Estimating international adverse selection in annuities

North American Actuarial Journal,  Oct 2002  by Mitchell, Olivia S,  McCarthy, David

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Our results are of interest because the choice of a mortality table rather importantly influences annuity valuation. We find that mortality rates of voluntary annuitants are similar in the U.S. and the U.K. and that annuitant mortality is much lighter than population rates. We then compute money's worth values of life annuities using these various mortality tables and the U.S. male population period mortality table as a benchmark. Compared to this group, annuity valuations would differ by 10-15% if instead one used U.S. or U.K. annuitant cohort mortality tables. This is a rather substantial variation, in light of the fact that life annuities relative to premiums are worth on the order of 90-95% in both the U.S. and the U.K. (Brown et al. 2000; Finkelstein and Poterba 1999).

Deciding which mortality table to use evidently has a potent effect in valuing these products. This is important to acknowledge because many developed nations and most developing countries lack adequate mortality data for use in pricing retiree annuities. When a country lacks mortality data, an insurer may use the U.S. or U.K. tables but may require a higher margin to reserve against greater uncertainty. Consequently, annuities could likely be worth less in a country where mortality data are difficult to come by. Alternatively, if U.S. or U.K. mortality tables were used without such reserves, unexpected mortality developments could quickly undermine the survival of the insurance sector. We believe that annuities are likely to become more important internationally as countries replace traditional pay-go social security systems with privately funded social security systems. Estimating the likely extent of adverse selection in annuities markets, especially in countries where sufficient data on annuitants do not exist, is vital to ensure that this process runs smoothly.

Our central finding is that adverse selection associated with the purchase of individual annuities reduces mortality by least 25%. We also find that there is no significant difference between the effects of voluntary and compulsory selection on mortality, which warrants further research. We do not believe that this result implies that in an individual country there is no significant difference between compulsory and voluntary selection. Rather, we interpret it to mean that the ranges of variation of what might be called "compulsory" and "voluntary" selection in different countries overlap. This, we believe, highlights the important point that the extent of adverse selection is highly dependent on the legal and economic environment.

Of late, some analysts have sought to measure the effect of adverse selection due to private information on the mortality of a wide rang of insurance purchasers (cf. Finkelstein and Poterba 2001; Cawley and Philipson 1997). Using aggregate data, of course, it is difficult to differentiate between income effects and adverse selection due to asymmetric information, without making further assumptions. In the present paper, we assume that the distribution of income is the same for both compulsory and voluntary annuitants, permitting us to use aggregate data to test for adverse selection by comparing the mortality of compulsory and voluntary annuitants. A companion paper makes an alternative assumption, namely that the income of life insurance purchasers and annuitants is equal, so mortality differentials may be used to test for adverse selection (McCarthy and Mitchell 2002). Further pinpointing of the magnitudes of adverse selection would benefit greatly from individual-level data.