Mega Trend 4: pension funds and insurers include longevity impact in climate risk management

Every year the World Economic Forum (WEF) publishes its global risks report, exploring the major risks the world is likely to be facing in the coming year. It may come as no surprise that the report published in January 2021 places the risk of infectious diseases at the top of the list, although it’s worth noting that the same risk sits much further down the agenda in the report published twelve months previously – back in the day when everyone with a correct understanding of the word “furlough” could be squeezed into the Club Vita stationery cupboard.

In contrast, a recurring feature of every edition of the WEF global risk report that has ever crossed my desk is the focus on climate-related risks. Given the potential consequences of climate change on global financial systems, as set out in these reports and by high profile individuals such as Larry Fink, it should be no surprise that the industry is beginning to sit up and take notice. An example of the spotlight on climate related risks is the rapidly increasing interaction of pension funds and insurers with the disclosure recommendations published by the Task Force on Climate-related Financial Disclosures (TCFD).

A key pillar of the TCFD recommendations is the need to disclose metrics to assess climate-related risks (and opportunities!) where the impact could be material. As we pointed out in a recent Top Chart, longevity risk is now the largest unhedged risk for pension funds in the UK and no doubt also weighs heavily on the minds of those responsible for risk management at insurance companies and pension funds in other regions – so these institutions will need to think carefully about the longevity impact when considering climate related risks.

An example of how pension funds and insurers could think about the potential impact on life expectancy (and therefore liabilities) is the “Hot and Bothered” scenario analysis that Club Vita published back in 2018. This research remains relevant and can be used to consider possible evolutions of life expectancy under three specific scenarios, where climate change and resultant resource constraints impact the future environment in which we live.

The following three scenarios are considered in the analysis:

1. Green revolution assumes that widespread calls for change and rapid technological advances lead to positive adaptation to climate change, leading to improved longevity, higher life expectancy and, ultimately, higher pension fund liabilities.
2. Challenging times considers an outcome where we achieve some positive adaptation to the changing environment, but still struggle to adapt quickly enough to overcome the limitations of finite resources. For example, we consider the implications of the possibility that we have reached ‘peak oil flow’ and that the availability of oil will become a constraint to economies in the future.
3. Head in the sand simulates a range of disastrous outcomes resulting from a total lack of response to resource and environmental risk. This includes global crop failures and food shortages, as well as more favourable conditions for disease vectors leading to the incidence of infectious diseases akin to what we might have seen a century ago.

Of course, these scenarios are merely three examples out of a wide range of potential future outcomes of climate change; intermediate and more extreme scenarios are certainly possible. Material changes to the liabilities of a pension fund or insurer could follow– the spread of life expectancies in our scenarios for current pensioners of c2.5 years would broadly equate to a swing of c10% in liability terms, with the impact even greater on younger members. And, of course, assets and employer covenant strengths would be affected too.

What do you think?

So, as financial institutions start to weave the TCFD requirements into their overall risk management frameworks, it will be important to consider longevity risk alongside other potential effects of climate change that impact asset portfolios or the strength of sponsoring employers. Fresh from the experiences of a 1 in 100-year event that took many of us by surprise, is there any excuse for not measuring and monitoring a systemic risk that has been in front of our eyes for some time now?