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Managing Systematic Mortality Risk in Life Annuities: An Application of Longevity Derivatives

Author

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  • Man Chung Fung

    (The Commonwealth Scientific and Industrial Research Organisation (CSIRO), North Ryde, Sydney, NSW 2113, Australia)

  • Katja Ignatieva

    (Business School, Risk and Actuarial Studies, Randwick, Sydney, NSW 2052, Australia)

  • Michael Sherris

    (Risk and Actuarial Studies and Centre of Excellence in Population Ageing Research (CEPAR), Business School, University of New South Wales, Randwick, Sydney, NSW 2052, Australia)

Abstract

This paper assesses the hedge effectiveness of an index-based longevity swap and a longevity cap for a life annuity portfolio. Although longevity swaps are a natural instrument for hedging longevity risk, derivatives with non-linear pay-offs, such as longevity caps, provide more effective downside protection. A tractable stochastic mortality model with age dependent drift and volatility is developed and analytical formulae for prices of longevity derivatives are derived. The model is calibrated using Australian mortality data. The hedging of the life annuity portfolio is comprehensively assessed for a range of assumptions for the longevity risk premium, the term to maturity of the hedging instruments, as well as the size of the underlying annuity portfolio. The results compare the risk management benefits and costs of longevity derivatives with linear and nonlinear payoff structures.

Suggested Citation

  • Man Chung Fung & Katja Ignatieva & Michael Sherris, 2019. "Managing Systematic Mortality Risk in Life Annuities: An Application of Longevity Derivatives," Risks, MDPI, vol. 7(1), pages 1-25, January.
    • Handle: RePEc:gam:jrisks:v:7:y:2019:i:1:p:2-:d:194650
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    References listed on IDEAS

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