Gregorio Impavido, Craig Thorburn, Mike Wadsworth this section focuses on supply constraints on the part of providers.<sup>32</sup> We briefly summarize the risks that providers generally insure against when selling annuities; we then present a conceptual framework for sharing these risks between providers and annuitants<sup>33</sup> .

# **_II.A A Paradigm of Risk_**

Risk, represented by volatility or by the potential for difference in outcome, exists within the annuity environment in several forms and from several perspectives. For sake of simplicity we focus here on longevity or survivorship risk, and investment risk.

First, consider the position of an individual with an accumulated stock of financial assets combined with other resources usually represented by a limited future potential for further earnings, entitlements to social protection from governments and other support from their own networks and family. Exposure to risk can be characterized as the inability to meet consumption needs. This can arise because individuals outlive their available assets and other resources, financial or otherwise, or because the circumstances of their lives change such that their resources prove inflexible or insufficient to respond to this change, or because financial markets fail to perform at the level necessary to deliver on a plan they may have. The plan may be either explicit or implicit. In addition, the alternative sources of support may be identified as inadequate or the social protection or other network contribution may fail – these aspects are largely outside the consideration of this paper.

In terms of mortality, the individual is at risk of what may be considered undue survivorship. The purchase of a life annuity can transfer this risk to the annuity provider but usually brings with it other risks to the individual.

The annuitant is then exposed to the credit risk of the annuity provider. That is, there is a risk that the annuity provider will fail to live up to their obligations. This risk can be reduced through diversification – selecting a number of providers – although this may be limited by the practical constraints such as minimum sizes of investment in the market or limited numbers of available providers. Legislative requirements may also restrict the availability of this option by requiring particular selections or by imposing administrative burdens on individuals which expand with the addition of providers.

The annuitant could also, at least in theory, consider the financial soundness of the provider at the time of purchase. This is, however, generally considered to be difficult if not impossible. Efforts to expose participants to market scrutiny are usually applied; however, the consideration is that they are insufficient so there is also a common policy response to require providers to be subject to additional prudential supervision.

> 32 The distinction between supply and demand constraints is simply dictated by expositional needs.  We do not want to imply that there is an excess demand or supply that can be cleared through increased availability of information on either side of the market. Again, it is likely that appropriate regulation of products, in terms of design, availability and distribution, be the key determinant for promoting the development of these markets.

> 33 The section draws on Wadsworth _et al_ . (2001).

- 15 -