Band 3, Heft 1 - Longevity Risk and Capital Markets

The huge economic significance of longevity risk for corporations, governments and individuals is beginning to be recognized and quantified. The traditional insurance route for managing this risk is capacity constrained, leaving the capital markets to provide an effective solution. We consider what capital markets need to both start and evolve. We then look at the first generation of bond-based capital market solutions that have been tried so far and examine their success or failure. The lessons learned here have informed the design of the second generation of derivatives-based capital market solutions. Although there remain barriers to surmount, we are witnessing the birth of the life market, the market in longevityrelated financial instruments.

Over the past century human life expectancy has risen substantially around the world, and longevity in the modern world is largely determined by the age at which adults die. There is an ongoing, longstanding trend to higher average ages at death for both sexes in most countries. Accompanying this trend has been a decrease in the dispersion of the age of adult death which has slowed in most countries in the past five decades. Mortality forecasts can be made using the Lee-Carter method and provide stochastic projections of average longevity. We may think of the dispersion in the forecasted averages as a form of systematic risk that is important in pricing longevity risk. The dispersion around the average age at death is a form of individual risk. This individual risk certainly does matter to individuals making decisions about consumption, savings, bequests and so on. In particular it matters to economic aggregates such as population wealth, health, and savings, and to the fiscal flows in private and public pensions. Realistic models of annuity valuation are likely to be nonlinear and so annuity values are also likely to depend on the individual component of longevity risk. Analysis of the distribution of individual risk in subgroups (e.g., with high or low educational attainment) suggests that selection for low risk subgroups may be difficult to achieve.

Longevity risk is one of the remaining frontiers challenging modern financial markets and financial engineering. Financial innovation has yet to successfully master this very significant risk facing many countries internationally. For well over a hundred years this risk has been the domain of life insurance companies, reinsurance companies and actuaries. The aging population around the world drives the need for new products for managing longevity risk and new markets for hedging this risk. We consider how financial markets and financial product innovations can ideally be used to hedge longevity risk and also consider lessons from the insurance linked securities market that could be used to successfully fund this risk in financial markets.

Longevity risk transfer via the capital markets is now a reality. Pension plans and annuity providers can hedge longevity risk with capital markets instruments, reflecting the emergence of a new market that is poised to take off. The key players in this market are hedgers (pension plans and annuity providers), intermediaries (investment banks and broker-dealers) and end investors (ILS funds, hedge funds, endowments, etc.). We argue that the development of liquidity in this market depends on the acceptance of longevity indices and the development of standardized instruments to transfer this risk.Until now, hedgers of longevity risk have almost exclusively approached the subject from the perspective of indemnification (100 percent risk transfer). We propose an alternative approach based on a risk management paradigm that does not require 100 percent risk transfer and is consistent with the way in which other pension-related risks are managed. To this end we present a framework for longevity hedging cantered on standardized indexbased hedges. This framework uses a building-block approach in which standardized hedge building blocks are combined to provide a longevity hedge tailored to the specific demographics, benefit structure and mortality table of any pension plan. The effectiveness of this hedge is maximized by careful calibration of the mix of building blocks and then verified in hedge effectiveness tests.We also discuss customized longevity hedges that will be preferred by some hedgers, who are unconcerned by the lower liquidity and onerous requirements for data disclosure associated with these hedges, and are prepared to pay the additional premium above the cost of a standardized hedge.

Life annuities provide a guaranteed income for the remainder of the recipient’s lifetime, and therefore, annuitization represents an important option when choosing an adequate investment strategy for the retirement period. While there are numerous scientific articles studying annuities from the pensioner’s point of view, thus far, there have been few contributions considering annuities from the provider’s perspective. In particular, there are no surveys on the general risks within annuity books.The present paper aims at filling this gap: Using a simulation framework, it provides a longterm analysis of the risks within annuity books. More specifically, the mutual as well as the respective impacts of systematic mortality risk and investment risk on the insurer’s financial situation are studied.The key finding is that under the model specifications and using annuity data from the United Kingdom, the risk premium charged for longevity risk seems to be very high relative to its characteristics. Possible explanations as well as economic implications are provided, and potential caveats are discussed.

A considerable literature examines the optimal decumulation of financial wealth in retirement. We extend this research to incorporate housing, which comprises the majority of most households’ non-pension wealth.We estimate the relationship between the returns on housing, stocks, and bonds, and simulate a variety of decumulation strategies incorporating reverse mortgages. We show that homeowner’s reversionary interest, the amount that can be borrowed through a reverse mortgage, is a surprisingly risky asset. Under our baseline assumptions, we find that the average household would be as much as 24 percent better off taking a reverse mortgage as a lifetime income relative to what appears to be the most common strategy: delaying tapping housing wealth until financial wealth is exhausted and then taking a line of credit. In addition, we show that housing wealth displaces bonds in optimal portfolios, making the low rate of participation in the stock market even more of a puzzle.

There has been a significant increase in the life expectancies of the Taiwanese population after the end of Second World War. Like in many developed countries, due to the prolonging life expectancy and lower fertility rates, the aging population has now become a major policy concern in Taiwan. The search for feasible methods for modeling the future mortality changes has become a popular issue in Taiwan. The Lee-Carter (LC) model, the reduction factor (RF) model and the age-period-cohort (APC) model are three frequently used methods for modeling future mortality dynamics. In this paper, we introduce these three models and discuss their respective pros and cons. We carry out an empirical study using these models based on Taiwan mortality experience. In addition, we make a comparison analysis of different models with different mortality experience in Japan, England and Wales, and the US.

As the population ages and the deterioration of pension funds continue, hedging longevity risk is becoming increasingly important in Taiwan. This article analyzes the potential market for issuing longevity bonds to hedge against the longevity risk in Taiwan. Many recent studies have suggested that longevity bond can serve as an effective risk management tool to mitigate the longevity risks. Following the design of the longevity bond proposed by Denuit, Devolder and Godernaiaux (2007), we make an illustration of pricing longevity bond using Lee-Carter model on the basis of the mortality experience in Taiwan. Our results show that the risk premium for issuing a longevity bond in Taiwan is lower than that in the United State. However, in order to measure the longevity risk more precisely and to overcome the potential problems of issuing longevity bonds in Taiwan, the quality of mortality data should be improved and more regulations need to be amended in the near future.

The use of forward models for the future development of mortality has been proposed by several authors. In this article, we specify adequate volatility structures for such models. We derive a Heath-Jarrow-Morton drift condition under different measures. Based on demographic and epidemiological insights, we then propose two different models with a Gaussian and a non-Gaussian volatility structure, respectively. We present a Maximum Likelihood approach for the calibration of the Gaussian model and develop a Monte Carlo Pseudo Maximum Likelihood approach that can be used in the non-Gaussian case. We calibrate our models to historic mortality data and analyze and value certain longevity-dependent payoffs within the models.