The second Lecturer to the Faculty of Actuaries is Professor Paul Embrechts, Professor of Mathematics at the ETH Zurich (Swiss Federal Institute of Technology, Zurich), specialising in actuarial mathematics and mathematical finance. His previous academic positions include ones at the Universities of Leuven, Limburg and London (Imperial College), and he has held visiting appointments at various other universities. He is an elected Fellow of the Institute of Mathematical Statistics, an Honorary Fellow of the Institute of Actuaries, a Corresponding Member of the Italian Institute of Actuaries, Editor of the ASTIN Bulletin, on the Advisory Board of Finance and Stochastics and Associate Editor of numerous scientific journals. He is a member of the Board of the Swiss Association of Actuaries and belongs to various national and international research and academic advisory committees. His areas of specialisation include insurance risk theory, integrated risk management, the interplay between insurance and finance and the modelling of rare events.

Late-life mortality patterns are of crucial interest to actuaries assessing longevity risk. One important explanatory variable is year of birth. We present the results of various analyses demonstrating this, including a statistical model which lends weight to the importance of year-of-birth effects in both population and insured data. We further find that a model based on age and year of birth fits United Kingdom mortality data better than a model based on age and period, suggesting that cohort effects are more significant than period effects. The financial implications of these cohort effects are considerable for portfolios with long-term longevity exposure, such as annuities written by insurance companies and defined benefit pension schemes.

The Profession claims to make financial sense of the future, and our particular angle is our purported ability to see past the whims of the short termists and keep an unwavering eye on the long term. The pensions arena has been no different … until now?

In June 2003, the Government converted defined retirement benefits unambiguously from an arguably vague promise to a debt, behind which the sponsor has to stand. A series of subsequent legislative changes, including the introduction of Scheme Specific Funding and of the Pension Protection Fund (PPF), with its proposed risk-based levies, has forced trustees to take a more commercial view to make sure that accrued benefits are met.

This stands in contrast to the gentler ‘funding’ environment in which pension schemes and Scheme Actuaries had become used to working. In that environment, the actuarial ‘long term’ justified many of the decisions taken in funding schemes — the long-term focus drove investment strategy and the approach to setting or agreeing contribution rates.

Has the rationale for the ‘long term’ disappeared: now that some of the discussion about funding has included talk of deficit correction periods of less than five years; now that accounting standards put any investment and actuarial volatility in the pension scheme into the sponsor's accounts every year; and now that PPF levies will change from year to year as funding levels and sponsor covenants change?

Has the Actuarial Profession over-reacted in focusing on the short term, or has it under-reacted? Will investment strategies look very different in years to come? Will valuations and funding advice take on a different shape?

This paper explores the effect of unhedgeable background risks such as mortality and labour risks (such as wages and turnover) on pension funding and finance. We explore the literature on the economics and finance of background risk, and discuss its applicability to pensions. Most of the results in economics apply to the special case of additive background risk, which is part of, but not all of, the background risk faced by pension funds. We develop three illustrative models and show the impact of background risk on pension funding and asset allocation. We find that the asset allocation and funding decisions of pension plans in general change with the introduction of background risk, in some cases significantly. We also explore implications of background risk for fair value calculations.

This paper addresses the problem of longevity risk — the risk of uncertain aggregate mortality — and discusses the ways in which life assurers, annuity providers and pension plans can manage their exposure to this risk. In particular, it focuses on how they can use mortality-linked securities and over-the-counter contracts — some existing and others still hypothetical — to manage their longevity risk exposures. It provides a detailed analysis of two such securities — the Swiss Re mortality bond issued in December 2003 and the EIB/BNP longevity bond announced in November 2004. It then looks at the universe of hypothetical mortality-linked securities — other forms of longevity bonds, swaps, futures and options — and investigates their potential uses. It also addresses implementation issues, and draws lessons from the experiences of other derivative contracts. Particular attention is paid to the issues involved with the construction and use of mortality indices, the management of the associated credit risks, and possible barriers to the development of markets for these securities. It suggests that these implementation difficulties are essentially teething problems that will be resolved over time, and so leave the way open to the development of flourishing markets in a brand new class of securities.

Most businesses have assets financed by capital providers. The cost of capital is a measure of the returns required by those capital providers. Its main use is to set a target for the profits, which must be achieved on the firm's assets in order to satisfy equity and bond holders.

This paper describes the classical theory of the cost of capital, and then applies it to the special case of banking and insurance firms. We develop implications for product pricing, performance measurement and capital structure optimisation.

This note continues a regular series on mortality rates in the United Kingdom. Mortality experienced in each of the years 1999 to 2004 is shown by five-year age groups, and comparisons are made for broad age groups, on a standardised basis, with mortality in earlier years.