The evidence of diversity in life expectancy is overwhelming, and the uncertain timing of future medical breakthroughs increase demand for insurance. But, the resources required - risk capital and actuarial skills - are limited. So how do you meet demand in the most efficient way?
A generally-accepted system for classifying people into groups that are expected to have similar future lifespans would bring powerful benefits for managing demographic risk, and for the security of our societies as we face up to the challenges of ageing populations.
The natural hedge of longevity against mortality
Depending on the type of insurance contract that an individual enters into, the insurer is exposed to the risk of making a loss if the person lives longer or shorter than assumed. Annuity-style contracts create longevity risk, and life insurance policies that pay out on death create mortality risk. But, the two types of risk both relate to the same person and pull in opposite directions, creating a natural hedge for an insurer holding both positions.
Insurers’ conventional risk management strategies
An insurer’s first line of defense is to mitigate the risks relating to the lifespans of individual people by pooling many lives in a portfolio. Pooling mitigates idiosyncratic risk, but does not deal with the risk of people generally living longer (or indeed shorter) lives, what we refer to as “trend risk”. The second line of defense is for insurers to write a mixture of annuity and life insurance contracts to mitigate trend risk, or make use of reinsurance arrangements. This still leaves insurers with the residual risk that their mortality book and longevity book may not move in harmony (because of different age profiles, varying trends between socio-economic groups or different country effects). The third line of defense is to hold capital against the risk of divergence in the mortality and longevity books which increases the cost of both forms of insurance. If the confidence of the insurers that their mortality and longevity books are well aligned (or the alignment can be improved through targeted reinsurance) can be increased, then the cost of both forms of insurance could be reduced.
Longevity time zones
Whilst our chronological ages are measured on a consistent world-wide basis (all countries work off a standard 365 day year and dates of birth are well recorded), individually we are not all ageing at the same pace. It has become clear that lifestyle differences – which largely follow the socio-economic strata of our societies - explain the vast majority of the differences in mortality rates. In other words, the biological clocks of different people – or groups of people – are ticking away at different speeds due to their lifestyle and environment. Whilst the average pensioner retiring at the chronological age of 65 may be deemed to have a biological age of 65, those following the least healthy lifestyles will already have reached 70, whilst the healthiest have only just reached 60. Whilst the headline national averages of countries may differ, sub-groups within countries will align on an international basis.
To efficiently transfer the risk from insurer to reinsurer, a pre-agreed classification system allocating each person to the most appropriate “time zone” would enable better alignment of mortality and longevity risks.
Benefits of longevity time zones
A generally-accepted classification system that enabled people with similar lifespans to be grouped together, would enable risk takers to improve the alignment of their mortality and longevity risks. This has the potential to release capital and to reduce the cost of underwriting each unit of risk, benefiting both shareholders of insurers and their prospective customers, notably defined benefit pension plans.
But the benefits don’t stop there. A classification system has already been adopted by UK bulk annuity insurers and reinsurers to enable back-to-back longevity reinsurance for smaller bulk annuity deals. The size of the deals that are handled through such automated processes will rise as insurers grow their confidence in the model and stakeholders see the value of assumption transparency.
The same principles can be extended to automating bulk annuity pricing, when actuarial systems are wired into the same classification system, and all parties in the process can see into the same system. There is no need to wait for a fancy blockchain to deliver significant operational efficiency savings.
More fundamentally, longevity time zones would open up new innovation avenues. I see two particular benefits: reducing the cost of life insurance increases demand. Secondly, a generally accepted classification system would enable creating longevity derivatives, introducing access fresh risk capital from the capital markets. All of these benefits flow from the simple task of the industry adopting a standard system for classifying people according to expected lifespan. What’s not to like?