Miscalculating longevity risk could cost pensions $1 trillion per year: IAIS

The International Association of Insurance Supervisors (IAIS) estimates that for every year that longevity risk is underestimated by risk holders, such as pension funds, insurers or reinsurers, the liability to them could be increasing by as much as $1 trillion.

The IAIS published its 2014 Global Insurance Market Report yesterday and in the report gives a stark warning of why it is absolutely vital that longevity risk measurement and the actuarial mortality tables that are used to estimate longevity exposure are kept as up to date as possible.

Longevity risk, the risk that people live longer than previously expected or estimated resulting in payouts from pensions or financial instruments such as annuities being made for longer than budgeted, can leave pension funds and other risk holders with shortfalls and gaps that need filling.

The size of the longevity gap in a pension fund is defined through the calculation of its exposure, using mortality tables, risk models and other inputs that allow an estimation to be made. How accurate that estimation is remains vital, as underestimating can lead to inaction. By the time the miscalculation is realised filling the gap with financing, longevity risk transfer, insurance or hedging can be a considerably more costly exercise.

The IAIS says that longevity risk is a potential area of growth for the insurance industry, which as a result presents an opportunity to the reinsurance industry and also insurance-linked securities (ILS) investors that might like to allocate capital to this risk.

The underestimation of longevity risk is a constant challenged for the risk holders, which include governments, pension funds and some life insurers. When measured from a financial perspective, total longevity risk grows rapidly with any extension to life expectancy.

The IAIS says that for every year of additional life expectancy around 3% to 4% can be added to the present value of a pension fund risk holders liabilities. The global amount of annuity and pension related longevity risk exposure is estimated to be in the range of $15 trillion to $25 trillion, from which the IAIS derives the fact that for every year that longevity risk is underestimated by the risk holders could have to pay from $450 billion to as much as $1 trillion.

The IAIS notes that in the currently low interest rate economic environment this has crystallised this exposure for the risk holders, creating the financial motivation for risk transfer and leading to a number of large deals. However these have to date been largely contained to the UK and some European pension fund needs. Details of most major longevity hedging deals, largely longevity swaps and longevity reinsurance transactions, can be found in our Longevity Deal Directory.

“Against this background, supervisors need to monitor market developments and to ensure that institutions taking on longevity risk are able to withstand unexpected, as well as expected, increases in life expectancy,” the IAIS concludes.

We’ve written about inaccuracies in mortality data and how changes in life expectancy affects pension fund liabilities before. A selection of these articles can be found below:

– Potential flaw in UK mortality data may impact longevity re/insurers.

– UK pension fund longevity risk grows with life expectancy increase.

– Pension plan longevity set to jump with new actuarial mortality tables.