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Longevity hedging 101: A framework for longevity basis risk analysis and hedge effectiveness

  • Coughlan, Guy
  • Khalaf-Allah, Marwa
  • Ye, Yijing
  • Kumar, Sumit
  • Cairns, Andrew
  • Blake, David
  • Dowd, Kevin

Basis risk is an important consideration when hedging longevity risk with instruments based on longevity indices, since the longevity experience of the hedged exposure may differ from that of the index. As a result, any decision to execute an index-based hedge requires a framework for (1) developing an informed understanding of the basis risk, (2) appropriately calibrating the hedging instrument, and (3) evaluating hedge effectiveness. We describe such a framework and apply it to a U.K. case study, which compares the population of assured lives from the Continuous Mor- tality Investigation with the England and Wales national population. The framework is founded on an analysis of historical experience data, together with an appreciation of the contextual relationship between the two related populations in social, economic, and demographic terms. Despite the different demographic profiles, the case study provides evidence of stable long-term relationships between the mortality experiences of the two populations. This suggests the important result that high levels of hedge effectiveness should be achievable with appropriately cali- brated, static, index-based longevity hedges. Indeed, this is borne out in detailed calculations of hedge effectiveness for a hypothetical pension portfolio where the basis risk is based on the case study. A robustness check involving populations from the United States yields similar results.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 35743.

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Date of creation: 2011
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Publication status: Published in North American Actuarial Journal 2.15(2011): pp. 150-176
Handle: RePEc:pra:mprapa:35743
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  1. Carter, Lawrence R. & Lee, Ronald D., 1992. "Modeling and forecasting US sex differentials in mortality," International Journal of Forecasting, Elsevier, vol. 8(3), pages 393-411, November.
  2. Plat, Richard, 2009. "Stochastic portfolio specific mortality and the quantification of mortality basis risk," Insurance: Mathematics and Economics, Elsevier, vol. 45(1), pages 123-132, August.
  3. 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.
  4. Jennifer L. Wang & H.C. Huang & Sharon S. Yang & Jeffrey T. Tsai, 2010. "An Optimal Product Mix for Hedging Longevity Risk in Life Insurance Companies: The Immunization Theory Approach," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 77(2), pages 473-497.
  5. Dowd, Kevin & Cairns, Andrew & Blake, David & Coughlan, Guy & Khalaf-Allah, Marwa, 2011. "A gravity model of mortality rates for two related populations," MPRA Paper 35738, University Library of Munich, Germany.
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