The Longevity Risk of Life Insurance Policies Induced by Pricing Error

Compounded Increasing Whole Life Insurance Policies (CIWLIPs) have underpricing and underreserving problems, which are aggravated by mortality improvements. This paper illustrates these problems by analyzing the accumulated surplus, and subsequently, applying the Lee-Carter model to quantify the longevity risk. In order to quantify the risk of the CIWLIPs, a standard formula is proposed to calculate the risk-based capital requirements of insurance risk and estimate the associated risk factor. The findings reveal that the product incurs significant underpricing and underreserving problems whenever actuaries fail to take full account of the product characteristics, and mortality improvements further aggravate these problems. The insurance risk factor for this type of policies is significantly larger than that of traditional whole life insurance policies and the risk factor decreases when the product characteristics are appropriately considered. Therefore, it is suggested that insurance regulators should ensure that the product characteristics as well as mortality improvements are appropriately considered in pricing and reserving.