How life insurers can mitigate the impact of increasing longevity in a low interest rate environment

Increased life expectancy over the last decades and a prolonged period of low interest rates precipitated by the credit crunch of 2007/08 have presented life insurers throughout the world with a formidable challenge.

Long-term investment guarantees and lifelong benefits have increased the insurers' exposure to a variety of financial factors which threaten uncomfortable consequences for their capital requirements and balance sheets. The increasing costs of these guarantees could become unsustainable, potentially threatening the financial stability of entire insurance companies. Therefore, a careful assessment of all risks involved are crucial when contracts are being designed.

The authors of the research paper The impact of longevity and investment risk on a portfolio of life insurance liabilities have sought to assess the joint impact of two key risk factors currently affecting most life insurance products, namely biometric risk (i.e.- all risks related to human life conditions) and investment risks.

For this study, a stylised, contingent claim based life insurance company was modelled. Biometric risk and its components, namely diversifiable and systematic risk, were then explicitly introduced to the model.

Subsequent analysis explored in detail the interplay of guarantees, market regimes, mortality assumptions, and portfolio sizes.

The main findings can be summarised as follows:

• First, idiosyncratic biometric risk vanishes even in small portfolios. In other words, when homogeneous contracts are pooled together, diversification becomes fully effective with relatively small portfolio sizes
• Second, longevity risk has a very substantial impact on the market values of participating life insurance liabilities. The relative size of this impact on the fair participation coefficients is particularly relevant when systematic biometric risk is paired with a low interest rate environment, and is preserved when the solvency capital or the pricing rule is adjusted to reflect the portfolio size.

Overall, the results stress the predominance of systematic over diversifiable risk in determining fair participation rates.

An investigation of the interaction of contract design, market regimes and mortality assumptions shows that, particularly for lifelong benefits, the participation rate must be very conservative if longevity improvements are expected to persist.

The study does however recommend possible courses of action a life insurer could take in order to mitigate the effect of longevity risk. The insurance company can either increase the volatility of the assets or decrease the magnitude of the surpluses distributed to the policyholders to maintain the fairness of the contracts. As it stands, continued improvement in life expectancy will make those surplus participation rates currently offered, particularly in a climate of low interest rates, unsustainable.

The full paper The impact of longevity and investment risk on a portfolio of life insurance liabilities was published in European Actuarial Journal in December 2018. The paper received the Best Paper Award in “Aspects of long-term savings: uncertainty in low real returns, longevity and inflation” at the 2018 International Congress of Actuaries in Berlin.

An article on the research, Longevity Impact on Life Insurers in Low Interest Rate Environment was published in The European Actuary in October 2018.