Solvency II and Longevity Risk Transfers
In short, longevity risk is the risk that policyholders (or underlying beneficiaries or pension scheme members) in general live longer than is expected. Under the new Solvency II framework longevity risk is more accurately defined as “the risk of loss, or of adverse change in the value of insurance liabilities, resulting from changes in the level, trend, or volatility of mortality rates, where a decrease in the mortality rate leads to an increase in the value of insurance liabilities”.[1] Recent estimates of the total global value of longevity risk exposures (annuity and pensions) range from $15 trillion to $25 trillion.[2] Owing to improvements in healthcare, drug treatments, medical interventions, and lifestyle trends, people are living longer, and therefore insurance companies have been increasingly exposed to longevity risk exposures. Moreover, in practice it has been noted that a one year longevity underestimation may in aggregate, cost risk holders anywhere between $450 billion to $1 trillion.[3]
Under Solvency II, the Solvency Capital Requirement (SCR) is the minimum amount of capital that life insurers must hold, and is based on a number of individual SCRs for each risk, including longevity risk. Longevity risk is classified as a non-hedgeable risk and life insurers must therefore hold capital to address this risk.[4] Some factions within the life insurance market believe the Solvency II capital charge for longevity risk is excessive, and it has therefore been predicted that the longevity risk transfer market will remain busy post-Solvency II.[5] Current reinsurance pricing for transferring longevity risk has been cited as incentivising insurers to execute deals in order to effectuate capital efficient hedging strategies as opposed to internal retention of longevity risk.[6] There are four main types of longevity risk transfer method, namely a ‘buy-in’, a ‘buy-out’, a ‘longevity bond’, or a ‘longevity swap’.[7] However, when considering longevity risk transfers (LRTs) there are a number of other issues that should be noted in addition to risk transfer methods.
First, firms should note that the Prudential Regulation Authority has warned that LRTs should only be undertaken for genuine risk transfer purposes, and it will be reviewing such transfers in order to ensure insurers are not creating excessive counterparty or concentration risks.[8] Second, research using mathematical calculations and Monte Carlo simulations has demonstrated that longevity swaps for higher ages (90 years and above) have higher market hedging costs than the saving in the cost of Solvency II regulatory capital.[9] Third, research has also shown that although longevity swaps reduce the overall SCR (thereby increasing free equity), they do not create value or affect the Solvency II Market Value Margin (MVM).[10] Fourth, research has also demonstrated that not only does the Solvency II Standard Formula overestimate the Solvency II capital requirement, but that Internal Models can be calibrated to produce significant capital savings for longevity risk compared to the Standard Formula approach.[11] Fifth, it has been noted that LRTs can not only create basis risk and counterparty risk, but that increasing LRT deals may lead to increased interconnectedness, more contagion during times of stress, and a build-up of large tail risk as LRT markets increase.[12]
If you would like to discuss any of the implications of Solvency II on your business, or for more information on our Solvency II reporting solutions and prices, please email DataTracks at: enquiry@datatracks.eu.
[1] CEIOPS’ (2009). Advice for Level 2 Implementing Measures on Solvency II: Standard formula SCR – Article 109 c Life underwriting risk (CEIOPS-DOC-42/09), p.5.
[2] CRO Forum (2010). Longevity. CRObriefing Emerging Risks Initiative – Position Paper (November); Biffis E. and Blake, D. (2012). How to start a capital market in longevity risk transfers. Unpublished paper (September).
[3] The Joint Forum (2013). Longevity risk transfer markets: market structure, growth drivers and impediments, and potential risks. Basel Committee on Banking Supervision International Organization of Securities Commissions International Association of Insurance Supervisors c/o Bank for International Settlements, CH-4002 Basel, Switzerland (August).
[4] “The capital charge for longevity risk is intended to reflect the uncertainty in mortality parameters as a result of changes in the level, trend and volatility of mortality rates and capture the risk of policyholders living longer than anticipated. This risk may be captured in a number of different ways: a simple approach of a reduction in base mortality rates, a more realistic approach of using improvement factors which leads to a two dimensional mortality table, or a combination of these two approaches.” CEIOPS (2009), p.10.
[5] Artemis (2015). Longevity risk transfer market to remain busy due to Solvency II (7 December).
[6] Artemis (2015).
[7] The Joint Forum (2013), p.1; DeNederlandscheBank Eurosysteem (2015). Longevity Risk Transfer activities by European insurers and pension funds, Occasional Studies, Vol. 13-5, p.10.
[8] Bank of England Prudential Regulation Authority (2016). Longevity Risk Transfers, Letter, Andrew Bulley (Director of Life) and Chris Moulder (General Insurance Supervision) (9 February).
[9] Meyricke, R. and Sherris, M. (2013). Longevity risk, cost of capital and hedging for life insurers under Solvency II. Insurance: Mathematics and Economics, Volume 55 (March), pp.147-155.
[10] Pang, S. (2014). Longevity swaps and value creation. Zanders Treasury & Finance Solutions.
[11] Salah, S. B. and Belkacem, L. (2015). On the Longevity Risk Assessment Under Solvency II. The Journal of Applied Business Reseach, Volume 31, Number 3 (May/June), pp.1149-1158.
[12] The Joint Forum (2013), p.1; DeNederlandscheBank Eurosysteem (2015). Longevity Risk Transfer activities by European insurers and pension funds, Occasional Studies, Vol. 13-5, p.24.