What Is Longevity Risk?
Longevity risk refers to the chance that life expectancies and actual survival rates exceed expectations or pricing assumptions, resulting in greater-than-anticipated cash flow needs on the part of insurance companies or pension funds.
The risk exists due to the increasing life expectancy trends among policyholders and pensioners and the growing numbers of people reaching retirement age. The trends can result in payout levels that are higher than what a company or fund had originally accounted for. The types of plans exposed to the highest levels of longevity risk are defined-benefit pension plans and annuities, which sometimes guarantee lifetime benefits for policyholders.
- Longevity risk is the risk that pension funds or insurance companies face when assumptions about life expectancies and mortality rates are inaccurate.
- The impact of medicine on life expectancies is difficult to measure, but even minimal changes can increase longevity risk.
- An aging population and greater numbers of people reaching retirement age add to longevity risk.
- Pension funds and other defined-benefit programs that promise lifetime retirement benefits have the highest risk.
- Current mortality rates and longevity trend risk are the two factors considered when attempting to transfer longevity risk.
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Understanding Longevity Risk
Average life expectancy figures are on the rise, and even a minimal 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 have not been quantified. In addition, the number of people reaching retirement age—65 or older—is growing as well, with the total projected to reach 95 million by 2060, up from roughly 56 million in 2020.
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. Also, 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 in their longevity.
Organizations can transfer longevity risk in several 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. The first is the current levels of mortality, which are observable but vary substantially across socioeconomic and health categories. The second is longevity trend risk, which is the trajectory of the risk and is systematic as it applies to an aging population.
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 plan or an insurance company, one reason to cede risk is uncertainty around the exposure to longevity trend risk, particularly due to the systematic nature.