Hedging Brevity Risk with Mortality-based Securities
AbstractIn 2003, Swiss Re introduced a mortality-based security designed to hedge excessive mortality changes for its life book of business. The concern was apparently brevity risk, i.e., the risk of premature death. The brevity risk due to a pandemic is similar to the property risk associated with catastrophic events such as earthquakes and hurricanes and the security used to hedge the risk is similar to a CAT bond. This work looks at the incentives associated with insurance-linked securities. It considers the trade-offs an insurer or reinsurer faces in selecting a hedging strategy. We compare index and indemnity-based hedging as alternative design choices and ask which is capable of creating the greater value for shareholders. Additionally, we model an insurer or reinsurer that is subject to insolvency risk, which creates an incentive problem known as the judgment proof problem. The corporate manager is assumed to act in the interests of shareholders and so the judgment proof problem yields a conflict of interest between shareholders and other stakeholders. Given the fact that hedging may improve the situation, the analysis addresses what type of hedging tool would be best to use. We show that an indemnity-based security tends to worsen the situation, as it introduces an additional incentive problem. Index-based hedging, on the other hand, under certain conditions turns out to be beneficial and therefore clearly dominates indemnity-based strategies. This result is further supported by showing that for the same strike prices the current shareholder value is greater with the index-based security than the indemnity-based security.
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Bibliographic InfoPaper provided by University of Munich, Munich School of Management in its series Discussion Papers in Business Administration with number 1219.
Date of creation: Oct 2006
Date of revision:
alternative risk transfer; insurance; default risk;
Find related papers by JEL classification:
- G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
- G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
This paper has been announced in the following NEP Reports:
- NEP-ALL-2006-10-28 (All new papers)
- NEP-FIN-2006-10-28 (Finance)
- NEP-HEA-2006-10-28 (Health Economics)
- NEP-IAS-2006-10-28 (Insurance Economics)
- NEP-RMG-2006-10-28 (Risk Management)
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