The Securitization of Longevity Risk and its Implications for Retirement Security

The economic significance of longevity risk for governments, corporations, and individuals has begun to be recognized and quantified. The traditional insurance route for managing this risk has serious limitations due to capacity constraints that are becoming more and more binding. If the 2010 U.S. population lived three years longer than expected then the government would have to set aside 50% of the U.S. 2010 GDP or approximately $7.37 trillion to fully fund that increased social security liability. This is just one way of gauging the size of the risk. Due to the much larger capacity of capital markets more attention is being devoted to transforming longevity risk from its pure risk form to a speculative risk form so that it can be traded in the capital markets. This transformation has implications for governments, corporations and individuals that will be explored here. The analysis will view the management of longevity risk by considering how defined contribution plans can be managed to increase the sustainable length of retirement and by considering how defined benefit plans can be managed to reduce pension risk using longevity risk hedging schemes

On Corporate Risk Management and Insurance

Insurance contracts provide the corporation with an instrument to manage risk and create value. Insurance is designed to manage pure risk; a pure risk only yields a loss unlike speculative risks that may yield a gain or loss. Received theory does not provide the necessary distinction between pure and speculative risks that would allow the role of insurance to be investigated. Pure and speculative risks are modeled here as independent random variables. The role that insurance plays in determining an optimal capital structure and otherwise managing risk is investigated. This analysis is a generalization of a classic financial market model and it shows that earlier results such as the use of insurance to control the risk-shifting problem continue to hold. This role, however, can be duplicated by a variety of other instruments including convertible bonds and futures. In an attempt to provide a distinction the analysis is extended. It provides a tax result in which the corporation creates value by substituting a safe tax shelter for a risky tax shelter; this is accomplished by issuing debt to purchase insurance so that the random deduction due to the pure loss is replaced by a known deduction due to the debt. Hence, the analysis reveals a role that insurance can play in developing an optimal capital structure. The analysis also provides the basis for comparing the use of financial futures with that of insurance in managing risk. The analysis shows the conditions under which the corporation may create value for its shareholders by using both insurance and futures contracts to hedge the pure and speculative risks.