'Til Death Do Us Part
How Insurers can de-risk the impact of increased life expectancy
What happens when machine grows smarter than man? At this point, an unimaginable increase in inventive capacity occurs, as technology gains the capacity to improve itself and become integrated within human physiology. This theoretical point is known as “technological singularity”, and what lies beyond it is “a profound and disruptive transformation in human capability”. Technological singularity would fundamentally change human destiny and radically extend human life, and experts in artificial intelligence say that this point could occur by 2045. Despite much skepticism, the risk of technological singularity exists, and it threatens to dramatically alter life expectancy assumptions for insurers. What is an insurance company selling annuities to do to de-risk its business against this threat?
Annuity products are sold with the assumption that life expectancy will follow a linear and somewhat predictable path. To best shield from the prospect of rapid longevity growth, insurance companies should actively monitor nascent technologies that could fundamentally alter the length of human life and negatively affect the profitability of annuities businesses. Insurance companies should also take steps to refocus operations away from annuities and bolster their core life insurance segments.
Life expectancy has increased significantly over the past two centuries, increasing in developed nations at 2.5 years per decade since 1840. The pace of growth has also shown no signs of deceleration, with a 98% correlation between time and average life expectancy. In the 19th century and early 20th century, increases in life expectancy were due to reductions in death rates at younger ages, as living standards improved and diseases were eradicated. In the second half of the 20th century and the start of the 21st century, life expectancy increases have been fuelled by mortality reductions at later ages due to medical advances and improvements to elderly health services.
These increases in life expectancy have had a significant impact on the temporal-based financial products of the insurance industry. General actuarial opinion suggests that increases in life expectancy will soon reach an upper bound. In fact, the Canadian Institute of Actuaries (“CIA”) has even proposed base mortality improvement rates of only 1% for ages 60 to 90 and 0% for ages 100 and over. Given that the financial well-being of insurance companies relies heavily on the accuracy of these assumptions, expecting that life expectancy will not exceed some upper bound exposes insurance companies to significant risk.
Contrary to actuarial opinion, believers in technological singularity theorize that life expectancy will not hit an upper bound in the near future. They believe that humans will transcend biology through the application of artificial intelligence, genetic engineering, nanotechnology, and robotics. Ray Kurzweil, the mogul behind speech recognition technology and Director of Engineering at Google, believes that technological singularity is rapidly approaching and that technology will start being integrated within human cells and organs by mid-century. This integration of technology into human bodies has the potential to push life expectancy towards unforeseen levels.
While this theory may seem futuristic today, genetic therapy and organ printing are currently being studied in labs with encouraging levels of success. For example, researchers at Spain’s National Cancer Research Center have genetically altered cancer-ridden mice to live up to 45% longer. Additionally, the Wake Forest Institute for Regenerative Medicine has successfully grown and transplanted human organs with patients’ own cells. Technological improvements have also allowed 3-D printing to create human blood vessels to replace damaged ones.
Observers like Kurzweil argue that new technologies and artificial intelligence will sustain life expectancy growth and will provide capacity for further acceleration. If this phenomenon were to occur, the potential implications for insurance companies would be enormous, representing a seismic shift in their fundamental operating assumptions.
Present Value of Future Cash Flows
Insurance companies would be the most exposed group to increases in life expectancy, with annuity products being the most adversely affected segment. Annuities are streams of payments to policyholders, generally paid annually until death, making them inherently susceptible to longevity increases. Under annuity products’ current structure, profitability would be severely impaired by an increase in life expectancy, as annuity tables currently reference backward-looking mortality statistics.
Even if pricing models were to evaluate technological singularity and other causes of rapid longevity growth as real risks, insurance companies would be hard-pressed to sell annuity products at inflated prices. To justify purchasing expensive annuities, consumers would need to thoroughly understand the likelihood and magnitude of longer life. This realization would be necessary because annuitants are responsible for paying the present value of all expected future cash flows, discounted by both interest and survivorship.
Imagine two individuals who pay to receive $20,000 per year from retirement at age 65 until death. Now imagine that one individual is sure to die at age 85, while the other individual is sure to die at the extreme yet feasible age of 120. At a 4% discount rate, the first individual needs $271,807 to fund their annuity, whereas the second individual needs $442,172. Would the average consumer be willing to pay an additional $170,000 or 63% prior to retirement? Unlikely, especially given low savings rates and minimal Registered Retirement Savings Plan (“RRSP”) contributions among Canadians. If long-term interest rates were to remain at current levels of approximately 3.1%, the aforementioned discrepancy between an 85 year old death and a 120 year old death would be $229,995 or 78%.
The previous example is illustrative. In a true case, premiums for both annuitants would be reduced because policyholders may die prior to their expected mortality date. In this case, insurers would not be required to make further payments. However, the percentage discrepancy is indicative of the dramatic upward pressure life expectancy has on annuity prices, and it highlights the low probability that Canadians will take advantage of the value that annuities provide.
Meanwhile, another insurance product stands to profit from this situation. In contrast to annuities, core life insurance is positioned to benefit from increased life expectancy, as death claims are distributed at later dates and policyholder premiums accrue for longer durations. Additionally, policies like term insurance, which provides coverage for a defined period, would expire more frequently without a death claim. The lack of consumer appreciation for increasing life expectancy also means that clients are unlikely to clamour for lower premiums to compensate for lower insurer risk.
There is significant uncertainty associated with causes of rapid longevity growth. Technological singularity, for example, does not explicitly account for the impact of increased rate of heart disease and diabetes due to the obesity epidemic. With that said, the subset of individuals who are unwilling to change to healthy behaviours is more likely to welcome technology-aided longevity improvement. Furthermore, the integration of technology into human physiology would effectively create better humans that are more capable of overcoming such illnesses.
Will life expectancy reach an upper bound in the near future? Even given professional skepticism, it is difficult to rule out longer lifespans due to the inherent uncertainty and the disruptiveness of technological innovation. Accordingly, insurers highly exposed to these long-term financial liabilities would do well to prepare for the unknown future.
Canadian insurers such as Great-West Life and Manulife should start to divest their annuities businesses and look to acquire additional life insurance assets. Two noteworthy competitors, Sun Life Financial (“SLF”) and Industrial Alliance Insurance Inc. (“IAG”), have recently employed this strategy through the sale of their US annuities businesses to Guggenheim Partners, a private equity firm. As Great West Life and Manulife look to exit their positions, private equity firms present themselves as strong potential buyers. In order to continue acting as a “one-stop shop” for insurance products, GWL and MFC should negotiate arrangements with new owners of annuities businesses that would allow consumers to purchase annuities through existing GWL and MFC platforms. This prearrangement would be mutually beneficial for GWL or MFC and their respective annuities suitors, as insurers hold salient expertise and entrenched customer relationships, while financial buyers provide the necessary risk appetite.
In addition, insurers should look to acquire additional life insurance assets. These bolt-on acquisitions would strengthen large Canadian insurers’ cost advantage over smaller competitors, present opportunities for synergies through scale, and reduce the threat of new low-priced entrants. An example of an insurance company that would be a strong acquisition target is IAG. The life and health insurance provider based in Quebec City would provide additional life insurance exposure, geographic diversification within Quebec, and a refocus away from fixed annuities. The valuation is also attractive, as IAG currently trades at 2.0x its tangible book value with compound annual sales growth of 7.7% between 2009 and 2012. These figures compare to 6.2x and -0.5% for Great-West Life and 2.1x and -10.3% for Manulife.
At current prices, core life insurance remains the most attractive segment for insurance companies. Therefore, based on the extrapolation of current life expectancy growth rates, core life insurance products will continue to be more profitable than actuarial models indicate. However, it is likely that in the long run a tipping point will take place when Canadian consumers internalize the impact of life expectancy trends. At this point, Canadians may also begin to appreciate the likelihood for continued acceleration of human lifespans through technology. These realizations would undoubtedly lead to consumers demanding cheaper life insurance products and would negatively impact insurer profitability. Consumer pressure will force insurance companies to use better, more forward-looking information in mortality calculations and necessitate action today to prepare for the changing future.
The Meaning of (Longer) Life
While the potential impacts of longer life could dramatically undermine insurance companies` current business models, this change brings with it both risks and opportunities. On one hand, the risks are associated with annuity clients outliving current policy assumptions by years if not decades. On the other hand, the opportunities are captured by those insurers who position themselves to take advantage of longevity, should people continue to live longer and healthier lives. It is hard to imagine a sector of the economy that has more at stake over the next 30 years than the insurance industry. Whether individual insurers thrive or merely survive will depend upon their ability to plan for these enormous, if uncertain, risks and opportunities.