EUROPEAN PAPERS ON THE NEW WELFARE

3. An Insurers’ Challenge: Product Design

Even leaving aside the quantum leap in risk management the industry may make once new hedging and transfer options are fully in place, the industry is already in a position to sensibly adjust the design of the annuity products it offers in order to yield to a more balanced risk exposure and contextually reduce their capital costs. For instance:
1. Insurers may improve the pricing of pure longevity risk by refining actuarial techniques. In order to price annuity products correctly, it is essential for insurers to have a clear picture about future longevity trends. Given the fundamental difficulty of forecasting life expectancy over the full period of an annuity contract, it is even more important to gain information about the current and future life expectancy of a specific cohort population. In some countries, however, mortality tables are either hardly available at all or only with a considerable delay. By providing timely and accurate mortality tables, states would help insurers to assess future mortality trends more reliably. While it remains in the insurance company’s own interest and responsibility to understand the mortality risk to which it is exposed, greater transparency would reduce the mark up on the risk premium to account for the uncertainty of mortality trends.
2. Insurers may improve the pricing by fully pricing options and guarantees, and by excluding supplementary financial features not perceived and esteemed by the policyholder. For deferred annuities, for example, often annual guarantees are granted. Although such guarantees — or financial options — may look attractive at first sight, they come at a price. If these options are ‘in the money’, companies need to put aside additional capital to back them, whether they are exercised or not, resulting in additional cost-of-capital. In the end such a ‘financial options’ may even prove to be a bad deal for the policyholder. Cost of guarantees may be mitigated by designing products with limited guaranteed duration. It has been estimated that a shift from terms guaranteed on an annual basis to terms guaranteed on average, and even better only by the end of the contract, can have a dramatic impact on the cost of the guarantee (see Figure 1).

Figure 1: Cost impact of various guarantee structure

Type A: Annual guarantee, annual crediting of excess returns.
Type B: Annual guarantee, excess returns credited as terminal bonus.
Type C: Terminal value guarantee, excess returns credited as terminal bonus.
Source: Mercer Oliver Wyman.

3. Insurers need to minimise administrative and distribution costs. In order to back the business for several years administrative expenses for maintaining the infrastructure need to be loaded on the premiums. These cost loadings are usually expressed as a percentage of premiums; in reality, though, administrative costs tend to be, to a certain extent, fixed. As a result, a minimum volume is needed to be maintained in order to achieve desired profitability levels and the bigger the book of business underwritten, the higher will be the economies of scale and the potential expense profit to be reaped. If the insurer manages to lower their expenses relative to the pricing of the contract (for instance due to subsequent improvements in administrative efficiency), it may earn an ‘expense profit’. This is an indirect way for insurers to improve the profitability of the business underwritten, especially in highly transparent, competitive or regulated markets.
All those actions would positively impact on the level of capital required to support the business. This development will be further encouraged by the broader regulatory and rating trend towards risk-adjusted reserving, which renders the cost of financial guarantees and options embedded in annuities more transparent and, consequentially, pricing practices less arbitrary.

4. Fostering a Healthy Market Environment for Private Solutions

Demographic ageing is certainly a major challenge for societies today. While demographics may not be inverted nor corrected (with reasonable costs), labour markets and pension systems need to be flexible in order to adapt to the changing demographics. Certainly, the ‘static trichotomy in human life’ — education until 20 to 25, employment until 60 to 65, and ever increasing time as retirees thereafter — needs to be reconsidered. However, it takes a lot of effort to convince people today that the almost not noticeable, but the ongoing, irreversible changes in demographics need action today.
Where market-facilitating mechanisms are in place, private-market solutions will emerge for the benefit of individuals, corporates and the public sector as a whole. A healthy and well developed market of private solutions is not the one-and-only solution, but it removes the pressure from ailing state pension systems. And it is a win-win-solution, everyone benefits from more efficient insurance markets. Therefore governments have a responsibility and crucial role to play in nurturing conditions conducive to healthy development of private market solutions to longevity risk.
In particular, government actions can take several directions: fostering individuals’ financial needs, awareness and education; sponsoring the issuance of long-dated government bonds (30 years +) suitable for hedging; eliminating adverse selection for instance by providing tax incentives that encourages savings and support self-provision in the form of annuity purchases. And importantly, since annuity sales are extremely sensitive to changes in factors outside the insurer’s control, such as tax environment, state of the pension system, regulatory intervention and capital requirements, government should set a stable, market-oriented regulatory framework that takes account of the long-run nature of the annuities business.

References
CRIS Research Report (2005): “How Long Do People Expect to Live?”, published by the Centre for Risk & Insurance Studies, Nottingham University Business School.

OECD (2007): Pensions at a Glance — Public Policies across OECD Countries, 2007 Edition, OECD Publications, Paris Cedex.

Richards, S. and Jones, G. (2004): Financial Implications of Longevity Risk, presented to the Staple Inn Actuarial Society, Staple Inn, London, 26th October, www.sias.org.uk/data/papers/LongevityRisk/DownloadPDF

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.

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