specific risk. Systematic risk results from incorrect assumptions about the base mortality rate and level of mortality improvement. Specific risk comes from the normal volatility that occurs around any best estimate assumption. While it is possible to diversify much of the specific risk, given the specific risk profile of some exposures it may not be possible to eliminate. Systematic risk can not be diversified away, and needs to be quantified and managed.
Current longevity risk management techniques in the US market are limited, and consist primarily of traditional methods such as natural hedging and reinsurance. Natural hedging refers to companies that are exposed to both increases and decreases in mortality. Since long-term improvement assumptions are generally thought to apply to the entire population, a decrease in mortality will hurt payout annuity products while improving the profitability of traditional life insurance products. Because of this, companies with well diversified life and annuity lines of business have lower overall exposure to one-directional changes in mortality.
Given the limited ability to quantify longevity risk in the US, the markets are not as efficient as they are for traditional mortality risk. This is true for both reinsurance and capital market solutions. There has been an attempt in recent years to shift longevity risk to the capital markets through swaps tied to mortality indices. This market is in its infancy in the US, but is much more developed in the UK.
In times of high market volatility, Wall Street is likely to try and obtain investments with little to no correlation to their existing invested assets. Therefore, the market for longevity risk is likely to increase and more efficient methods of transferring this risk are likely to emerge during these times.
