Insurers can limit their longevity risk by concluding reinsurance agreements or by acquiring financial instruments. Different requirements and points for attention apply, depending on the selected risk mitigation method. Below we describe the main requirements laid down in the Directive Solvency II (hereafter: Directive) and the Delegated Regulation Solvency II (hereafter: Delegated Regulation), and the main points for attention for insurers. Based on these requirements and main points for attention, DNB will assess longevity instruments and their effects on a case-by-case basis. In this assessment other legislations and regulations than mentioned here could be relevant. Furthermore, DNB does not rule further guidance in the future because of developments in the longevity market and deliberations within EIOPA.
Q&A on instruments to limit longevity risk
- Relevant for:
- 16 june 2016
Which criteria apply to instruments to limit longevity risk?
Reinsurance or financial instrument
A contract can qualify as a reinsurance contract only if the transfer of risk has economic substance and is effective, and if the accepting counterparty is an insurance undertaking or a reinsurance undertaking satisfying the criteria set out in article 211(2), of the Delegated Regulation. Furthermore, the specific legislation and regulation in de right column of the table below are relevant. If a contract does not satisfy the criteria then the requirements of financial instruments are relevant (left column). Some requirements are applicable in the same way to reinsurance contracts and financial contracts.The regulations apply in the same way to insurers using the standard formula and insurers using an internal model, unless specified.
Risk mitigation using financial instruments
Risk mitigation using reinsurance contracts
A longevity bond (issued or purchased), a longevity index swap or a longevity (index) forward contract. In general payments are done on the basis of trends in an index or mortality figures or life expectancies.
A reinsurance contract or an indemnity swap with a (re)insurance undertaking where payments are reinsured or exchanged in relation to expected payments (with a premium or surcharge)
Valuation of the longevity instrument
Article 75 (Directive) and articles 7 through 10 (Delegated Regulation)
Article 83 (Directive) and articles 41 through 42 (Delegated Regulation)
Guideline 78 (Guideline for the valuation of the technical provisions, EIOPA)
The amounts recoverable from reinsurance contracts and special purpose vehicles shall be calculated consistently with the boundaries of the insurance contracts to which those amounts relate.
Cash flows shall only include payments in relation to compensation of insurance events.
For the calculation of the capital requirements underlying the risk margin, the specific financial instruments of the insurer are not taken into account. From article 38 (Delegated Regulation) follows that only insurance and reinsurance contracts are transferred to the reference undertaking.
Article 38 (Delegated Regulation)
It can be assumed that the reinsurance contract is transferred to the reference undertaking and is taken into account in the (capital requirements of) the risk margin.
Solvency capital requirement
Standard formula: Articles 208, 209, 210, 211 (reinsurance) and 212 (financial instruments) (Delegated Regulation)
Internal model: Article 235 (Delegated Regulation)
Guidelines on basis risk(EIOPA)
The transfer of risk is clearly defined and incontrovertible.
When taking into account risk mitigation techniques the economic realism of the technique used must be reflected, for example by calculating the expected value of the payments of the hedge by a projection of future payments. This calculation is consistent with the valuation of the hedge instrument (also with respect to non-observable market inputs for the valuation).
The basis risk can arise from:
If the payment of the hedge instrument depends on a number of parameters then this could also lead to a significant basis risk and higher complexity. In the Guidelines on basis risk, it is indicated that an insurance undertaking (for example) can model with a stochastic model the complete probability distribution of payments of the hedge instrument and the trend of the insurance obligations to provide insight in the effectiveness and the basis risk.
Internal control of valuation of assets and liabilities
Article 267 (Delegated Regulation)
The valuation process of the longevity instrument must be sound and solid, the inputs of the valuation models are adequate and reliable and there is an independent evaluation of verification of the information, data and assumptions which are used in the valuation approach.
Article 44 (Directive)
The insurance undertaking has in place an effective risk-management system comprising strategies, processes and reporting procedures necessary to identify, measure, monitor, manage and report, on a continuous basis the longevity risks, at an individual and at an aggregated level, to which they are or could be exposed, and their interdependencies.
The insurance undertaking takes into account the effectiveness of the longevity instrument, the resulting basis risk, the counterparty default risk and possible effects of the longevity instrument on other risks (for example lapse and interest rate risk) and other non-quantifiable risks (for example legal risk)
The basis risk between the insurance obligations and the hedge instrument are completely identified, measured and mitigated and the outcome of this is taken into account in the calculation of the capital requirement.
Article 48 (Directive)
Contribution to effective implementation of the risk management system, in particular with respect to the risk modelling underlying the calculation of the solvency capital requirements and to the ORSA.
Article 48 (Directive)
Article 272 (Delegated Regulation)
The actuarial function expresses an opinion on the adequacy of reinsurance arrangements.
The actuarial function shall produce a written report to be submitted to the administrative, management or supervisory body, at least annually. The report shall document all tasks that have been undertaken by the actuarial function and their results, and shall clearly identify any deficiencies and give recommendations as to how such deficiencies should be remedied.
The actuarial function shall be carried out by persons who have knowledge of actuarial and financial mathematics, commensurate with the nature, scale and complexity of the risks inherent in the business of the insurance or reinsurance undertaking, and who are able to demonstrate their relevant experience with applicable professional and other standards.
Risk profile and solvency capital requirement (SCR)
In general, instruments mitigating longevity risk impact insurers' risk profiles as well as their solvency capital requirements. However, it is also possible that such instruments do not lead to lower risk profile. In principal, this cannot lead to a reduction of the solvency capital requirements. A reduction of solvency capital requirements should be in proportion to the reduction of the risk profile. The premium paid for the reinsurance contract in relation to the reduction of the solvency capital requirements is an indication for this. If applicable, insurers must assess the significance with which the risk profile deviates from the standard formula assumptions in their ORSA (Article 45 of the Directive). In the case of a significant deviation of the risk profile from the standard formula assumptions DNB may impose measures to limit this deviation (Articles 37 and 119 of the Directive).
 The list of equivalent countries can be found by http://ec.europa.eu/finance/general-policy/docs/global/equivalence-table_en.pdf
 basis risk means the risk resulting from the situation in which the exposure covered by the risk-mitigation technique does not correspond to the risk exposure of the insurance or reinsurance undertaking