Understanding, modelling and managing longevity risk: key issues and main challenges

Abstract

This article investigates the latest developments in longevity-risk modelling, and explores the key risk management challenges for both the financial and insurance industries. The article discusses key definitions that are crucial for the enhancement of the way longevity risk is understood, providing a global view of the practical issues for longevity-linked insurance and pension products that have evolved concurrently with the steady increase in life expectancy since s. In addition, the article frames the recent and forthcoming developments that are expected to action industry-wide changes as more effective regulation, designed to better assess and efficiently manage inherited risks, is adopted. Simultaneously, the evolution of longevity is intensifying the need for capital markets to be used to manage and transfer the risk through what are known as Insurance-Linked Securities (ILS). Thus, the article will examine the emerging scenarios, and will finally highlight some important potential developments for longevity-risk management from a financial perspective with reference to the most relevant modelling and pricing practices in the banking industry.

Keywords:

• Longevity risk
• Stochastic mortality
• Pensions
• Life insurance
• Regulation
• Long-term interest rates
• Securitisation
• Risk transfer
• Incomplete market
• Population dynamics

Acknowledgements

We are grateful to an anonymous referee for his valuable comments. We also thank the Fédération Bancaire Française for its support to the working group on longevity risk.

Notes

1. The available mortality data are based upon statistics from various national institutes (including but not limited to: Bureau of Census in the USA, CMI in the UK and INSEE in France). For most developed countries, these data are also available through the Human Mortality Database.

2. When mortality rates decrease, life annuity costs increase and death benefit costs decrease and vice versa.

3. The Goldman Sachs Mortality Index, launched in December 2007, was based on a sample of insured over 65s in the USA. It targeted the life-settlement market, but was discontinued in December 2009, following the global financial crisis.

4. This bond project with a maturity of 25 years included coupons based on a survivor index.