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Longevity Risk

Updated on May 2, 2024
Article byPallabi Banerjee
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Longevity Risk?

Longevity Risk refers to the possibility of an increase in the life expectancy of individuals, which will result in payment of pension amounts, insurance claims, or retirement amounts. This becomes a risk for the companies maintaining such funds because it creates financial pressure on them.

Longevity Risk

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The potential risk arising due to such deviation from expectations creates a huge payout obligation inconsistent with the planned liabilities and payments for the future because the insurance industry and retirement funds depend a lot on life expectancy calculations while setting aside resources for the same. It also creates unemployment and disturbs the resources kept aside for retirement.

Key Takeaways

  • The concept of longevity risk explains the risk arising for insurance and pension funds due to a rise in the life span of individuals.
  • It also affects the financial plans and portfolio set aside as retirement benefits because it leads to unplanned cash outflow beyond the expected time period.
  • The risk affects the insurance industry with serious and long-term implications on sustainability through the pressure of financial resources.
  • Due to this risk, insurance products and policies become more costly, and premiums increase.

Longevity Risk In Insurance Explained

Longevity risk explains the financial pressure that insurance companies and pension funds face when the survival rates of individuals turn out to be more than the life expectancy anticipated for them. It results in more than planned outflow of cash and a payout for a longer time.

As a result of the above situation, even the policyholders end up paying more premiums in such cases of longevity risk in retirement because the companies need to handle higher risks, thus putting a strain on their finances and solvency. Calculations like retirement planning and insurance policy greatly depend on the possible life span of individuals, based on which the premium amount and funds for pension are decided.

With the advancement in the medical field and exposure to better living conditions, life expectancy is on the rise. It is increasingly becoming difficult to predict as more and more people are able to reach retirement age. Therefore, companies and trustees have started to look for new opportunities and methods that will help evaluate the lifespan or identify new solutions that will aid in managing such risk.

This longevity risk in retirement becomes quite significant from the financial point of view because as more and more years are added to the life of a human being, the liability of the payout increases by 3-4% each year. To tackle such a risk, the pension funds of various countries transfer this risk to some other insurer either in full or partially, sometimes across borders. However, this arrangement is yet to be explored in detail by many companies because there are many factors involved in their smooth functioning, including potential risks from market participants.

Factors

Some common factors that lead to this longevity risk in insurance, are as follows:

  • Age and gender – Studies show that generally, women live longer than men and aged people with good health conditions tend to live longer.
  • Medical advancement – The current trend of medical facilities and thorough research in this field has contributed to the invention of various medicines and techniques that can cure diseases that were considered to be fatal some years back. Medical breakthroughs and easy cure for many chronic problems have increased the life expectancy.
  • Demographics – In many areas of the world, due to weather conditions, people tend to fall sick very little, and thus, they can stay healthy for a longer time.
  • Income – As people’s income and earnings continue to increase over time, they are able to afford a better lifestyle, food, medical facilities, and living conditions, leading to a healthier life for many years.
  • Education– Education plays a huge role in increasing the lifespan and thus creating longevity risk. The more knowledgeable a person is, the more they are aware of any health-related problems and their solutions, which acts as a guide for them to prevent any health issues, thus increasing longevity.

Thus, the above factors contribute to longevity risk in insurance.

Examples

Let us understand the concept of longevity risk in investment with the help of some suitable examples, as given below:

Example #1

We assume that KGS Ltd is an insurance company that provides products like life insurance, health insurance, pension funds, etc. Their client, Mike, was 45 years old when he took medical insurance from the company along with a pension plan. His premium was at par with other insurance holders at that time, and the company calculated his life expectancy based on his health conditions. But later, he continued to live beyond the calculated lifetime with no serious health issues. Thus, KGS Ltd increased its premium because it now needs to continue paying the pension amount, which is beyond the planned cash outflow and also the risk of claim has increased.

Example #2

Swiss Re, the world’s second-largest reinsurer, launched into the market a series of insurance-linked securities (ILS) that are longevity-based. This is the first time in the history of the global financial market that this risk has been securitized in the form of a bond, leading to longevity risk management.

According to Standard & Poor (S&P), the company prepared to sell these instruments through the Special Purpose Vehicle (SPV) Kortis Capital Ltd. The S&P rated the instruments BB+, which will transfer the risk to the investors and participants of the capital market.

Impact

The risk tends to have a significant impact on the financial markets and society. Let us study the details of the same.

Individuals

  • Every individual plans for their own retirement by keeping aside some funds accumulated during their working years so as to meet daily expenses and other immediate financial needs. If the life span of such individuals goes beyond the normal expectancy, the resources get depleted, resulting in financial constraints.
  • Even though the life span increases, the physical ability keeps decreasing, leaving these individuals dependent on family in various ways.

Financial institutions

  • They face an increase in liability as there is the need to continue paying pension funds and health claims beyond the estimated period, resulting in more than planned cash outflow.
  • It becomes difficult to calculate the life expectancy of policyholders based on which premium can be charged because of volatility in longevity.

Society

  • Living longer and depletion of personal financial resources in case of longevity risk in investment will mean that the person has to depend on and access government aid and social welfare services, thus putting pressure on the government.
  • There will be an increase in the demand for healthcare services.
  • The labor market gets impacted too. People who are aged but are in a position to work may take up jobs, thus blocking the job opportunity that could be allotted to younger generations.

How To Hedge?

Hedging refers to the concept of creating strategies to limit any kind of risk arising from loss of financial resources. Some measures can be taken to limit such risk and create longevity risk management, as follows:

In many countries, the risks involved in pension plans are gradually shifted to the individuals. But that has not solved the problem because this has created a greater demand for annuity from the pensioners. So, the insurers are back in the same position. Therefore, the only way left is to use some risk management tool, like the upgradation of the mortality chart and designing premium and pension plans according to them.

Another method to hedge longevity risk in investment is the issue of floating-rate bonds that are linked to the updated mortality index. Even the governments of countries can issue such bonds, which will help spread the risk among the younger generation. This will be easy to sell as they have minimal risk exposure.

Longevity Risk vs Mortality Risk

Both the above concepts refer to the life expectancy of an individual but with certain differences. Let us study the same, as given below:

  • The former refers to the risk that arises due to an increase in the tenure of life of a person, and the latter refers to the risk arising from a decrease in the tenure of life of a person.
  • The former leads to financial pressure on insurance and pension funds for a payout that will be longer than expected, and the latter leads to financial pressure on insurance claims with a sudden heavy payout.
  • Developments in the medical field lead to an increase in the former but a decrease in the latter.

Thus, the above are some important differences between the two concepts.

Frequently Asked Questions (FAQs)

How to manage longevity risk?

This risk can be managed by creating a larger corpus of resources at a personal level so as to continue getting the flow of money, upgradation of mortality index by the financial institutions, and calculating the premiums and using various risk transfer methods by insurers like buy-in, buy-out and longevity swap.

What is longevity risk transfer?

Very often, in some countries, the risk is transferred to some reinsurer, which may be a buy-in involving the insurer retaining the assets and liabilities but paying a lumpsum premium upfront to match the pension payout, a buy-out involving the transfer of assets and liabilities to the reinsurer and paying upfront premium or longevity swap, where the pension fund pays fixed payment to a reinsurer in exchange for periodic payments.

What are the components of longevity risk?

The components of the risk can be categorized as systematic and specific. The systematic refers to incorrect or mistaken assumptions that insurers make during life expectancy calculation. But specific risk refers to the frequent fluctuation on the life span that may be close to the actual calculation.

This article has been a guide to what is Longevity Risk. Here, we explain it with examples, how to hedge it, differences with mortality risk, factors, and impact. You may also find some useful articles here –

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