Academic journal article Journal of Risk and Insurance

Longevity Risk and Capital Markets

Academic journal article Journal of Risk and Insurance

Longevity Risk and Capital Markets

Article excerpt

As populations in countries around the world age, governments, corporations, and individuals face increasing longevity risk. Pay-as-you-go state pensions and corporate pension plans are putting severe financial pressures on governments and companies; IBM and Verizon are just two of many recent corporate examples in the United States; British Airways and the Co-op are two current examples in the United Kingdom. Fertility rates have also fallen in many countries around the world and this, in conjunction with increased longevity, has caused the inversion of some countries' age distributions and so increased the severity of the longevity risk problem for pay-as-you-go government pension plans by both reducing the tax base and extending the payout period. Mortality improvements at older ages have also increased the severity and make it ever more likely that individuals with inadequate pension arrangements will require other tools to manage their longevity risk.

Longevity risk exists at an individual and aggregate level. For the individual, it is the risk of outliving one's accumulated wealth. In the aggregate, it is the risk that the average member of a birth cohort will live longer than expected. Tools have long existed for the management of individual longevity risk; some of the modern means include social security systems provided by governments, defined benefit plans provided by corporations through pension funds, and life annuities (1) provided to individuals by insurers. (2) The Law of Large Numbers would suffice to make longevity risk manageable for pension funds and insurers in the absence of the aggregate longevity risk problem. The aggregate form of the problem, however, has made the provision of risk management tools for individuals an increasingly difficult task.

Capital markets do provide governments, corporations, and individuals with a means of transferring risks and resources across time as well as spreading risks across individuals. Similarly, individuals can transfer income forward via security purchases to fund their retirement years. Existing instruments, however, do not allow agencies or corporations to effectively hedge the aggregate longevity risk that they face.

The Second International Longevity Risk and Capital Market Solutions conference was held in Chicago on April 26, 2006. (3) It was convened to consider the scope of the aggregate longevity risk problem and the possible capital market solutions. The following were some of the questions considered: How significant and how large is the aggregate longevity risk problem and who currently holds that risk? How might that risk develop and what are the prospects for the allocation and pricing of that risk? Who should bear longevity risk? Alternatively, who should issue a capital market instrument to hedge longevity risk? Government? Individuals? Corporations? Is longevity a mathematically tractable risk or is it an inherent uncertainty? (4) If the former, then what methodological development is necessary to generate a single coherent forecasting model? What financial engineering is necessary at the individual and aggregate risk levels? If mortality-based instruments are financially engineered by corporations then how can they be priced in an incomplete market setting? A premium will have to be paid for some market participants to bear the longevity risk. How do we determine that risk premium in the incomplete market setting?

Given the continued demise of defined benefit company plans and the probable cuts in social security benefits, individuals in the future will face increasing personal exposure to longevity risk. They could respond to this by increasing their demand for life annuities and similar hedging instruments. In the absence of robust and sustainable capital market solutions to the aggregate longevity risk problem, however, the capacity of life annuity markets is likely to remain severely limited and, as a consequence, individuals will be forced to bear the longevity risk themselves. …

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