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Longevity risk is an increasingly important risk for pension plan and annuity providers and, indeed, individuals to recognize, quantify and manage. It is not such an immediate or even as large a risk as, say, interest rate or inflation risk, two of the key risks that pension funds are now beginning to hedge using, for example, duration and inflation swaps. But having hedged these two risks, longevity risk becomes a relatively much larger risk to manage.
Longevity risk is also qualitatively different from other risks. It is essentially a long-term trend risk. Getting the trend improvements in life expectancy right is the key to managing this risk. However, this has proved difficult to do in the past and even official agencies have systematically underestimated previous mortality improvements. Nevertheless, longevity risk, like interest rate and inflation risks, is an unrewarded risk and pension plan and annuity providers are beginning to question whether this is a risk they should be assuming.
Having recognized the nature of longevity risk, the next step is to quantify it. Different stochastic mortality models are being developed to do this. Some are more successful than others in predicting changes in trend. Longevity, mortality and survivor fan charts are being developed to show confidence intervals of possible dispersions of life expectancies, mortality rates and survival rates around the most likely forecasts of these quantities in future years.
Having quantified the risk, the final step is to manage it. Both insurance contracts and capital market derivatives are being developed to do this. Recent examples include longevity swaps and q-forward contracts. Some hedge specific longevity risk, while others hedge aggregate longevity risk.
These new contracts will be discussed at the 4th International Longevity Risk and Capital Markets Solutions Conference, as will the role of capital markets in pricing longevity risk and in transferring it to investors who wish to hold it in their portfolios.
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