3.7 Underwriting risk is the risk of mis-pricing annuities due to improper assumptions about future mortality rates, investment returns, and operating costs. In the case of fixed life annuities, one of the major sources of underwriting risk is longevity risk, or the risk that the annuitant will live longer than anticipated when the contract is underwritten. This may arise due to a variety of factors, including insufficient or poor mortality data, difficulties in assessing future improvements in longevity (due, for example, to unanticipated medical advances and lifestyle improvements), the greater uncertainty of the tail-end of the age distribution, or failure to differentiate annuitants according to their level of risk.

3.8 Annuity contracts may also be mis-priced due to unrealistic assumptions about future reinvestment rates or about the company’s capacity to manage its operating costs (e.g., overestimating the effect of improvements in technological advances or the impact of gains in market share and increased economies of scale). Underwriting risk is often increased by the intensity of competition in decentralized markets, the incurrence of unduly high marketing costs, and the adoption of aggressive selling campaigns.

3.9 Investment risk relates to losses arising from the volatility of asset and liability prices, which are affected by changes in interest rates, exchange rates, equity prices and property values. It reflects the extent of mismatching between assets and liabilities. Providers who offer life annuities usually suffer from mismatched positions. Typically, the duration of assets is substantially shorter than the duration of liabilities. Their risk then becomes reinvestment risk and relates to the risk that the returns on the funds to be reinvested will fall below anticipated levels.

3.10 Investment risk is increased by exposure to pre-payment risk, which is the risk that issuers of debt instruments use their right to pay their obligations before the contracted maturity. This risk is present in the case of mortgage bonds or mortgagebacked securities, where the underlying mortgages have refinancing options, or in the case of callable corporate bonds.

3.11 Investment risk can be subdivided into interest rate, equity, currency and inflation risks. Interest rate risk results from fluctuations in the general level as well as the term structure of interest rates. The exposure to this risk is greater the larger the mismatch between the duration of assets and liabilities. This is one of the most important risks faced by providers of fixed life annuities, as they tend to invest heavily in fixed interest assets but are unable to maintain completely matched positions.

3.12 Equity risk arises from the exposure to fluctuations in equity prices and is greater the larger the mismatch between the size of the equity portfolio and the size of annuity contracts linked to equity prices. Likewise, currency risk occurs when the provider issues annuities denominated in one currency but holds assets denominated in another currency. Inflation risk is faced by the providers of retirement products when they issue life or term annuities indexed to prices but do not hold sufficient inflation-indexed financial instruments.

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