EUROPEAN PAPERS ON THE NEW WELFARE

Pensions, Social Security and Private Insurance Solutions: Opportunities Squandered

3. Specific Challenges Facing Individuals and Managing Longevity Risks

I now want to directly address the specific challenges facing individuals and the managing of their longevity risks.
The first group of risks concern the health and long-term care of individuals. There is a possibility that the resources allocated to cover these risks provide insufficient to cover all related expenses. The next risk facing individuals is the investment risk. That is the possibility that the actual investment returns deviate from the expected, with the possibility of a shortfall due to smaller returns than foreseen. The third and final risk is the so-called ‘pure’ longevity risk. It is the real possibility of outliving resources or, alternatively, of dying with resources remaining. It is the task and the chance for life insurance companies to help their customers cope with these risks.
The individual longevity risk management is likely to become more important. More responsibility is being shifted to individuals:
a) employers continue substituting defined contributions for defined benefits pensions, shifting decisions about securing retirement income to individuals;
b) public pension benefit levels are declining relatively, shifting more of the retirement income burden to individuals;
c) the partial ‘privatization’ of public pension systems is a further likely shift of retirement income decisions to individuals. So, individuals are not just having more extended responsibilities to deal with, they are also facing increasing uncertainties surrounding longer life expectancies. Medical breakthroughs and complex tax and old-age security systems complicate the management of an individual’s longevity risk. It is here where insurance companies can be of special service.
What to do? Economic theory makes it clear that the rationale response by individuals is the purchase of actuarially fair life annuities. Yet, comparatively few individuals annuitize their wealth in any market worldwide. Why? In some cases certainly because public pensions, defined benefit plans and family security preclude the need for substantial annuitization for some. However, this is not the case for most persons5. There might be a desire to retain assets because of concerns of other retirement risks and/or possible bequests. However, one of the key questions is whether there is so little annuitization because of the lack of information and/or inefficient markets coupled with incompetence on both sides, the customer and the provider.
Let us consider one of the key components: The imperfections in the private annuity market.
1. There is a lack of inflation indexed annuities in most markets. This could be addressed, particularly with increasing prevalence of inflation indexed government securities which would help us hedging risks.
2. The irreversibility of annuitization: This problem is difficult to address because of adverse selection problems. However, it is not totally impossible.
3. Consumer problems: Low consumer knowledge about annuities can be rectified, however, consumers’ difficulty in assessing distant future states is much more challgenging. Overcoming the myopic behaviour of consumers in this regard, is a key challenge.
4. The lack of actuarially fair pricing because of loadings and the failure to price the risk (correctly): Loadings seem to be less of a problem than the lack of risk-based pricing. Products could be easily changed to avoid front-loading and to provide customers with a more equilibrated spread of administration and sales costs over the life of the product.
The consequences for life insurers of imperfections in the annuities market are dire. They forgo potentially enormous sales in a major market segment, particularly for those in less than perfect health where offers for covering their future needs are especially sparse. Insurers also fail to retain assets under management. In most of the cases, at liquidation, substantial proportions of annuity funds are withdrawn. Comparatively modest proportions of benefit payments under life insurance policies are retained by insurers under payout options including annuitization. It is one of the key challenges to a life insurance company, to make sure that any life insurance policy that comes due allows them to retain the asset under management for a longer period of time, rather than encouraging their customers to look for solutions elsewhere.
There are four important questions to tackle concerning the competitive issues that were just discussed:
1. Why have life insurers failed to respond more positively and creatively to annuity market imperfections?
2. How much profits are foregone and how much value-added for consumers was never created?
3. Are obstacles to comprehensive risk-based pricing really insurmountable?
4. How can the capital market be used to address this issue?
The challenges for the life insurance industry lie in various areas. It has to reconsider the value propositions of life, health and long-term care insurance solutions, especially under the scenario of a very rapidly increasing older population with continuing improvements in remaining life expectancy. Life insurers have to live up to the opportunities that the gradual exit of state systems provides for private old age provision. Insurance is not only a protection but also a savings vehicle of great importance to individuals. It acts as a distribution mechanism not only between groups of individuals, but also, and most importantly, over time. There are very little other financial solutions that distribute risks over groups and over time. Life insurance contracts are also private contracts that, in contrast to public solutions, usually enjoy a better legal protection and are more difficult to change through unilateral action by a government. Another key challenge to the life insurance industry is to speed up the development of new products, especially in retirement planning and for health and long-term solutions.
In a demographic environment that is changing so rapidly and in directions that are completely new to mankind, it is surprising to find how little true innovation we have seen in the past few years, especially for the key risks that individuals face in their lives. Beyond this, the life insurance industry has to help develop financial markets for instruments that can be used to lay off some of the insured risks. Only if life insurance companies are able to organize efficient distribution systems on the one side and then decide which risks to keep on their balance sheet and which risks to lay off to the capital markets in an efficient way, will they be able to accelerate the scope and depth of available solutions in the marketplace.


5 There is a wide body of literature available for most countries in the world indicating a shortfall of existing and expected assets of citizens to finance their retirement at an appropriate level (usually set at 80% of the last net income). Consult the OECD and World Bank websites for extensive lists of references of these studies.

References
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German Commission for the Sustainability of the Financing of Social Security Systems (2003): Final Commission Report “Nachhaltigkeit in der Finanzierung der Sozialen Sicherungssysteme”, available in German (full report) and English (abridged version) at www.bmas.bund.de

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Liedtke, P (2006): “From Bismarck’s Pension Trap to the New Silver Workers of Tomorrow: Reflections on the German Pension Problem”, European Papers on the New Welfare, Risk Institute, January.

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