Longevity Risk: Covering the cost of long lives
It seems somewhat ungrateful to the advances in medicine to worry about the fact that we are living longer. Such sentiments, though, are part of the job if you are responsible for a company pension scheme. Longevity is hard to predict, and the volatility associated with it can pose a risk amounting to €100m or more for some large companies. Fred Kleipert of Swiss Re discusses.
What do Akzo Nobel, BMW, British Airways, ITV and Rolls Royce have in common?
Answer: They have all insured the longevity risk associated with their UK pension plans.
Over the past couple of decades we have seen dramatic increases in life expectancy, and this has had a significant financial impact on corporations with defined benefit pension funds. For a pension fund with €1 billion of liabilities the plausible impact from uncertain life expectancy could be of the order of €100 million. In recent years, an increasing number of companies have taken the positive decision to remove this very significant risk from their futures.
Predicting life expectancy is incredibly difficult. Ultimately, how long we live depends on a multitude of factors including medical advances, genetics, exercise, diet, smoking, family medical history and exposure to diseases or harmful substances, to name just a few. When assessing pension liabilities, it is necessary to make projections of life expectancy for several decades into the future; historically improvements in life expectancy have been substantially underestimated. As a result, pension funds and corporate sponsors have been faced with unexpected increases in liabilities and the requirement to pay additional contributions.
In the above cases (and others) where companies have removed the financial impact of uncertain life expectancies through longevity insurance, the vast majority of the risk has been underwritten by the reinsurance market. Large global reinsurance companies, such as Swiss Re, are the only institutions with the capacity and expertise to take on such risks. The reason they can do this (despite the complexity associated with predicting future life expectancies) lies in the large books of life insurance that they reinsure. As life expectancy increases, reinsurers actually gain on the blocks of life insurance policies they have reinsured (i.e. they pay fewer life insurance claims). This gives reinsurers a natural offset against increasing life expectancy and a strong rationale to underwrite longevity risk, resulting in a mutually beneficial economic outcome. Swiss Re is also uniquely positioned due to its significant presence in both the insurance market, through its Corporate Solutions business unit, and the reinsurance market, through Swiss Reinsurance Company Ltd.
Longevity insurance offers a way of completely removing the uncertainty of future pension funding requirements arising from uncertain life expectancies. This is achieved through a simple but effective insurance solution that does not require an upfront cash premium payment. Longevity insurance works as a cashflow swap – the pension fund makes a fixed series of premium payments to the insurer and in return the insurer pays claims equal to the total pension payments made to members of the pension fund. If life expectancy increases then the payments made to members will be higher for longer and will be met by payments from the insurer to the pension fund. Ultimately the pension fund's liability becomes the fixed series of premium payments to the insurer (these are set at outset and will not change with changing life expectancy).
The pension fund retains control of its assets which provides security and allows it to continue to invest those assets in the most efficient manner to meet its funding objectives. Longevity insurance removes a significant risk that is not efficiently held by corporate sponsors of defined benefit pension funds whilst also maintaining maximum flexibility on the asset / investment side of the pension fund.
Longevity insurance is a long dated insurance solution and as a result the choice of counterparty is critical. Pricing, counterparty security and future flexibility (to adapt to changes in the future) are generally the three most important areas to consider when selecting a provider. There is growing appreciation of the significant financial impacts arising from longevity risk. As a result, it is no surprise that an increasing number of companies are now investigating how longevity insurance can be used as part of the tool kit for managing risks associated with their defined benefit pension funds.
"Predicting life expectancy is incredibly difficult"
Fred Kleipert is Managing
Director EMEA, Swiss Re
Corporate Solutions