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Life is Cheap: Using Mortality Bonds to Hedge Aggregate Mortality Risk

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  • Leora Friedberg
  • Anthony Webb

Abstract

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.

Suggested Citation

  • Leora Friedberg & Anthony Webb, 2006. "Life is Cheap: Using Mortality Bonds to Hedge Aggregate Mortality Risk," NBER Working Papers 11984, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:11984
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    References listed on IDEAS

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    Cited by:

    1. Justin van de Ven & Martin Weale, 2007. "Annuities and Aggregate Mortality Uncertainty," WEF Working Papers 0027, ESRC World Economy and Finance Research Programme, Birkbeck, University of London.
    2. Jeffrey R. Brown & Amy Finkelstein, 2007. "Why Is the Market or Long-term Care Insurance So Small?," NBER Chapters,in: Public Policy and Retirement, Trans-Atlantic Public Economics Seminar (TAPES), pages 1967-1991 National Bureau of Economic Research, Inc.
    3. Coughlan, Guy & Khalaf-Allah, Marwa & Ye, Yijing & Kumar, Sumit & Cairns, Andrew & Blake, David & Dowd, Kevin, 2011. "Longevity hedging 101: A framework for longevity basis risk analysis and hedge effectiveness," MPRA Paper 35743, University Library of Munich, Germany.
    4. Bauer, Daniel & Börger, Matthias & Ruß, Jochen, 2010. "On the pricing of longevity-linked securities," Insurance: Mathematics and Economics, Elsevier, vol. 46(1), pages 139-149, February.
    5. repec:cup:jfinqa:v:52:y:2017:i:05:p:2251-2275_00 is not listed on IDEAS
    6. Bisetti, Emilio & Favero, Carlo A. & Nocera, Giacomo & Tebaldi, Claudio, 2017. "A Multivariate Model of Strategic Asset Allocation with Longevity Risk," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 52(05), pages 2251-2275, October.
    7. David Blake & Christophe Courbage & Richard MacMinn & Michael Sherris, 2011. "Longevity Risk and Capital Markets: The 2010–2011 Update," The Geneva Papers on Risk and Insurance - Issues and Practice, Palgrave Macmillan;The Geneva Association, vol. 36(4), pages 489-500, October.
    8. Gong, Guan & Webb, Anthony, 2010. "Evaluating the Advanced Life Deferred Annuity -- An annuity people might actually buy," Insurance: Mathematics and Economics, Elsevier, vol. 46(1), pages 210-221, February.
    9. Chen, Bingzheng & Zhang, Lihong & Zhao, Lin, 2010. "On the robustness of longevity risk pricing," Insurance: Mathematics and Economics, Elsevier, vol. 47(3), pages 358-373, December.
    10. David Blake & Andrew Cairns & Guy Coughlan & Kevin Dowd & Richard MacMinn, 2013. "The New Life Market," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 80(3), pages 501-558, September.
    11. Post Thomas, 2012. "Individual Welfare Gains from Deferred Life-Annuities under Stochastic Mortality," Asia-Pacific Journal of Risk and Insurance, De Gruyter, vol. 6(2), pages 1-26, June.
    12. repec:bla:jrinsu:v:84:y:2017:i:1:p:153-175 is not listed on IDEAS
    13. Plisson, Manuel, 2009. "Assurabilité et développement de l'assurance dépendance," Economics Thesis from University Paris Dauphine, Paris Dauphine University, number 123456789/5064 edited by Lorenzi, Jean-Hervé, March.
    14. Blake, David & Brockett, Patrick & Cox, Samuel & MacMinn, Richard, 2011. "Longevity risk and capital markets: The 2009-2010 update," MPRA Paper 28868, University Library of Munich, Germany.
    15. 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.
    16. Guan Gong & Steven A. Sass, 2007. "Evaluating the Advanced Life Deferred Annuity - An Annuity People Might Actually Buy," Working Papers, Center for Retirement Research at Boston College wp2007-15, Center for Retirement Research, revised Sep 2007.

    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • J11 - Labor and Demographic Economics - - Demographic Economics - - - Demographic Trends, Macroeconomic Effects, and Forecasts
    • J14 - Labor and Demographic Economics - - Demographic Economics - - - Economics of the Elderly; Economics of the Handicapped; Non-Labor Market Discrimination

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