Longevity, Systemic Models and Business Risk

4. Longevity as business risk

Our basic hypothesis is that only the combined and synergic implementation of a heterogeneous number of adequate tools partially internal and partially external to the corporate system can allow life insurance companies to correctly carry out the role that the evolution described in the the basic situation would tend to assign them.
On the other hand, it is apparent that in a modern system only insurance companies can jointly access all risk management tools: that is why they play a necessary role in facing the needs caused by the progress of longevity. This is their ontological peculiarity, which (potentially) is the origin of their statutory peculiarities, and not vice versa.
Before dealing with each one of them briefly, we list below the management tools which can be identified, grouped according to their macro-types:
• internal asset soundness tools,
• internal management and organisational tools,
• external systemic balance tools.
The classification above partly matches that reported in Blake, Cairns and Dowd (2006)16, although that is less focused on highlighting the internal means available to businesses.
The internal asset soundness tools provide the pre-requisites starting to play a role, rather than a means of avoiding/covering the risk, and include:
1. the solvency margin, i.e. the allocated capital,
2. the adjustment of technical reserves.
They both entail costs and not revenues for the business system.
Internal managerial and organisational tools are related to the strictly managerial aspects of how enterprises deal with longevity risk management. They include:
3. contingency loading,
4. risk limits,
5. the dynamic adjustment of operational variables,
6. product flexibility and risk sharing with the insured,
7. bundling marketing policies.
The list mostly includes possible sources of income or means to contain costs; consequently, those are tools for tackling the risk.
Finally, external systemic readjustment tools are mainly ways of containing costs and are:
8. reinsurance,
9. hedging through financial markets (in particular derivatives).
We will dedicate the last paragraph of our article to the last item, since it is the key stone in the creation of the fourth pillar and goes beyond the normal boundaries of insurance companies.

5. Solvency margin

We consider this to be a simple prerequisite rather than a tool for managing risk profitably: without adequate capital such a significant risk cannot be taken on over a long period of time, during which unexpected losses cannot be considered an unlikely occurrence. Without adequate funding, managing short-term fluctuations and consequently safeguarding customers/annuitants would not be viable.
The funding level must be defined by developing adequate quantitative models, as happens with other types of risks.
Consequently, there is a need for an adequate remuneration of the risk through contingency loading and asset management margins.

6. Technical reserves adjustment

This item is also included in the group of prerequisites: a cautious year by year assessment of reserves is a vital element and the obligations expected must be immediately and prudently identified. In this case too, the prerequisite generates costs.

7. Contingency loading

If the general expectation is that the risk is prospectively unmanageable, then clearly that element has to be ‘costed’ at the time of taking it on. As far as insured customers are concerned, they have to pay for covering the concrete risk that human life might be extended. Of course, there is an upper ceiling for determining that contingency loading, i.e. the need that value for money (i.e. money’s worth, according to O. Mitchell’s terminology) remains sufficient to avoid affecting the potential customer’s (already small) willingness to pay.
Therefore, it is the willingness to acknowledge the value of risk cover which may define the amount of contingency loading, rather than a quantitative determination theoretical model, which however is always useful for defining the basic decision-making framework. Such contingency loading is an additional revenue; and so is in logical juxtaposition to possible future losses.

16 Blake, D., Cairns, A. and Dowd, K. (2006): “Living with mortality: longevity bonds and other mortality-linked securities”, Pensions Institute.

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