CAIA L2 - 1.7 - Longevity And Liabilities: Bridging The Gap

Question 1

List

3 factors
that increased
life expectancy

1.7 - Longevity and Liabilities

Answer 1

1. Advances in medicine
2. Better health care
3. Reducing poverty

1.7 - Longevity and Liabilities

Question 2

List

2 steps
to mitigate longevity risk
(in pension plans)

1.7 - Longevity and Liabilities

Answer 2

1. Re-evaluate portfolio allocations.
   increase the allocation to growth assets:
   * higher growth investments,
   * diversified equity investments, and
   * alternative asset strategies.
   increase allocations to less liquid assets:
   * real estate,
   * private equity, and
   * infrastructure investments.
   increase allocation to higher yielding fixed-income:
   * leveraged loans,
   * high-yield corporate bonds,
   * emerging market debt,
   * asset-backed securities,
   * mortgage-backed securities, and
   * collateralized loan obligations.
2. Address duration risks:
   life expectancy up => liabilities duration up => interest sensitivity of assets and liabilities up.
   
   • long-term bonds
   • use of derivatives (e.g., interest rate swaps, interest rate futures, swap options—or “swaptions”) to manage interest rate risk.

1.7 - Longevity and Liabilities

Question 3

List

2 types of
Pension risk transfers

1.7 - Longevity and Liabilities

Answer 3

Pension risk transfers, which are more widely used than longevity insurance in the United States, are conducted through buyouts and buy-ins.

1. Buyouts.
   Pension assets + Liabilities => insurance company
   The pension fund transfers the pension assets and liabilities to an insurance company. The insurance company then pays participants and guarantees those payments for life. In essence, all risks are shifted to the insurance company. Administrative expenses are also reduced, including premiums to the U.S. Pension Benefit Guaranty Corporation. Because the plan’s assets and liabilities are being transferred, there is an acceleration of the recognition of deferred losses and gains. In other works, buyouts trigger settlement accounting. A decrease in pension risk may increase shareholder value. Each pension plan must assess whether risk transfer is worth it, given the specific circumstances of the plan.
2. Buy-ins.
   some risk (interest rate, longevity, investment risk) => insurance company
   Buy-ins allow pension funds to transfer some risks to an insurance company (e.g., interest rate risk, longevity risk, and investment risk) for a portion of the plan’s participants. The contract is retained as a plan asset. The pension fund is responsible for providing pension benefits. There are benefits to a buy-in contract, such as allowing the pension fund to phase in risk transfer, to avoid settlement accounting, and to maintain a specific funding ratio.

1.7 - Longevity and Liabilities