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Life insurance companies writing annuity business are exposed to longevity risk. The current regulatory framework (and indeed that proposed under the pan-European standard, Solvency II) require companies to set aside risk capital that is consistent in magnitude with the additional liabilities arising (or to be more precise modeled to arise) under an extreme adverse scenario.
Such a scenario is required to be calibrated at the 99.5th percentile (so a 1 in 200 event) over a one year time horizon.
This has proved challenging to calibrate for many companies but the overlay of a Longevity Catalyst framework can be useful for the following reasons
- A one year time horizon is widely acknowledged as insufficient for significant changes in experience to emerge. Changes in expectations, however, may emerge as a result of for example (a) a Longevity Catalyst event (b) increased likelihood of such an event or (c) changes in other Indicators.
- Acknowledged good practice in this area is to itemize each element of the risk for which you are holding capital. This can (a) promote understanding (b) avoid double-counting (c) reduce capital held for "unknown risks" to the extent your itemized list captures all "known risks". Longevity Catalysts can help greatly within this area.
- Some firms choose to calibrate the adverse capital scenario over run-off (the projected lifetime of the annuity book) rather than over a one year time horizon as this is viewed as more consistent with how the risk manifests itself, certainly in terms of observable adverse scenarios. Such approaches are also acceptable to the UK regulator (subject to conditions). Again, the Longevity Catalysts framework can supplement or even lead this analysis insofar as (a) a causal approach is used for (part of) this assessment (b) it is useful explicitly specify which particular catalyst(s) / indicator(s) occurrence / level are consistent with the adverse capital scenario provided.
- Furthermore, to the extent that there are differing degrees of catalyst and / or Indicators-this can provide a more general (realistic) capital management framework which seeks to capture stresses that are less onerous than a 1 in 200 event over one year.
- By clearly specification of the Longevity Catalysts that are consistent with a firm's risk capital scenario(s), it may be possible to reduce capital in future if the likelihood of these risks is decreased and / or if the occurrence of these catalysts can be hedged (eg via the capital markets)
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