Using the widely-cited Lee-Carter mortality model, we quantify aggregate mortality risk as the risk that the average annuitant lives longer than is predicted by the model, and we conclude that annuity business exposes insurance companies to substantial mortality risk. We calculate that a markup of 3.7% on an annuity premium (or else shareholders%u2019 capital equal to 3.7% of the expected present value of annuity payments) would reduce the probability of insolvency resulting from uncertain aggregate mortality trends to 5% and a markup of 5.4% would reduce the probability of insolvency to 1%. Using the same model, we find that a projection scale commonly referred to by the insurance industry underestimates aggregate mortality improvements. Annuities that are priced on that projection scale without any conservative margin appear to be substantially underpriced. Insurance companies could deal with aggregate mortality risk by transferring it to financial markets through mortality-contingent bonds, one of which has recently been offered. We calculate the returns that investors would have obtained on such bonds had they been available over a long period. Using both the Capital and the Consumption Capital Asset Pricing Models, we determine the risk premium that investors would have required on such bonds. At plausible coefficients of risk aversion, annuity providers should be able to hedge aggregate mortality risk via such bonds at a very low cost.
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11984.
Length: Date of creation: Jan 2006 Date of revision: Handle: RePEc:nbr:nberwo:11984
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Find related papers by JEL classification: G12 - Financial Economics - - General Financial Markets - - - Asset Pricing G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies G23 - Financial Economics - - Financial Institutions and Services - - - Pension Funds; Other Private Financial Institutions J11 - Labor and Demographic Economics - - Demographic Economics - - - Demographic Trends and Forecasts J14 - Labor and Demographic Economics - - Demographic Economics - - - Economics of the Elderly; Economics of the Handicapped
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Olivia S Mitchell & John Piggott & Michael Sherris & Shaun Yow, 2006.
"Financial Innovation for an Ageing World,"
RBA Annual Conference Volume,
in: Christopher Kent & Anna Park & Daniel Rees (ed.), Demography and Financial Markets
Reserve Bank of Australia.
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