Demographic trends in many countries are unambiguous: while people are having fewer children, they are living longer than any generation before. The result is irreversible for the foreseeable future: the population is ageing at a rapid pace, both in the developed and developing world. This has dramatic social, cultural, and economic consequences. The insurance industry is one of the key players affected by those changes, as the ageing process directly impacts health care, long-term care, and pension provision.
Although low fertility rates are the main driver of the global ageing process, the increasing life expectancy and the rising number of elderly citizens is much more visible. This is best illustrated by the number of centenarians — i.e. people age 100 and above — which has been doubling every 10 years since the 1960s in North America, Europe and Japan2. In the United States, the U.S. Census Bureau has projected that by mid of the 21st century, the number of centenarians might even raise to one million. Even though becoming a centenarian will not be everyone’s destiny, living to age 85 and far beyond will become a reality for many people over the coming decades. Certainly this is a humanitarian triumph, but it also introduces new risks. While it is good news in one respect, anyone faced with the prospect of extended life expectancy would also be faced with the need to ensure current savings and anticipated pension income are sufficient to pay for their late-life needs.
Despite the fact that studies about the consequences of longevity for old age and healthcare provision (only to mention two examples) are cited almost daily in the media, many people still underestimate their life expectancy and their needs to cope with its financial consequences. Recent research in the United Kingdom indicates that subjective life expectations underestimate actuarial expectancies by approximately 5 years on average.3
This would not be dramatic if replacement rates of mandatory pension systems — i.e. pension in retirement relative to earnings when working — would allow to fully meet the expenses of retirees. This is not the case. A recent OECD study indicates that in many countries there is a significant pension gap4. Taking life expectancy, retirement age and the benefits of mandatory pension schemes into account, gross replacement rate for an average earner is below 60% in many OECD countries. In the United Kingdom, Germany, Japan, Belgium, United States, Australia and Canada public pensions are relatively small. Individuals will have to make extra private savings to ensure that their living standards do not decline sharply when retired, not only in the countries mentioned.
Demographic trends will force changes in the income mix of retirees. First, as there are ever fewer wage and salary earners to finance the pensions of a growing number of retirees, traditional public pay-as-you-go systems become unsustainable. This will most likely induce a relative reduction in state-provided pension income. Second, the marked trend away from defined-benefit corporate pension schemes towards defined-contribution schemes means that employer-related pension benefits could become more uncertain too, shifting the longevity risk back to individuals. Third, the extended mobility of the workforce has broken down traditional family networks, hence impeding or at least reducing the ability of the offspring to take care of the older ones.
Hence, individuals will have to become more self-reliant and will want to consider supplementing their sources of income in retirement, assigning greater weight to private solutions. Furthermore, the fact that people are living longer and that the effective retirement age is unlikely to be adjusted upward by the same degree as increases of life expectancy would suggest, makes it necessary for individuals to put aside an even greater proportion of their financial means in order to cover the cost of their extended lifetime.
However, demographic changes and the longevity risk will not only affect individuals. While at the individual level the longevity risk can be expressed as the risk of outliving one’s savings, for pension funds, insurance companies but also employers and governments facing obligations towards retirees — the longevity risk emerges as the risk that assets prove to be inadequate to meet liabilities. Given the sheer size of the longevity risk and its predicted growth, it comes as no surprise that highly-exposed parties are looking for risk-transfer solutions. Corporates and governments in particular are looking for ways to offload their huge pension liabilities.
2. The Role of the Insurance Sector
The insurance industry is well placed to aid workers and retirees in addressing their financial needs, both in their asset accumulation and decumulation phases. First, the insurance industry helps individuals build up a desirable level of savings throughout their working years in a flexible (in the amount and timing of their contributions to the capitalisation plan) and efficient way (via investment diversification, gradual adjustment of the risk/return profile based on age, tax advantages). Second and most important, insurance allows individuals to run their asset pool down smoothly while offering protection against longevity but also inflation risks. The product best suited to transfer the whole longevity risk away from the pensioner are annuities.
The core feature of annuities is protection against longevity risk: Through an annuity, individuals buy a life-long stream of income which protects them against the risk of outliving their savings. Annuities often have embedded guarantees that protect the insured against interest and equity market fluctuations; others offer inflation protection for the policyholder or death benefits to the beneficiaries of the policy. Often annuities offer tax advantages, i.e. they are treated as tax-qualified instruments by governments wishing to give individuals an incentive to save for their retirement and to buy protection against longevity risk.
Extended longevity clearly renders annuities one of the most promising insurance markets of the future. In countries that rely heavily on private solutions (as in the US, UK and Switzerland), assets backing pension liabilities already amount to 100-150% of GDP. According to OECD statistics, pension and insurance assets add up to USD 20 000 billion for all OECD countries, with the US alone accounting for USD 12 000 billion. Furthermore, assets are growing at a sustained pace worldwide. Over the 2000-2005 period, annual average asset growth stood at 10% in the OECD countries, and over 20% in the Euro zone.
However, these growth opportunities are intertwined with significant financial market and insurance risks:
• Financial market risks — meaning interest rate, stock market, inflation and credit risks — come in as the difference between the pricing assumptions and the actual market conditions. The long duration of life annuity contracts — often spanning 30 years or more — together with the widespread practice of offering embedded financial options and guarantees can prove to be very costly. The key instruments insurers use for managing these risks are asset-liability management as well as product design.
• Insurance risks: annuities are particularly prone to the risks of longevity mis-pricing and adverse selection. A mis-priced annuity contract may lock losses in for decades. Despite considerable progress made to date in understanding the drivers of longevity, there is still a long way to go, both in putting the acquired knowledge into everyday practice and in improving industry-wide comprehension of longevity trends.
• Systematic longevity risk: The insurance risk associated with the population as a whole enjoying longer life expectancy is particularly relevant. This risk is systematic in nature, rendering risk management techniques based on member pool diversification ineffective. Systematic risks can be extremely costly to manage and to keep on the balance sheet, as they accumulate instead of diversifying out.
The English, German, French, Italian, Spanish, Chinese and Japanese versions of the sigma study No. 3/2007, “Annuities: Private Solution to Longevity Risk” are available electronically on Swiss Re’s website: www.swissre.com/sigma.
Lukas Steinmann, Swiss Re Economic Research & Consulting, Mythenquai 50/60, P.O. Box, 8022 Zurich Switzerland, +41 43 285 4687, e-mail: Lukas_Steinmann@swissre.com
Veronica Scotti, Swiss Re Client Solutions.
2 Robine, J.M. and Paccaud, F. (2005): “Nonagenarians and Centenarians in Switzerland, 1860-2001: A Demographic Analysis”, Journal of Epidemiology and Community Health, 2005; 59, pp. 31-37.
3 CRIS Research Report (2005): “How Long Do People Expect to Live?”, published by the Centre for Risk & Insurance Studies, Nottingham University Business School.
4 Pensions at a Glance — Public Policies across OECD Countries, 2007 Edition.
Tags: centenarians, health care insurance, life expectancy, longevity risk, pension provisions, private savings, public pensions