| Longevity risk 101 |
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| 13/05/2007 | |
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Guy D Coughlan, Global Head of Asset Liability Management at JP Morgan, answers this week's questions on mortality risk. 1. What are longevity and mortality risks? Longevity risk and mortality risk are opposite sides of the same coin. In other words they are different manifestations of the same risk. Longevity risk is the risk of people living longer, or having higher life expectancy, than anticipated. A direct consequence of longevity risk is the increase in the size of liabilities of defined benefit pension plans and annuity providers due to an improvement in life expectancy beyond what is currently anticipated. These improvements have a negative impact on the performance of annuity providers, defined benefit pension plans, life settlement investments, etc. Increasing life expectancy is cumulative long term risk. An increase in longevity materialises gradually over time making it hard to forecast and accurately measure longevity risk. Mortality risk, on the other hand, is the risk people that people will live shorter than anticipated due to higher than expected mortality rates. Deterioration in life expectancy has a negative impact on life insurance companies, since death benefits must be paid out sooner than anticipated. Unlike longevity risk, mortality risk can be reflected in sharp changes in mortality rates due to for example a pandemic or natural disaster. 2. Where does longevity risk currently reside? Longevity risk resides in a number of different types of organisations, including · Defined benefit pension plans · Corporations as sponsors of defined benefit pension plans · Governments and public sector entities as sponsors of defined benefit pension plans and social security programs · Insurers & reinsurers · Long-term healthcare providers and individuals Perhaps surprisingly, very little of the world's longevity risk lies with insurers and reinsurers, who traditionally have been best equipped to manage it. In fact most of the world's longevity exposure lies with the sponsors of defined benefit pension plans, who have not until recently paid it any real attention. 3. Why is so much attention turning to longevity risk recently? Changes in accounting standards (in particular IFRS & US GAAP) along with changes in regulation (insurance and pension regulation) in many countries have made longevity exposures much more visible to both management and shareholders. They have belatedly realized that for decades, projections of future longevity have consistently underestimated increasing life expectancy and consequently the size of pension liabilities. To get a flavour of the magnitude of longevity risk exposure, it is useful to examine historical changes in mortality rates, life expectancy and the corresponding pension values for 65–year-old males (see table below). Mortality rates for 65-year olds:  source: JPMorgan LifeMetrics Index 4. What is needed to create a liquid market for longevity/mortality risk transfer? Until recently there have been several obstacles to the development of a traded market in longevity/mortality risk. In particular: · Lack of visibility of this risk · Lack of appreciation of its potential impact · Disconnect between economic impact and regulatory and accounting impact · The unfamiliar nature of this risk To create a liquid market for longevity/mortality risk requires a number of things: · Improving the alignment between economic impact and accounting and regulatory measurement of the risk. This process is already underway in the recent changes to accounting and regulation · Increasing visibility to the development of a transparent index of longevity and mortality · Provision of a standardised framework for measuring and managing longevity /mortality risk that bridges the conceptual and language gaps between actuaries and financial risk professionals · Developing appropriate risk transfer products in capital markets format 5. Why is now the right time for the development of a longevity market? A traded market in longevity risk is now emerging and we believe it will develop over the next few years into a market of considerable size and depth. There are several reasons why we believe now is the right time for the development of this market: · Changes in accounting and regulation have already raised awareness of longevity risk amongst all stakeholders · There is widespread recognition that longevity risk is a huge potential problem and something needs to be done about it · Investors of various types have begun to get interested in longevity/mortality as a new asset class, which is uncorrelated with other asset classes and provides an attractive risk premium for enhancing their investment returns. The publication of LifeMetrics has provided a transparent index of longevity/ mortality, together with a practical framework and practical tools for measuring and managing this risk. See www.lifemetrics.com for more details. |
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Articles of the same Serie : 101 |
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