rate-risk

Insurance companies and advisors must seriously address longevity risk while balancing the pressures of a low-rate environment. This risk can have a major impact on both insurers’ and clients’ balance sheets.

Insurers use an enterprise risk management framework that includes stress testing, scenario analysis, risk measurement and monitoring to understand the effects of longevity risk on their overall portfolios.

This helps them deal with annuity payouts: the longer the insured lives, the more strain it creates. Insurance companies are generally well-positioned to handle this risk, thanks to their life insurance portfolios.

For advisors and clients, the key concerns are portfolios that don’t deliver on projections, and clients who live longer than expected.

Read: 3 ways to simplify drawdown calculations

The problem of longevity

Mortality has been steadily improving over the last century. In 1940, a 65-year-old Canadian male was expected to live another 12.8 years. Today, a 65-year-old Canadian male is expected to live more than 22 years longer.

For insurance companies, an additional year of life expectancy can have a significant impact on their bottom lines. As a consequence, they’re building their longevity research teams to understand future mortality improvements resulting from lifestyle improvements (fewer people smoking, less second-hand smoke), and to stay abreast of medical breakthroughs.

Research has shown demographics, psychographics and geography impact mortality. A study by James Cheshire, for instance, shows life expectancy can vary by up to 20 years, depending on where someone’s born relative to the city’s subway stops. A recent Mercer study on the mortality of white-collar public sector pensioners in Australia showed:

  • 50% of retiring male white-collar workers are likely to live to 88 years; 35% to 91; 20% to 94; and 5% to 99. All are well above the average life expectancy of 84.1.
  • 50% of female white-collar workers are likely to live to 91 years; 35% to 93; 20% to 96; and 5% beyond 100. All are, again, well above the average life expectancy of 87.

One takeaway for advisors is that longevity hedging through annuity products becomes increasingly important as the number of years people are retired approaches the number of years they worked.

Those familiar with Moshe Milevsky’s work know that the volatility of your clients’ longevity is of the same magnitude as that of the stock market.

Read: Where to find investment risk

At a recent CALU conference, Milevsky presented data on the growth of $1 over a decade on the American stock market, going as far back as 1940. The results showed 55% variability in the market returns.

He then compared that to the arithmetic mean of the life expectancy of a 65-year-old (male or female) and the standard deviation of that sample group. It indicated 56% variability in longevity. That means clients need a risk management strategy for both market and longevity risk. Traditional retirement planning suggests clients withdraw money at a fixed percentage (indexed to inflation) per year. The 4% rule, for instance, says clients should have enough retirement income to keep them from running out of money, assuming normal life expectancy.

But given life expectancy’s expected to continue increasing, plus market volatility risk and persistent low rates, the 4% rule may need to be adjusted downward, and then further downward (or upward) each year as rates fluctuate, or the equity portion of the portfolio does exceptionally well.

While annuities are a natural fit to address longevity risk, the problem is locking up client money in the current low-rate environment. If it persists, indexed annuities would be ideal. They may provide lower initial income, but there’s potential for it to rise based on an index, interest rates or equity returns.

This structure provides a level of additional gains to cover inflation and/or cost of level increases. Therefore, income can never go down. The product is similar to a GMWB, but without the liquidity. Indexed annuities are gaining popularity in the U.S. as clients don’t want to lock in current rates. In addition, inflation is a potential risk, considering the current availability of cheap credit and quantitative easing.

Read: 4 investment tips for 2015

Other indexed products should also be considered, such as guaranteed market-indexed accounts, which are part of traditional universal life plans. This option makes a lot of sense for clients implementing a corporate or personal insured retirement plan.

If clients have an average 5% or 6% return by participating in some of the upside of the equity market, but none of the downside, they can leverage that insurance policy at 90%, potentially ending up with more years of retirement income via the line of credit.

What will happen to product guarantees?

Product guarantees will continue, but will likely be different from the past. We’re already seeing a trend toward smaller maximum exposure per single life on annuities. The logical progression would be to have pricing vary based on more factors, so that annuity pricing is further tailored by any of the following: occupation, lifestyle, demographics, etc.

You may also see some of the risk transferred back to the client; for instance, a guaranteed interest account in a UL policy with a 0% minimum, or an annuity that may have some portion fixed and another portion variable. Whole life could work because the insurer has the ability to declare dividends annually, and to adjust how much each cohort participates in that asset share. Policyholders receive a dividend based on how the business performs; the dividend’s consistent with their asset share. So, when an insurer declares a dividend, it’s not evenly distributed to all policyholders—one cohort may get more than another. This ensures contractual obligations to policyholders are met, and that the insurer can maximize payments to shareholders from the participating account up to legislative limits.

Read: Beware of dividend growth stocks

Adjustable premium and adjustable return products could also work. For life insurance, improvements in mortality help mitigate price increases resulting from falling interest rates. For annuities, the standard deviation of life expectancy is starting to widen due to factors such as demographics, lifestyle, occupation and advancement in medical research. It will, therefore, become increasingly important to price based on occupation, lifestyle and postal code.

by Rohit Thomas, FSA, FCIA, chief product actuary at BMO Life Assurance Company, and Pierre Ghorbanian , CFP, FLMI, an advanced markets senior business development manager at BMO Life Assurance Company.

Originally published in Advisor's Edge Report

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