Academic journal article Journal of Risk and Insurance

The New Life Market

Academic journal article Journal of Risk and Insurance

The New Life Market

Article excerpt

ABSTRACT

The huge economic significance of longevity risk for corporations, governments, and individuals has begun to be recognized and quantified. By virtue of its size and prevalence, longevity risk is the most significant life-related risk exposure in financial terms and poses a potential threat to the whole system of retirement income provision. This article reviews the birth and development of the Life Market, the new market related to the transfer of longevity and mortality risks. We note that the emergence of a traded market in longevity-linked capital market instruments could act as a catalyst to help facilitate the development of annuity markets both in the developed and the developing world and protect the long-term viability of retirement income provision globally.

INTRODUCTION

The start of the twenty-first century has witnessed the emergence of the "Life Market," the traded market in assets and liabilities linked to longevity and mortality. As one of the world's newest capital markets--and one that is of direct relevance to individuals and institutions in all countries--it has the potential to develop into a very large global market. (1) This is because of the growing recognition that longevity risk is a huge risk that is proving to be highly burdensome to those--corporations, governments, and individuals--that have to bear it. It cannot be hedged in existing capital markets, and although it can be transferred via the insurance markets, these currently lack the liquidity to support a fully fledged traded market.

What was missing until recently were new financial instruments for transferring longevity risk, together with the technology and tools to create a transparent, liquid market (Loeys et al., 2007). Over the last few years, these missing ingredients have started to emerge, as evidenced by the first publicly announced longevity derivative transaction between investment bank J.P. Morgan and Lucida, a UK-based insurer, which took place in January 2008 (Lucida, 2008) and a number of similar capital markets and insurance-based transactions that have followed.

The traditional method of transferring longevity risk is through insurance and reinsurance contracts. An important example of this is provided by pension plan buy-outs that have become prominent in the United Kingdom since 2006. This is a segment of the Life Market comprising annuity providers (insurers), pension funds, and reinsurers. This kind of transaction involves the transfer of all risks, including longevity risk and investment risk, from the pension plan to the insurance industry. This article surveys the development of the Life Market, focusing in particular on the longevity risk transfer segment of the market. In "Longevity Risk," we discuss the problem of longevity risk, distinguishing between so-called macro- and micro-longevity risk. We review the traditional solution for dealing with macro-longevity risk in "The Traditional Solution for Dealing With Macro-Longevity Risk." We then consider the requirements for capital markets to develop and grow ("Capital Market Solutions for Macro-Longevity Risk"). Next, we consider the first generation of bond-based capital market solutions for macro-longevity risk that have been tried so far ("First-Generation Capital Market Solutions"). The lessons learned here have informed the design of the second generation of derivatives-based capital market solutions, although there remain barriers to further development ("Second-Generation Capital Markets Solutions-Derivatives"). "The Micro-Longevity Risk Market" reviews the micro-longevity risk market, while "Life Securitization" discusses life securitization. Finally, we conclude in "Conclusions." Appendix A examines the main mortality forecasting models, while Appendix B lists some key organizations that have called on governments to support the development of the Life Market.

LONGEVITY RISK

Life expectancy has been increasing in almost all the countries of the world. …

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