Annuitization and a Lifetime of Risk

(February 11, 2013) — Lifetime annuities are a long game, and more insurers are starting to play it on a large scale.

Shifts in asset prices or longevity could have a massive effect on insurance firms holding these annuities in bulk, and three researchers have attempted to quantify just what those effects would be. John Evans, Amandha Ganegoda, and Toby Razeed found that the foremost threat to provider solvency is not market crashes or long lifetimes—it is both happening at the same time. 

“In issuing lifetime annuities, the two major risks of longevity improvement and investment return can be absorbed by the issuers if they are independent, but they may not make much profit, which in the long run is not sustainable,” the authors, all risk experts out of Australia, wrote in the study. “But issuers cannot withstand the simultaneous occurrence of both risks at the extreme.” 

Razeed, Evans, and Ganegoda stress-tested mock insurer portfolios for a variety of asset price and demographic conditions based on historical precedent, using two separate models. The study does not factor regulation into the models or taxes into returns. 

The more sophisticated stochastic model indicated that even with a typical life expectation of 85 years and no market crashes, a portfolio of 10,000 lifetime contracts has a 2.3% probability of losing money. If both longevity and asset prices took a turn for the worse, the study found it became “highly likely” any given issuer could no longer sustain their business. 

The authors came up with no tidy solution for hedging against the long tails of these two risk factors. Other studies have shown derivatives, including longevity bonds and market risk swaps, to be effective in theory. But, as this paper and others point out, longevity bonds in particular are not readily available from the capital market. Pooling lifetime annuities would also prove an ineffective hedge, the authors argued, because an individual insurer and a group of pooled annuitants are subject to the same risks. 

“The analysis indicates that lifetime annuities involve … uncertain risks related to adverse extreme longevity changes and investment returns, and none of the possible methods of managing these risks are sufficient to ensure survival of issuers of the lifetime annuities,” Razeed, Evans, and Ganegoda wrote. “Given the need for lifetime annuities to be provided at a reasonable cost, and the extreme risks cannot be determined, then it is appropriate this cost is borne across the community.” 

The most feasible way to provide affordable income streams over decades of retirement, the authors concluded, is another form of risk transfer: “Lifetime annuities can be written, but the major risks require a national reinsurance approach to ensure sustainability.” 

Read the entire paper, “An Analysis of the Relative Risks of the Lifetime Annuity Business and Their Management,” here.