Longevity risk

The pre-agreed fixed premium cash flow received by the insurer/reinsurer is usually based on an agreed base mortality table with agreed expected future mortality improvements. The diagram outlines the basic dynamics of a regular premium annuity treaty. The typical structure of the regular premium annuity treaty is best illustrated by means of an example:

The Defined Benefit scheme has to pay Mr X (pensioner) a guaranteed amount of GBP 50,000 pa for as long as he is alive. Let us assume he is 65 years old and is expected to live another 17 years. As a result of the considerable uncertainty around future mortality improvements, there is a very real possibility that Mr X will live for a longer period than the expected 17 years. In this case, the scheme is likely to have underestimated the assets required to match this liability, which may result in an eventual deficit in respect of this member.

Of course, Mr X may die sooner than expected, in which case the scheme will realise a surplus. It is this uncertainty and potential for downside that is a source of risk for the scheme. Under a regular premium annuity treaty, the pension scheme can exchange (swap) this uncertain series of cash flows for a pre-determined, certain set of cash flows.

Under such an arrangement, the insurer/reinsurer commits to paying the actual annuity payments as and when they become due, which will be for as long as the annuitant is alive. In return the scheme pays a pre-determined series of cash flows to the insurer/reinsurer that represents the expected payments that would be made (based on a base mortality table and expected future mortality improvements). This is typically a decreasing series of cash flows and is payable up to an age beyond the expected life expectancy of the lives covered, for example up to age 100.