Longevity Risk

Longevity risk is risk to which a pension fund or life insurance company could be exposed as a result of higher-than-expected payout ratios. Longevity risk exists due to the increasing life expectancy trends among policyholders and pensioners, and can result in payout levels that are higher than what a company or fund originally accounts for. The types of plans exposed to the greatest levels of longevity risk are defined-benefit pension plans and annuities, which guarantee lifetime benefits for policy or plan holders.

Average life expectancy figures are on the rise, but even a very small change in life expectancies can create severe solvency issues for pension plans and insurance companies. Precise measurements of longevity risk are still unattainable because the limitations of medicine and its impact on life expectancies has not been quantified.

Longevity risk affects governments in that they must fund promises to retired individuals through pensions and healthcare, and they must do so despite a shrinking tax base. Corporate sponsors who fund retirement and health insurance obligations must deal with the longevity risk related to their retired employees. In addition, individuals, who may have reduced or no ability to rely on governments or corporate sponsors to fund retirement, have to deal with the risks inherent with their own longevity.

Organizations can transfer longevity risk in a number of ways. The simplest way is through a single premium immediate annuity (SPIA), whereby a risk holder pays a premium to an insurer and passes both asset and liability risk. This strategy would involve a large transfer of assets to a third party, with the possibility of material credit risk exposure. Alternatively, it is possible to eliminate only longevity risk while retaining the underlying assets via reinsurance of the liability. In this model, instead of paying a single premium, the premium is spread over the likely duration of 50 or 60 years (expected term of liability), aligning premiums and claims and moving uncertain cash flows to certain ones.

When transferring longevity risk for a given pension plan or insurer, there are two primary factors to consider: current levels of mortality, which are observable but vary substantially across socio-economic and health categories, and longevity trend risk, which is systematic in nature as it applies to populations. The most direct offset available to the systematic mortality trend risk is through holding exposure to increasing mortality – for example, certain books of life insurance policies. For a pension scheme or an insurance company, one reason to cede risk is uncertainty around the exposure to this risk, particularly due to the systematic nature.