Which insurers sell longevity insurance
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Longevity harbors a financial risk, especially for providers of old-age provision and pension products: If life expectancy is incorrectly forecast and pensions have to be paid longer than expected, this can jeopardize the sustainability of pension products (longevity risk - LR). Particularly in countries where the share of company pension schemes is high, the interest of providers in reducing longevity risks by transferring them to insurers, financial institutions and the capital markets (longevity risk transfer - LRT) is growing.
It is true that the LRT markets are currently still too small to raise systemic concerns. In view of the enormous market potential and the growing interest of investment banks, however, it is important to create rules in good time that prevent significant systemic risks from arising. As with credit risk transfer, there is also a risk with LRT that the risk will accumulate and concentrate where it is least understood or incorrectly priced, for example due to incorrect correlation assumptions. As the 2008 financial crisis showed, credit risk transfer had led to the risk being concentrated with a relatively small number of investors who were then unable to bear them. In addition, a large number of transactions can mean that it becomes increasingly unclear who really holds the longevity risk. That too happened with credit risk transfers. In addition, when looking at the LRT market, it must be taken into account that market participants could change their behavior in response to new supervisory regimes, especially Solvency II and the regulatory package CRD IV / CRR (Capital Requirements Directive IV / Capital Requirements Regulation). However, this cannot yet be estimated.
Recommendations for action by the Joint Forum
The Joint Forum therefore dealt with the topic and published a report on it at the end of 2013. This describes the LRT market, shows growth and development factors and illuminates the potential risks from a cross-sectoral perspective. The report culminates in eight recommendations for action, which are aimed in particular at politicians, regulators and supervisors.
Recommendations to the supervisory authority:
- Intensify cross-sectoral and international communication and cooperation
- Ensure that risk takers have the necessary knowledge, skills, competencies and information
- Be aware of tail risks
Recommendations to politicians and regulators:
- Assess the appropriateness of relevant regulations
- Ensure adequate qualitative and quantitative standards
- Ensure the risk-bearing capacity of the risk takers
- Observe market developments
- Promote collection of data on longevity and mortality
The Joint Forum recommends that supervisors intensify cross-sectoral and international communication and cooperation on longevity risk transfer in order to reduce potential regulatory arbitrage. This recommendation applies in particular if pension funds and (re) insurers are not subject to the same supervisory authority. In addition, from the point of view of the committee, understanding the longevity risk exposure is crucial. Accordingly, supervisors should ensure that the supervised risk takers have all the knowledge, skills, expertise and information they need to manage longevity risk. The supervised risk takers should be able to demonstrate these qualifications to their supervisory authority. The Joint Forum also recommends that supervisors consider tail risks. If these are underestimated, this can lead to excessive losses at the distribution edge and the risk transfer chain collapsing. This risk arises in particular if the counterparty to an investment bank is unable to meet the contractual claims arising from the swap.
The Joint Forum recommends that political decision-makers generally determine who ultimately has to bear the longevity risk, i.e. who is the risk bearer. It also encourages them to review the longevity risk rules in order to maintain or establish appropriate qualitative and quantitative standards. The Joint Forum also emphasizes that it must be ensured that all institutions that assume longevity risks have an adequate risk-bearing capacity. You should be able to withstand expected and unexpected increases in life expectancy.
The committee also recommends closely monitoring the market developments of the LRT - including the amount and type of risks transferred and the resulting networks. Because a concentration of risk appears possible in the LRT market in view of the complexity and the special nature of the transactions, also against the background that only a few (re) insurers and investment banks are currently active in the LRT markets. In any case, there should be transparency about the whereabouts of the longevity risks in order to prevent the risks from building up too great. Finally, the Joint Forum recommends that decision-makers work to collect and disseminate longevity and mortality data that are relevant to assessing the obligations of pension and life insurers.
One of the fundamental obstacles to an even more dynamic development of the LRT market are the large information asymmetries between buyers and sellers of risks (selection effects). In order to curb this, some market participants try to link the transactions to the longevity of a comparison population using an index. This standardization is intended to improve market liquidity, but through indexing it can involve a significant base risk.
So far, the buyers of longevity risk have mainly been life and reinsurers. For these, the LR can partially serve as a natural hedge of their exposures against mortality risks. It is true that the obligations from (body) pension payments increase if the insured live longer. For life insurance, however, fewer payments have to be made. However, the LR exposure of European (re) insurers is significantly higher than the exposure to mortality risk.1 As a result, the reinsurers' capacity to take over longevity risks could at some point reach their limits. Equity analysts are also becoming increasingly critical of the growing burdens from company pension schemes, so that insurers are looking for new solutions.
Until recently, almost all of the non-insurance-only LRT activities took place in the UK. In 2012, however, three large transactions were carried out outside this country for the first time, i.e. those with a volume of over 5 billion US dollars (USD). In the Netherlands and the USA, the transactions had a volume of up to USD 26 billion. In addition, there have been several smaller buy-out transactions in Canada since 2006, each worth approximately 1 billion Canadian dollars. Nevertheless, the outstanding volumes of LRT transactions represent only a fraction of the global LRT market potential.
Longevity risk exposure has a total volume of around USD 15 to 25 trillion worldwide.2 In the past, the existing models mostly underestimated longevity. The International Monetary Fund assumes that each additional year of life expectancy causes the liabilities of typical defined benefit annuity products to grow by 3 to 4 percent. If the longevity is underestimated by a year, this costs the risk takers a total of between 450 billion and 1 trillion USD in addition.
Risk transfer instruments
Longevity risks are very long-term and illiquid. To manage them, companies, pension funds and insurance companies, especially in Great Britain, the Netherlands and the USA, are increasingly using alternative instruments for risk transfer: for example buy-ins and buy-outs, longevity swaps and longevity bonds (bonds). Which market participant chooses which type of transaction depends primarily on the type of counterparty. (Re) insurers are more likely to be associated with buy-ins and buy-outs as counterparties to pension funds, whereas longevity swaps are more likely to have investment banks and reinsurers as counterparties. Longevity bonds are basically another LRT instrument, but are currently just a concept. While there have been some attempts to place longevity bonds, none have been successful.
In a buy-out transaction, all assets and liabilities of the pension fund are transferred to a (re) insurer. In addition, the insurer receives a premium to be paid in advance from the holder of the pension plan. In return, the pension obligations of the pension fund and the assets to be covered are completely removed from the balance sheet of the risk transfer seller, i.e. the pension fund, in the sense of a true sale. The (re) insurer is therefore fully responsible for paying the pension obligations.
Even in the case of a buy-in, the pension plan carrier pays a premium to the insurer in advance, which in return then regularly pays the pension plan carrier the benefits that correspond to the carrier's payments to the (pension) beneficiaries. This “insurance policy” is held by the holder of the pension plan as an asset.
In the case of a longevity swap, the pension fund receives comparable protection: its sponsor regularly pays fixed, agreed premiums to the swap partner, who in return pays out the difference between the actual and expected pension benefits to the sponsor. The institution remains responsible for the pension payments to the beneficiaries. One advantage of the swap (and buy-in) is that it serves as a hedge for the longevity risks of specific groups, namely the population or customer group on which they are based. The advantage of swaps is that the longevity risk can be isolated. In buy-in and buy-out transactions, the investment risks of the assets are typically also transferred. Longevity swaps, on the other hand, can be combined with other derivatives - such as inflation, interest rate and total return swaps - so that synthetic buy-ins are created that also transfer the entire risk.
Interview with Thomas Schmitz-Lippert: "Enormous market potential"
Thomas Schmitz-Lippert is chairman of the Joint Forum and BaFin department head for international affairs
Mr Schmitz-Lippert, you head the Joint Forum, which developed the recommendations for action on the transfer of longevity risks. Do you have to worry about this issue?
So that there is no misunderstanding: The report with the recommendations does not say that the transfer of risks associated with increasing life expectancy is already a huge problem or will even trigger the next financial crisis. This market, which is still relatively young and therefore uncharted territory for us, has the potential to have a significant impact on the financial markets. It is therefore important that political decision-makers and supervisors deal with the issue in good time and prevent undesirable developments. The recommendations of the Joint Forum are aimed at them.
Why did the Joint Forum, of all places, deal with the topic?
The Joint Forum is - together with the Financial Stability Board FSB - the only global forum that examines cross-sectoral issues, i.e. topics that result from the growing interconnectedness of the financial sectors and their regulation. The Joint Forum brings supervisors from different countries and financial sectors to one table and is therefore able to identify potential risks at an early stage. We can sensitize politicians and regulators to these risks and look for solutions.
Isn't the topic of longevity actually just a topic in the insurance industry?
At first glance it might seem so. Longevity risks naturally affect pension funds and the insurance sector first of all. For the past two to three years, however, investment banks have also been involved in large-volume transfers of longevity risks. This was also the reason that the Joint Forum took up the topic. Although banks are not allowed to assume longevity risk directly in most countries, they can do so indirectly through swap transactions. In this way, a risk that is actually limited to one financial sector is expanded to other sectors or market participants and helps to ensure that the financial system is even more interconnected.
How can longevity risk transfer become a problem for the financial system?
When insurance risks are transferred to other markets, there is a link between companies and financial sectors. In view of the enormous potential of this market, systemic risks could arise here. The high dependency on models and possible information asymmetries between investors and sellers of longevity risks are parallels to credit risk transfer. To ensure that retirement provision remains stable, it must therefore be prevented in good time that the risks accumulate where they can be least understood and managed. The basis for system stability is and remains transparency: it must be known who is really holding the risk and whether their risk-bearing capacity is always sufficient.
In your opinion, what are the most urgent topics that the Joint Forum has on the agenda?
The topic of asset encumbrance is certainly high on the agenda. It is primarily associated with the banking sector. In contrast, the possible cross-sectoral effects of new regulations for the insurance industry or the securities market have so far been little investigated. Think, for example, of the future supervisory regime for insurers, Solvency II, or EMIR, the regulation on European market infrastructure, which has brought about major changes for OTC derivatives.
As a representative of an all-round financial authority, it is particularly important to me that the profile of the Joint Forum as a body for cross-sectoral issues is further strengthened. Only in this way can we adequately take account of the growing networking in the financial sector - with a forward-looking perspective.
How does the Joint Forum get the information it needs?
The supervisors and regulators who make up the Joint Forum can of course fall back on the know-how of their home authorities. In addition, we work closely with the international standard-setters, but also with other international and national participants. We seek the opinions of interested parties and consult each report before it is published. We evaluate all comments and adapt the reports if necessary. Often private market participants are also involved in the reports.
Thank you for talking to us, Mr. Schmitz-Lippert.
The Joint Forum is a joint body of global standard setters: the Basel Committee on Banking Supervision (BCBS), the International Association of Insurance Supervision (IAIS) and the International Organization of Securities Supervision IOSCO (International Organization of Securities) Commissions). The Joint Forum emerged in 1996 from its predecessor, the Tripartite Group, founded in 1993. It is made up of equal numbers of high-ranking banking, insurance and securities supervisors from the currently 15 member states and aims to support them in achieving their common regulatory and supervisory goals. The body regularly publishes reports, principles and recommendations aimed at national authorities, politicians, supervisors or financial companies. The chairmanship of the Joint Forum changes every two years between the standard setters. Thomas Schmitz-Lippert has headed the Joint Forum since November 2012. He was nominated by the IAIS. At the beginning of 2014 Schmitz-Lippert took over the chairmanship of the Joint Forum for another two years, now for the BCBS.
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