Annuity Providers Research Articles

Hedging Longevity Risk When Interest Rates are Uncertain

This paper proposes an asset liability management strategy to hedge the aggregate risk of annuity providers under the assumption that both the interest rate and mortality rate are stochastic. We assume that annuity providers can invest in longevity bonds, long-term coupon bonds, and shortterm zero-coupon bonds to immunize themselves from the risks of the annuity for the equity holders subject to a required profit. We demonstrate that the optimal allocation strategy can lead to the lowest risk under different yield curves and mortality rate assumptions. The longevity bond can also be regarded as an effective hedging vehicle that significantly reduces the aggregate risk of the annuity providers.

A utility-based comparison of pension funds and life insurance companies under regulatory constraints

This paper compares two different types of annuity providers, i.e. defined benefit pension funds and life insurance companies. One of the key differences is that the residual risk in pension funds is collectively borne by the beneficiaries and the sponsor’s shareholders while in the case of life insurers it is borne by the external shareholders. First, this paper employs a contingent claim approach to evaluate the risk return tradeoff for annuitants. For that, we take into account the differences in contract specifications and in regulatory regimes. Second, a welfare analysis is conducted to examine whether a consumer with power utility experiences utility gains if she chooses a defined benefit plan or a life annuity contract over a defined contribution plan. We demonstrate that regulation can be designed to support a level playing field amongst different financial institutions.

Longevity-Indexed Life Annuities

This paper addresses the problem of the sharing of longevity risk between an annuity provider and a group of annuitants. An appropriate longevity index is designed in order to adapt the amount of the periodic payments in life annuity contracts. This accounts for unexpected longevity improvements experienced by a given reference population. The approach described in the present paper is in contrast with group self-annuitization, where annuitants bear their own risk. Here the annuitants bear only the nondiversifiable risk that the future mortality trend departs from that of the reference forecast. In that respect, the life annuities discussed in this paper are substitutes for reinsurance and securitization of longevity risk.

Assessing securitisation and hedging strategies for management of longevity risk

In this article, we address the problem of developing a hedging strategy for managing a portfolio of longevity risk-sensitive products, such as annuities, term life insurance, using a shareholder value maximisation framework from a provider’s perspective. An annuity provider extends a portfolio of annuities and is exposed to the cash flow requirements underlying this portfolio. Given the mortality risk of the demographics of its customer-base, the provider needs to develop a long-term risk profile of the cash-flow requirements of the portfolio, and develop a hedge for the scenarios where the necessary payments may threaten the provider’s solvency. With a choice of newly emerging hedging instruments, such as mortality bonds, survivor swaps, longevity bonds, we assess the role these instruments can play in the risk management strategy of an annuity and/or insurance provider.

Longevity Risk Management in Singapore's National Pension System

AbstractAlthough annuities are a theoretically appealing way to manage longevity risk, in the real world relatively few consumers purchase them at retirement. To counteract the possibility of retirees outliving their assets, Singapore's Central Provident Fund, a national defined contribution pension scheme, has recently mandated annuitization of workers’ retirement assets. More significantly, the government has entered the insurance market as a public‐sector provider for such annuities. This article evaluates the money's worth of life annuities and discusses the impact of the government mandate and its role as an annuity provider on the insurance market.

An application of comonotonicity theory in a stochastic life annuity framework

A life annuity contract is an insurance instrument which pays pre-scheduled living benefits conditional on the survival of the annuitant. In order to manage the risk borne by annuity providers, one needs to take into account all sources of uncertainty that affect the value of future obligations under the contract. In this paper, we define the concept of annuity rate as the conditional expected present value random variable of future payments of the annuity, given the future dynamics of its risk factors. The annuity rate deals with the non-diversifiable systematic risk contained in the life annuity contract, and it involves mortality risk as well as investment risk. While it is plausible to assume that there is no correlation between the two risks, each affects the annuity rate through a combination of dependent random variables. In order to understand the probabilistic profile of the annuity rate, we apply comonotonicity theory to approximate its quantile function. We also derive accurate upper and lower bounds for prediction intervals for annuity rates. We use the Lee–Carter model for mortality risk and the Vasicek model for the term structure of interest rates with an annually renewable fixed-income investment policy. Different investment strategies can be handled using this framework.

Comonotonic Approximations to Quantiles of Life Annuity Conditional Expected Present Values: Extensions to General Arima Models and Comparison with the Bootstrap

AbstractThis paper aims to provide accurate approximations for the quantiles of the conditional expected present value of the payments made by the annuity provider, given the future path of the Lee-Carter time index. Conditional cohort and period life expectancies are also considered. The paper also addresses some associated simulation issues, which, hitherto, have been unresolved.

A Utility-Based Comparison of Pension Funds and Life Insurance Companies under Regulatory Constraints

This paper compares two different types of annuity providers, i.e. defined benefit pension funds and life insurance companies. One of the key differences is that the residual risk in pension funds is collectively borne by the beneficiaries and the sponsor's shareholders while in the case of life insurers, it is borne by the external shareholders. This paper employs a contingent claim approach to evaluate the risk return trade-off for annuitants. For that, we take into account the differences in contract specifications and in regulatory regimes. Mean-variance-skewness analysis is conducted to determine annuity choices of consumers. We calibrate the regulatory default probabilities such that the consumer is indifferent between a pension fund and a life insurer. The consumer's risk aversion level appears to play a crucial rule in this.

Longevity Risk Management in Singapore’s National Pension System

Although annuities are a theoretically appealing way to manage longevity risk, in the real world relatively few consumers purchase them at retirement. To counteract the possibility of retirees outliving their assets, Singapore’s Central Provident Fund, a national defined contribution pension scheme, has recently mandated annuitization of workers’ retirement assets. More significantly, the government has entered the insurance market as a public-sector provider for such annuities. This paper evaluates the money’s worth of life annuities and discusses the impact of the government mandate and its role as an annuity provider on the insurance market.

Optimal Risk Classification with an Application to Substandard Annuities

Substandard annuities pay higher pensions to individuals with impaired health and thus require special underwriting of applicants. Although such risk classification can substantially increase a company's profitability, these products are uncommon except for the well established U.K. market. In this paper, we comprehensively analyze this issue and make several contributions to the literature. First, we describe enhanced, impaired life, and care annuities, and then discuss the underwriting process and underwriting risk related thereto. Second, we propose a theoretical model to determine the optimal profit-maximizing risk classification system for substandard annuities. Based on the model framework and for given price-demand dependencies, we formally show the effect of classification costs and costs of underwriting risk on profitability for insurers. Risk classes are distinguished by the average mortality of contained insureds, whereby mortality heterogeneity is included by means of a frailty model. Third, we discuss key aspects regarding a practical implementation of our model as well as possible market entry barriers for substandard annuity providers.

On the pricing of longevity-linked securities

For annuity providers, longevity risk, i.e. the risk that future mortality trends differ from those anticipated, constitutes an important risk factor. In order to manage this risk, new financial products, so-called longevity derivatives, may be needed, even though a first attempt to issue a longevity bond in 2004 was not successful. While different methods of how to price such securities have been proposed in recent literature, no consensus has been reached. This paper reviews, compares and comments on these different approaches. In particular, we use data from the United Kingdom to derive prices for the proposed first longevity bond and an alternative security design based on the different methods.

Mortality-Linked Securities and Derivatives

In the last few years, the risk of mortality improvements has become increasingly capital intensive for pension funds and annuity providers to manage. The reason is that longevity risk has been systematically underestimated, making balance sheets vulnerable to unexpected increases in liabilities. The traditional way of transferring longevity risk is through insurance and reinsurance markets. However, these lack the capacity and liquidity to support an estimated global exposure in excess of $20tr (e.g., Loeys et al., 2007). Capital markets, on the other hand, could play a very important role, offering additional capacity and liquidity to the market, leading in turn to more transparent and competitive pricing of longevity risk. Blake and Burrows (2001) were the first to advocate the use of mortality-linked securities to transfer longevity risk to the capital markets. Their proposal has generated considerable attention in the last few years, and major investment banks and reinsurers are now actively innovating in this space (see Blake et al., 2008, for an overview). Nevertheless, despite growing enthusiasm, longevity risk transfers have been materializing only slowly. One of the reasons is the huge imbalance in scale between existing exposures and willing hedge suppliers. Another reason is that a traded mortality-linked security has to meet the different needs of hedgers (concerned with hedge effectiveness) and investors (concerned with liquidity and with receiving adequate compensation for assuming the risk), needs that are difficult to reconcile when longevity risk, a long-term trend risk that is difficult to quantify, is involved. A third reason is the absence of an established market price for longevity risk. We provide an overview of the recent developments in capital markets aimed at overcoming such difficulties and at creating a liquid market in mortality-linked securities and derivatives.

Hedging Pension Longevity Risk: Practical Capital Markets Solutions

Longevity risk transfer via the capital markets is now a reality. Pension plans and annuity providers can hedge longevity risk with capital markets instruments, reflecting the emergence of a new market that is poised to take off. The key players in this market are hedgers (pension plans and annuity providers), intermediaries (investment banks and broker-dealers) and end investors (ILS funds, hedge funds, endowments, etc.). We argue that the development of liquidity in this market depends on the acceptance of longevity indices and the development of standardized instruments to transfer this risk.Until now, hedgers of longevity risk have almost exclusively approached the subject from the perspective of indemnification (100 percent risk transfer). We propose an alternative approach based on a risk management paradigm that does not require 100 percent risk transfer and is consistent with the way in which other pension-related risks are managed. To this end we present a framework for longevity hedging cantered on standardized indexbased hedges. This framework uses a building-block approach in which standardized hedge building blocks are combined to provide a longevity hedge tailored to the specific demographics, benefit structure and mortality table of any pension plan. The effectiveness of this hedge is maximized by careful calibration of the mix of building blocks and then verified in hedge effectiveness tests.We also discuss customized longevity hedges that will be preferred by some hedgers, who are unconcerned by the lower liquidity and onerous requirements for data disclosure associated with these hedges, and are prepared to pay the additional premium above the cost of a standardized hedge.

Life Anuities with Stochastic Survival Probabilities: A Review

An insurance company selling life annuities has to use projected life tables to describe the survival of policyholders. Such life tables are generated by stochastic processes governing the future path of mortality. To fix the ideas, the standard Lee-Carter model for mortality projection is adopted here. In that context, the paper purposes to examine the consequences of working with random survival probabilities. Various stochastic inequalities are derived, showing that the risk borne by the annuity provider is increased compared to the classical independent case. Moreover, the type of dependence existing between the insured life times is carefully examined. The paper also deals with the computation of ruin probabilities and large portfolio approximations.

Transparency and Competition in the Choice of Pension Products: The Chilean and UK Experience

The growing importance of defined contribution (DC) pension plans is focusing attention on the decumulation or payout phase of pension systems. Where annuitization is encouraged or mandatory, how to ensure that individuals get the best price for annuity products is key. The complicated nature of these decisions means that purchases are highly dependent on the information and advice provided by the sellers of these products. This can be a problem where annuity providers are already involved in the preretirement, accumulation phase, leaving individuals open to abuse if ‘locked-in’ and not able to ‘shop around’ to find a better annuity rate from alternative providers. This paper discusses two countries building centralized information and quotation systems for annuity products to help individuals select the right retirement product at the right price. The SCOMP system in Chile is examined and developments around the Open Market Option (OMO) in the UK are discussed, with lessons drawn for other pension supervisory authorities contemplating introducing such centralized systems.

Hedging Pension Longevity Risk: Practical Capital Markets Solutions

Longevity risk transfer via the capital markets is now a reality. Pension plans and annuity providers can hedge longevity risk with capital markets instruments, reflecting the emergence of a new market that is poised to take off. The key players in this market are hedgers (pension plans and annuity providers), intermediaries (investment banks and broker-dealers) and end investors (ILS funds, hedge funds, endowments, etc.). We argue that the development of liquidity in this market depends on the acceptance of longevity indices and the development of standardized instruments to transfer this risk.Until now, hedgers of longevity risk have almost exclusively approached the subject from the perspective of indemnification (100 percent risk transfer). We propose an alternative approach based on a risk management paradigm that does not require 100 percent risk transfer and is consistent with the way in which other pension-related risks are managed. To this end we present a framework for longevity hedging cantered on standardized indexbased hedges. This framework uses a building-block approach in which standardized hedge building blocks are combined to provide a longevity hedge tailored to the specific demographics, benefit structure and mortality table of any pension plan. The effectiveness of this hedge is maximized by careful calibration of the mix of building blocks and then verified in hedge effectiveness tests.We also discuss customized longevity hedges that will be preferred by some hedgers, who are unconcerned by the lower liquidity and onerous requirements for data disclosure associated with these hedges, and are prepared to pay the additional premium above the cost of a standardized hedge.

Comonotonic approximations to quantiles of life annuity conditional expected present value

In large portfolios, the risk borne by annuity providers (insurance companies or pension funds) is basically driven by the randomness in the future mortality rates. To fix the ideas, we adopt here the standard Lee–Carter framework, where the future forces of mortality are decomposed in a log-bilinear way. This paper aims to provide accurate approximations for the quantiles of the conditional expected present value of the payments to the annuity provider, given the future path of the Lee–Carter time index. Mortality is stochastic while the discount factors are derived from a zero-coupon yield curve and are assumed to be deterministic. Numerical illustrations based on Belgian mortality (general population and insurance market statistics) show that the accuracy of the approximations proposed in this paper is remarkable, with relative difference less than 1% for most probability levels.

Governments and the Market for Longevity-indexed Bonds

Uncertainty about length of life, longevity risk, is a growing financial problem for pension funds and annuity providers. Unfortunately, there is a lack of financial instruments to hedge against this longevity risk, thereby complicating risk management by pension funds and hindering the expansion of the annuity market. Consequently, this paper examines the role of government in promoting a private market solution for longevity hedging financial products. Governments could in principle improve the market for annuities by issuing longevity-indexed bonds and by producing a longevity index. The paper argues that the first public policy role is hampered by the fact that governments are themselves already exposed to significant longevity risk. However, governments could take other steps such as producing a reliable longevity index.

Life Is Cheap: Using Mortality Bonds to Hedge Aggregate Mortality Risk

Abstract Insurance companies, employer pension plans, and the U.S. government all provide annuities and therefore assume aggregate mortality risk. Using the widely-cited Lee-Carter mortality model, we quantify aggregate mortality risk as the risk that the average annuitant lives longer than is predicted by the model, and we determine that annuities expose providers to substantial risk. We also find that other recent actuarial forecasts lie at the edge or outside of Lee-Carter's 95% confidence interval, suggesting even more uncertainty about future mortality.We then evaluate the implications of aggregate mortality risk for insurance companies; this analysis can be extended to private pension providers and Social Security. Given the forecasts of the Lee-Carter model, we calculate that a markup of 3.9% on an annuity premium (or shareholders' capital equal to 3.9% of the expected present value of annuity payments) would be required to reduce the probability of insolvency resulting from aggregate mortality shocks to 5%, and a markup of 5.7% would reduce the probability of insolvency to 1%. Based on the same model, we find that a projection scale commonly referred to by the insurance industry underestimates aggregate mortality improvements and would leave annuities underpriced.Annuity providers could manage aggregate mortality risk more efficiently by transferring it to financial markets through mortality-contingent bonds. We calculate the returns that one recently proposed mortality bond would have paid had it been available over a long period. Using both the Capital and the Consumption Capital Asset Pricing Models, we determine the risk premium that investors would have required to hold the bond. At plausible coefficients of risk aversion, annuity providers should be able to hedge aggregate mortality risk via such bonds at very low cost.

Governments and the Market for Longevity-Indexed Bonds

Uncertainty about length of life, longevity risk, is a growing financial problem for pension funds and annuity providers. They would like to transfer longevity risk away to institutions better placed to deal with it. Unfortunately, there is a lack of financial instruments to hedge against this longevity risk, thereby complicating risk management by pension funds and hindering the expansion of the annuity market. Consequently, this paper examines the role of government in promoting a private market solution for longevity hedging financial products. Governments could improve the market for annuities by issuing longevity indexed bonds and by producing a longevity index. The paper argues though that this public policy role is hampered by the fact that governments are themselves are already exposed to significant longevity risk. However, governments could take other steps such as producing a longevity index.