We know that individuals make investments and accumulate wealth during their working life in order to provide for their financial needs during retirement. At the date of retirement, it is common for a retiree to transfer his/her accumulated wealth to an insurance company in exchange for (typically) monthly income payments. These payments are called annuities.
To illustrate, consider the case of an individual who retires with an accumulated sum of €500,000. The individual is 65 years old and the he insurer predicts that the individual will live until 85 years. Based on this information, the insurer accepts €500,000 and provides the individual with a guaranteed payment of €2,500 at the beginning of each month for as long as the individual is alive.
This is a significant benefit for the individual. Why?
Even if the individual lives longer than 85 years, the insurer is obligated to make monthly payments of €2,500 until his/her death. Simply put, he/she does not have to worry about living longer than 85 years and not having enough money.
But there is a significant risk to the insurance company. Why?
The insurance company calculates its monthly payment assuming that the individual will die at age 85 years. If the individual lives longer, the insurance company has to make more payments that expected. This can create cash flow problem for the insurer.
How do insurance companies deal with the risk that retirees live longer than expected?
An answer to this key question involves the important principle of mutuality. This principle states that individuals who die earlier than expected (and so receive less payments) pay for those who live longer than expected (and so receive more payments). Clearly, having a large portfolio of retirees is important for this principle to be fully effective.
Retirees who die earlier than expected subside those that live longer than expected. In this way, insurance companies can deal with the risk that some retirees who live longer than expected.
Do you want to find out more about life annuities in retirement and the principle of mutuality? Download our eBook “Life Insurance” by Dr. Dick Harryvan and Dr. Abdul Rahman. You can also follow Dr. Rahman on Twitter at @AHRahman88.