Distinguishing Mortality Risk and Longevity Risk

Mortality Risk

Mortality risk refers to the risk associated with the death of policyholders or insured individuals. For life insurance companies, this risk arises when policyholders pass away earlier than expected, leading to higher claim payouts. Mortality risk is a critical consideration for life insurers as it directly impacts their claim liabilities and financial stability.

Longevity Risk

Longevity risk is the risk of policyholders living longer than anticipated. For annuity providers and pension funds, longevity risk results in the need to make payments to policyholders for a more extended period than originally estimated. This risk can strain the financial resources of insurance companies and pension funds.

Example

Let’s consider a life insurance company that sells term life insurance policies. The mortality risk for the insurance company would be that a significant number of policyholders pass away within the policy term, resulting in a higher volume of death benefit claims. On the other hand, for an annuity provider, longevity risk arises when retirees receiving annuity payments live much longer than initially projected, leading to extended payment obligations.

Hedging Strategies for Mortality and Longevity Risks

Mortality Risk Hedging

1) Reinsurance: Insurance companies can transfer a portion of their mortality risk to reinsurance companies. Reinsurers assume some of the policyholder mortality risk in exchange for a premium paid by the primary insurer.

2) Mortality Derivatives: Financial instruments such as mortality swaps or mortality options can be used to hedge against mortality risk. These derivatives pay out in the event of an unexpected increase in mortality rates, offsetting the impact on the insurance company’s liabilities.

Longevity Risk Hedging

1) Longevity Swaps: These financial contracts allow insurance companies or pension funds to transfer the risk of policyholders living longer than expected to a counterparty. In return, the counterparty pays the insurer if longevity exceeds predetermined levels.

2) Longevity Bonds: These specialized bonds provide investors with high yields but are at risk of principal reduction if life expectancy exceeds a specified threshold. For insurance companies, issuing longevity bonds allows them to transfer longevity risk to bond investors.

Case Study: Longevity Risk Management for a Pension Fund

XYZ Pension Fund manages retirement benefits for a large group of retirees. The fund faces the risk that its pensioners may live longer than initially projected, increasing its pension payment obligations. To manage longevity risk, XYZ Pension Fund adopts the following strategies:

1) Longevity Swaps: The pension fund enters into longevity swaps with financial institutions, transferring a portion of the longevity risk. In return, the pension fund receives payments from the counterparties if the pensioners live longer than expected.

2) Diversified Investment Portfolio: XYZ Pension Fund allocates its investment portfolio across various asset classes to generate higher returns. By earning better investment income, the fund can offset increased pension payouts resulting from greater longevity.

3) Regular Actuarial Reviews: The pension fund conducts frequent actuarial reviews to update longevity assumptions and assess the adequacy of its reserve levels. This ensures that the fund remains prepared for changes in life expectancy.

By implementing these longevity risk management strategies, XYZ Pension Fund reduces the uncertainty associated with increased life expectancies, ensuring the financial stability of the fund and providing pension security for its beneficiaries.