With the recent financial crisis, there more emphasis has been placed on the science of risk management than ever before. People are analyzing where it went wrong for Lehman Bros., Bear Stearns and AIG; however, managing key risks is not limited to large corporations, actuaries and risk management experts. Financial planners must work to assume the role of "Personal Chief Risk Officer" for each of their clients. There are important lessons that must be learned that should impact the way you work with clients when they consider emerging risks. This article will focus on the topic of mortality, or longevity risk, and how to make sure the customer is covered for the worst-case scenarios.
To help understand the risk management aspect of the financial meltdown, it is worth reading the following articles. In January 2009, the New York Times Magazine ran an article by Joe Nocera on risk management, in which Nocera describes the concept of Value at Risk (VaR): "Built around statistical ideas and probability theories that have been around for centuries, VaR was developed and popularized in the early 1990s by a handful of scientists and mathematicians -- `quants' they're called in the business--who went to work for JPMorgan. VaR's great appeal and its great selling point to people who do not happen to be quants, is that it expresses risk as a single number, a dollar figure, no less."
For investors, the risk is about the probability of losing money, so planning for the unexpected also should be considered. By assuming investors care about a large loss, VaR answers the questions, "What is my worst-case scenario?" and "How much could I lose in a really bad year?" Many investors were unprepared for these questions in 2008, and have since learned the consequences.
Mary Hardy, Ph.D., FIA, FSA, explained in her note in "An introduction to Risk Measures for Actuarial Applications" that, "VaR measure was actually in use by actuaries long before it was reinvented for investment banking. In actuarial contexts it is known as the quantile risk measure or quantile premium principle."
Both Nocera and Hardy point out some flaws with using VaR as the only measure. Both cover how VaR started as a tool for measuring certain types of risk, in which some people placed far too much confidence. However, the key principle of analyzing what the worst-case scenario could be is still very important, and must not be thrown away.
It seems that the lessons the financial crisis taught of not being diversified and placing all one's confidence in a simple model producing one number, still is used by consumers when they look at the risk of death and their lifespan.
It is important to remember that a lifetime is the actual number of years an individual lives, whereas life expectancy is the average number of years a person is expected to live based on a national average per age group, gender and other factors. In June 2008, the Centers for Disease Control and Prevention National Center for Health Statistics released its latest data, showing that U.S. life expectancy at birth reached a new record high of 78.1 years. Financial advisors know that this figure is for newborns, so they appropriately look at the current age of their customers and calculate their remaining life expectancy. This study showed that at age 65, a white male would have a remaining life expectancy of 17.5 years, while a white female would have 20.3 more years. So, if a customer with retirement needs is a 65-year-old white male, he should plan for an average life expectancy of 82.5 years.
But stopping at this point could represent double jeopardy. There is the risk of premature death during the income-earning years, and there is the risk of outliving accumulated savings by having financial instruments that may not perform for that entire time period, and the client could certainly exceed his life expectancy.
However, balanced planners often do not stop there; instead, they borrow a page from their actuarial colleagues. It is important to view life expectancy as a distribution, not a single number. There are several good life expectancy calculators available on the Internet that now take into account a variety of lifestyle factors and show the life expectancy, median lifetime (usually higher than the life expectancy), and the upper and lower quartiles. One such life expectancy calculator is available at the Society of Actuaries' Web site at www.soa.org/research/pension/research-simple-life-calculator.aspx
. This calculator allows for the possibility of including projected future mortality improvement, which many actuaries use in their projections to show about one percent improvement each year. This is driving the life expectancy to higher levels. However, calculators cannot account for all of the probabilities and likely events that may befall an individual.
So, if customers want to save money by cancelling their life insurance policy during this challenging economic cycle, it is very important that you act as the "Personal Chief Risk Officer" and ask more probing questions. For example, if a customer has a 15-year level term policy and is already 10 years into the policy, it is imperative to let him know that he will unlikely be able to replace the coverage at the same price, since he had essentially locked in to the average rate 10 years ago and was overpaying in the early years for the policy in order to receive lower rates in the policy's later years. If he had considered the actual cost of insurance charges for each year, he may have determined that the level premium rate for the past five years was actually a bargain.
Everything should start with the need for coverage and the length of time you will need protection. If the need for insurance still exists, it is important to ask the questions: What would happen to the family if there was an unexpected death next week if the policy is not replaced? Would they still be able to live in the same manner and have the same aspirations for their children to attend college?
Finally, health and age are other important factors. It is usually easier for someone in their mid-30s to get a new policy at a reasonable cost than someone who is in their early 60s with health risks. It is very important to insist that the customer keeps the current policy until another policy is in place.
However, a greater risk that many customers will face is outliving their resources. Planning to live to a certain age is risky, and planning to live to the life expectancy will be inadequate for about 50 percent of the population. In theory, retirees want to make sure their money will last a lifetime without changing their lifestyle
. In practice, however, unexpected events make this very difficult.
An October 2008 Society of Actuaries publication on managing post-retirement risks specifically addresses longevity risk. That report referenced payout annuities as an overlooked tool for retirees to purchase with a portion of their estate as a diversification tool because they maximize the amount of guaranteed lifetime income available from a sum of money.
Some of products that should also be considered include:
- A reverse mortgage used to convert home equity into lifetime income without the issue of trying to sell the home in this unfriendly real estate environment.
- Longevity insurance is an annuity that does not start paying benefits until the client reaches an advanced age, such as 85. The advantages include that it tends to offer bigger payouts than alternatives such as deferred annuities, and it can cost less to achieve the desired income with payments. The big drawback to consider is that there is no benefit if death occurs before age 85.
- Managed payout plans draw down one's assets gradually. Income from such plans is not guaranteed, or it may be guaranteed at a lower level than would be available from a payout annuity that has the same cost.
Just as actuaries are now looking at the worst-case scenarios in a new light, so should you do the same for your customers. Help them consider the risk of their worst-case scenarios; either premature death or outliving all their assets. The events of 2008 have taught us lessons in the danger of looking at the averages and ignoring the extreme event scenarios.