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Longevity Bonds and Derivatives

Andrew Ngai

26 January 2010

Disclaimer

The views and opinions expressed in this report are solely that of the author’s and do

not reflect the views and opinions of the Australian Prudential Regulation Authority.

Any errors in this report are the responsibility of the author. The material in this

report is copyright.

Other than for any use permitted under the Copyright Act 1968, all other rights are

reserved and permission should be sought through the author prior to any

reproduction.

Static Hedging Effectiveness for Longevity Risk with

Longevity Bonds and Derivatives

Andrew Ngai

January 26, 2010

Abstract

in Australia and many developed nations by providing a rigorous analysis of the

longevity risk in a range of annuities. There are several types of annuities which

involve lifetime payments that would help protect individuals against outliving their

savings. Traditional products include life and indexed annuities, whereas recent

innovations include the variable annuity with a guaranteed lifetime withdrawal

benefit. The development of a market for annuities requires a strong understanding

of the underlying risks, yet there are currently few contributions analysing the

risks of annuities from the perspective of an insurer. This paper investigates the

effectiveness of a variety of static hedging strategies based on q-Forwards and

longevity bonds. These strategies were applied to a typical annuity portfolio and

were generally found to be cost effective in reducing longevity risk as measured by

expected shortfall. Several sources of basis risk were also analysed and were found

to have minimal impact on the effectiveness of the hedging strategies. Improved

market and mortality models were also used to better account for the underlying

risks in annuities.

1

1. Introduction 2

1 Introduction

Longevity risk arises from the fact that future lifetimes are uncertain and may be longer

than expected. For an individual, this may result in insufficient savings to support their

retirement. With an ageing population in most developed nations and continual mortality

improvements, longevity risk is becoming an increasingly important issue in the developed

world as individuals seek insurance against outliving their savings (Blake et al, 2008 [7]).

Life insurers have traditionally offered life annuities that transfer longevity risk away from

the insured, such as immediate, deferred, and inflation-indexed annuities. A relatively new

innovation is the guaranteed lifetime withdrawal benefit (GLWB), a variable annuity rider

which has recently become popular in the US, Japan, and Europe. The attractive feature

of the GLWB is its insurance against longevity and market risks simultaneously while

allowing individuals to maintain flexibility in their investments (Ledlie et al, 2008 [25]).

However, the popularity and complexity of the GLWB also demands a detailed analysis of

its pricing and its risks. The recent financial crisis has already resulted large losses from

variable annuity writers in the US, and subsequent rating downgrades have caused insurers

to increase fees, reduce benefits, or withdraw from selling variable annuities altogether

(Burns, 2009 [9]; Lankford, 2009 [24]).

understand the nature of their risks and have appropriate risk management procedures

in place. Thus, to facilitate a market for life annuities, insurers must also have effective

techniques to hedge their longevity risk. A potential solution is the use of mortality-linked

securities (MLS) such as q-Forwards to transfer longevity risk to the capital markets

(Coughlan et al, 2007 [12]), while others have suggested that longevity risk could be

transferred to the government through the use of longevity bonds (Blake et al, 2009 [5]).

The effectiveness of such methods will be a significant step towards a successful solution

to the longevity risk problem.

insure against longevity risk which could be done by purchasing an annuity, transferring

the risk to an insurer. In turn, insurers have a need to transfer some longevity risk to

other parties due to (forthcoming) regulatory capital requirements in Solvency II. This is

currently a key issue which must be solved to allow the successful provision of longevity

insurance to individuals (Blake et al, 2009 [5]). Thus, an analysis of potential hedging

techniques will be a significant contribution to the insurance industry and to society, and

will make one further step towards an effective and sustainable market for longevity risk

2

1. Introduction 3

Capital Mkts

Annuities MLS

Individuals Life Insurers

Government

insurance.

Most of the existing literature on life annuities focus on the individual’s perspective and

Private Sector

address pricing and consumption issues in an attempt to explain the ‘annuity puzzle’ –

the phenomenon that relatively few individuals choose to annuitise their wealth despite

Annuities

Individuals Life Insurers MLS

studies showing that annuities increase expected utility. In an early paper, Yaari (1965)

[36] proved that individuals should choose to annuitise their entire liquid wealth in the

absence of a bequest motive, a result that was recently extendedPublic Sector et al (2005)

by Davidoff

[13] to a more general setting by relaxing a number of assumptions.

On the contrary, there is relatively little literature analysing annuities and their longevity

risk from an insurer’s perspective. Dowd et al (2006) [14] analyse the risks of various

mortality-dependent positions, such as an annuity book with a longevity bond hedge.

The longevity bond involves coupons in line with survival probabilities, and is therefore

structured to specifically match a typical life annuity book for a given cohort. A range

of risk measures such as expected shortfall and spectral measures are used to quantify

the risk in the portfolios. Bauer and Weber (2008) [3] focus on the risk in an annuity

book itself, discovering that the mortality risk premium charged by UK annuity providers

is relatively large. The paper focuses on the simplest form of annuity, a single premium

immediate life annuity. The authors choose to use relatively simple stochastic models to

describe the market and mortality processes, and also assume independence between the

short rate and stock processes.

The literature on GLWBs and other equity-linked guarantees focus mainly on pricing

and market risk issues. A detailed overview of variable annuities and all its guarantees

is provided by Ledlie et al (2008) [25], who use an economic scenario generator to

stochastically analyse the GLWB from the consumer’s perspective, price the guarantees,

3

1. Introduction 4

and perform a series of sensitivity analyses. Other pricing analyses include Milevsky and

Posner (2001) [28] who determine a fair price for the guaranteed minimum death benefit

(GMDB), and Milevsky and Salisbury (2006) [29] who analyse the guaranteed minimum

withdrawal benefit (GMWB). A continuous-time model is developed to price the GMWB

allowing for both static and dynamic policyholder behaviour. Bauer et al (2006) [2]

develops a general framework for the pricing of variable annuities and its guarantees,

which is used by Holz et al (2007) [19] for pricing the GLWB under a deterministic

market and mortality.

to manage their longevity risk. Standardised hedging is discussed in detail by Blake et

al (2006), Cairns et al (2008), and Biffis and Blake (2009) [4, 6, 11]. A key advantage

of standardised hedging is its information transparency, while liquidity is significantly

increased by basing the mortality-linked security on a standardised mortality index.

However, the use of a standardised index introduces significant basis risk due to a possible

mismatch between the experience of the insured lives and the overall index. Thus, there is

essentially a trade-off as standardisation helps to improve liquidity at the cost of increasing

basis risk (Blake et al, 2008 [7]).

Bauer and Weber (2008) [3] and Dowd et al (2006) [14] make significant contributions

in analysing the longevity risk in a portfolio of annuities, an area which had not been

addressed previously in the literature. This paper will provide a long-term analysis of

the risks in life annuities in the nature of Bauer and Weber, but will make further

improvements with the addition of improved market and mortality models that take

into account long-tail behaviour and dependence. An analysis on longevity risk hedging

will also be performed, further developing the work of Dowd et al with the application

of a larger variety of hedging strategies to an annuity portfolio. This paper will focus

on hedge effectiveness and analyse a larger variety of annuities, such as deferred and

indexed annuities, which have additional benefits of lower initial cost and insurance against

inflation respectively.

The longevity hedging applied in this paper will focus on standardised hedges as their

advantages of higher liquidity and transparency are considered to be key requirements

of a successful market for mortality-linked securities. However, the main disadvantage of

using standardised hedging is that it introduces basis risk, which must not be neglected.

A better understanding of basis risk would be valuable to insurers for determining ap-

propriate hedging and risk management techniques, however, there is currently minimal

literature in this area. This paper will make a step towards filling this gap in the literature

4

2. Market Model 5

by quantifying the basis risk due to uncertainty in the relationship between annuitant

and population mortality and analysing the effect of this basis risk on the overall hedge

effectiveness. The basis risk due to the bucketing of q-Forwards by age groups will also

be analysed with regards to their impact on hedge effectiveness.

This paper is structured as follows. Sections 2 & 3 develop the market and mortality

models which are applied in Section 4, where the longevity risk in a portfolio of annuities

is assessed. Longevity risk management techniques involving q-Forwards and longevity

bonds are applied and evaluated in terms of hedge effectiveness. Sensitivity analyses are

also performed, including an analysis of the effect of basis risk on hedge effectiveness. The

results are presented in Section 5, while Section 6 provides a conclusion.

2 Market Model

A number of multivariate time series models have been used in the literature for market

modelling purposes. A vector autoregressive (VAR) model was used by Wilkie (1986,

1995) [32, 33], while Harris (1997) [17] and Sherris and Zhang (2009) [30] incorporate

regime switching into the VAR model. Regime switching was found to be effective in

accounting for the long-tail nature (heteroskedacity) of market data. In addition, a

cointegration relationship can be incorporated by using a vector error correction model

(VECM). A regime switching VECM was used by Maysami and Koh (2000) [27] for

modelling several stock indices, and Krolzig et al (2002) [23] for modelling the UK labour

market.

This paper will use a regime switching VECM due to its ability to account for short-run

dynamics through its autoregressive structure, long-run equilibria using a cointegration

relationship (Johansen, 1995 [21]), and heteroskedacity through the use of regime switch-

ing. The RS-VECM was also found to be the best model according to AICc and SBC.

p−1

X

∆yt = µ + Ai ∆yt−i + BCyt−p + εt (ωt ) (1)

i=1

5

2. Market Model 6

series, µ is the mean vector, A is a d × d parameter matrix of coefficients, B and C0 are

d × r matrices of rank r describing the cointegration (equilibrium) relationship between

the variables, and εt (ωt ) is a vector of regime-dependent multivariate normal random

errors with covariances Σωt :

εt (ωt ) ∼ Nd (0, Σωt ) (2)

A lag of p = 2 was found to be appropriate according to AICc and SBC and for parsimony.

Two regimes are used in the model, representing a normal state and high-volatility state

respectively:

0 normal regime

ωt = (3)

1 high-volatility regime

The probabilities of switching between regimes are described in a Markov chain with

transition matrix P:

!

p0 1 − p0

P= (4)

1 − p1 p1

The model was fitted using a two-stage procedure detailed by Krolzig (1997) [22]. The first

step in fitting a RS-VECM is to determine the cointegration rank r and matrix C using

the Johansen (1988, 1995) [20, 21] methodology. The second stage of the estimation

procedure involves the use of an Expectation-Maximisation algorithm to estimate the

remaining parameters.

2.2 Data

ln Bt = Log Bond Index (Accumulated 90-day Bank-Accepted-Bill Yields)

ln St = Log Stock Price Index (ASX All Ordinaries)

ln Ft = Log Inflation Index (CPI)

6

2. Market Model 7

Statistic ∆ ln Gt ∆ ln Bt ∆ ln St ∆ ln Ft

Mean 0.0078 0.0227 0.0137 0.0146

Standard Deviation 0.0101 0.0101 0.1010 0.0115

Skewness -0.2010 0.7783 -1.8734 0.9470

Excess Kurtosis 1.4224 -0.5803 7.6267 1.1543

1st Quartile 0.0021 0.0140 -0.0262 0.0060

Median 0.0082 0.0191 0.0258 0.0125

3rd Quartile 0.0129 0.0296 0.0692 0.0216

Minimum -0.0299 0.0107 -0.5719 -0.0046

Maximum 0.0367 0.0483 0.2298 0.0566

Each market variable is one component of the time series vector yt . These are the variables

considered important for modelling economic scenarios for the purposes of this research.

The bank bill yield is representative of the risk-free interest rate, and is used in place

of a short-term T-bill yield due to data availability. The stock index and interest rates

are required for the investments (and possibly claims) of the insurer and policyholders,

and inflation is required for inflation-linked products. GDP is considered an important

macroeconomic variable which interacts with the other market variables, and is often

included in economic scenario generators in the literature (eg. Sherris and Zhang, 2009

[30]).

Market data was obtained from the Reserve Bank of Australia (RBA). The data consists

of observations over the period 1970 to 2009, the maximum period over which data was

available for all 4 variables. Quarterly data was used as GDP and CPI observations are

not available at a higher frequency. Note that the bond index is not directly observed,

but was obtained by accumulating at the 90-day bank-accepted-bill yield.

2.3 Simulation

The RS-VECM produces simulations of the economic series into the future that are

comparable with historical data. The model occasionally simulates negative bond returns

(around 1% of simulations) which is clearly unreasonable. In these cases, the bond return

was set to 0%. The following analysis is based on 100,000 simulations.

Figures 2-3 show the average simulation paths and returns along with 95% confidence

7

3. Mortality Model 8

400000

2000

100000

1000000

200000

Level

Level

Level

Level

500 1000

40000

400000

0

0

2010 2030 2050 2010 2030 2050 2010 2030 2050 2010 2030 2050

Figure 2: Average Simulation Path (and 95% CI) of the Market Variables

0.6

0.12

0.06

0.08

0.08

Level

Level

Level

Level

0.2

0.02

0.04

0.04

−0.02

−0.2

0.00

0.00

2010 2030 2050 2010 2030 2050 2010 2030 2050 2010 2030 2050

Figure 3: Average Simulation Returns (and 95% CI) of the Market Variables

intervals, whereas Figure 4 shows the overall distribution of returns for each variable

obtained from these simulations and provides a comparison with the observed (historical)

distribution. Table 2 provides summary statistics of the simulated quarterly returns,

which are generally similar to the historical statistics in Table 1.

3 Mortality Model

The model for fitting and simulating mortality rates into the future is largely based

on the Wills and Sherris (2008) [34] model due to its applicability to pricing and risk

management. A further improvement is made by including a model for the relationship

between annuitant and population mortality. This is important when analysing a portfolio

of annuitants, and also facilitates an analysis of basis risk in hedging strategies.

8

3. Mortality Model 9

40000

50000

30000

25000

Frequency

Frequency

Frequency

Frequency

20000

20000

10000

10000

0

0

−0.05 0.05 0.10 0.00 0.10 0.20 −0.5 0.0 0.5 1.0 −0.05 0.05 0.15

(Note: Red = Historical Distribution)

Mean 0.0077 0.0175 0.0250 0.0106

Standard Deviation 0.0104 0.0078 0.1062 0.0091

Skewness 0.0319 0.2159 0.4904 0.0311

Excess Kurtosis 1.0849 0.2565 1.610 0.8810

1st Quartile 0.0017 0.0124 -0.0372 0.0052

Median 0.0077 0.0175 0.0196 0.0106

3rd Quartile 0.0136 0.0223 0.0796 0.0160

Minimum -0.0468 0.0000 -0.4250 -0.0370

Maximum 0.0658 0.0571 0.8259 0.0580

1 1

0 0

−1 −1

Rate

Rate

−2

−2

−3

−3

−4

−4

−5

1970 1970

100 1980 100 1980

90 1990 Year 90 1990 Year

Age 80 Age 80

70 2000 70 2000

Figure 5: Observed Logit Mortality Rates for Males (Left) and Females (Right)

9

3. Mortality Model 10

The model for the force of mortality for a life currently aged x at time t, denoted µx,t , is

a linear model with an age factor x:

µx,t

∆ logit µx,t ≡ ∆ ln = a + bx + εx,t (5)

1 − µx,t

where a and b are constant parameters and εx,t is an error term. As in Wills and Sherris

(2008) [34], the difference operator is applied in the cohort direction:

The vector of errors at each time t are multivariate normal with zero mean, and can be

written as:

εt = (εx1 ,t , . . . , εxN ,t )0 = σWt (7)

captures the dependence structure between ages.

The logit transform was chosen based on Cairns et al (2006) [10] and observation of the

data. Figure 5 shows the historical logit mortality rates which can be observed to be

approximately linear.

The parameters were estimated in a two-stage procedure as in Wills and Sherris (2008)

[34]. Firstly, maximum likelihood is used to estimate the parameters a, b and σ assuming

independent observations of ∆ logit µx,t . The covariance matrix D is then determined

using principal components analysis on the standardised residuals.

3.2 Data

The mortality model is based on population data as Australian annuitant data is not

available. Mortality data was obtained from the Human Mortality Database (HMD) and

the Australian Bureau of Statistics (ABS). The data contains annual central rates of

mortality, mx,t , for ages 65 to 109 and years 1970 to 2007. The minimum age of 65 is

chosen to reflect the retirement age in Australia. Note that the data at higher ages does

not consist of raw mortality rates, as the rates have been smoothed as described in the

HMD Methods Protocol (Wilmoth et al, 2007 [35]) due to a lack of observed deaths at

higher ages.

10

3. Mortality Model 11

Male Force of Mortality Female Force of Mortality

0.6 0.6

0.4 0.4

Rate

Rate

0.2 0.2

1980 1980

0.0 2000 0.0 2000

100 r 100 r

2020 Yea 2020 Yea

90 90

Age 80 2040 Age 80 2040

70 70

Figure 6: Observed and Projected Mortality for Males (Left) and Females (Right)

3.3 Simulation

One of the issues noted by Wills and Sherris (2008) [34] was the ‘ridges’ effect in the

projection which arose from the use of unsmoothed mortality rates, µx,T . To prevent this,

the observed logit mortality rates for the last year in the data (2007) are smoothed using

cubic splines before simulation.

Realisations of the random vector Wt were simulated from the multivariate normal

distribution, NN (0, D̂). The average mortality rates for all ages 65–109 are shown in

Figure 6. The average (projected) mortality rates and 95% confidence intervals for the

cohort aged 65 in 2007 are shown in Figure 7.

To apply the model to a portfolio of annuitants, the mortality rates will be adjusted based

on the observed historical relationship between population and annuitant mortality. As

there is no Australian annuitant data available, an investigation of Australian annuitant

mortality was not possible. UK annuitant data was available from the Continuous Mor-

tality Investigation (CMI) for years 1947, 1968, 1980, 1992, and 2000. This data was

compared to UK population mortality available from the Human Mortality Database

(HMD) and the Office for National Statistics (ONS).

The relationship between annuitant (or pensioner) mortality and population mortality

can be described using the ratio between initial rates:

A

qx,t

ρx,t = (8)

qx,t

11

3. Mortality Model 12

1.0

1.0

0.8

0.8

0.6

0.6

Rate

Rate

0.4

0.4

0.2

0.2

0.0

0.0

0 10 20 30 40 0 10 20 30 40

Years Years

Figure 7: Projected Male Mortality Rates for Cohort 65 (with 95% CIs)

A

where qx,t and qx,t are the annuitant and population mortality rates for age x at time t.

Stevenson and Wilson (2008) [31] investigate the relationship between Australian pen-

sioner and population mortality for the period 2005-07, concluding an approximate linear

increasing relationship between age and the ratio. The relationship between UK annuitant

and population mortality is also approximately linear and increasing, as shown in Figure 8.

However, Stevenson and Wilson found that the ratio for the pensioner data (significantly)

exceeds 1 at higher ages, which is inconsistent with the UK data. There is currently no

explanation for pensioner mortality exceeding population mortality at higher ages.

Due to the similarity between the pensioner and UK data at earlier ages, and the lack

of explanation for the higher observed ratio in the pensioner data at higher ages, the

following model will be based solely on the UK annuitant data for conservatism. Given

the observed linearity of the ratio and the relative scarcity of data (only 5 observations

per age), a simple linear model was used to model the ratio:

νx,t ∼ N (0, θ2 ) (10)

The variation in the ratio from year to year due to the error terms will result in basis

risk. Note that the error terms are unlikely to be independent by age, as the year to

year variation in actual mortality would depend on factors that affect the population as

a whole. However, since the analysis in the following chapter will based on a portfolio

12

4. Risk Analysis and Management 13

Male Female

1.4 1.4

1.2 1.2

1.0 1.0

Ratio

Ratio

0.8 0.8

0.6 0.6

0.4 0.4

65 70 75 80 85 90 95 100 65 70 75 80 85 90 95 100

Age Age

Pensioner UK '00 UK '92 UK '80 Pensioner UK '00 UK '92 UK '80

UK '68 UK '47 Fitted UK '68 UK '47 Fitted

of lives of the same initial age, and the ratio ρx,t does not depend on past error terms

νx,s (s < t), correlation of the errors between ages will not affect the results of this analysis

and is therefore ignored in this model.

The parameters are estimated using maximum likelihood assuming independent observa-

tions of ρx,t . The fitted ratios are superimposed in the graphs of observed ratios (Figure 8)

for comparison. Furthermore, the linear relationship is extrapolated to age 110. For both

males and females, the extrapolated ratio remains below 1, and therefore no adjustment

is deemed necessary.

The following products were stochastically analysed using the market and mortality

models developed in the previous sections:

13

4. Risk Analysis and Management 14

These products have potential in insuring individuals against longevity risk as they involve

an income stream for life.

to their advantages of liquidity and transparency. The effect of basis risk (the key

disadvantage of mortality-linked securities) on hedge effectiveness was also analysed. The

strategies use longevity bonds and q-Forwards, which are considered to have potential in

transferring longevity risk away from insurers based on previous literature (eg. Coughlan

et al, 2007 [12]; Dowd et al, 2006 [14]). q-Forwards have already been used by insurers to

hedge longevity risk, whereas longevity bonds could be issued by the government in the

future (Blake et al, 2009 [5]).

An effective hedge will reduce the longevity risk in the insurer’s final surplus. This is

measured by analysing the simulated distribution of the final surplus and calculating risk

measures such as expected shortfall. The decision to focus on expected shortfall is based

on its qualities as a risk measure (eg. coherency, focus on tail-risk, robustness) which

have led to its increasing popularity (Hardy, 2003 [16]). The risk measure should be

significantly reduced when an effective hedge strategy is applied.

The analysis focuses on static hedges due to their low cost and a lack of liquidity in

the MLS market. At present, dynamic hedges would be difficult to implement due to

illiquidity and high transaction costs.

The life insurer’s portfolio consists of 1,000 male policies of initial age 65, similar to Bauer

and Weber (2008) [3] and Dowd et al (2006) [14]. This would resemble a typical insurer’s

portfolio resulting from the sale of annuities to newly-retired individuals. In practice, an

insurer may write and hedge such a portfolio each year as each cohort of lives enter their

retirement.

The purchase of each annuity involves an initial lump-sum payment. For immediate and

variable annuities, the initial payment is assumed to be $100,000. For deferred annuities,

individuals will generally require a significant amount of their savings for consumption

during the deferral period, and therefore a lower initial investment of $10,000 is assumed.

14

4. Risk Analysis and Management 15

The risk analysis is largely based on the framework of Bauer and Weber (2008) [3].

The aim is to obtain a distribution for the insurer’s final surplus at time T after all

policyholders have died.

Pt = total premiums (fees) at time t

Ct = total claims at time t

Ht = net hedging cash flows at time t

The surplus Ut refers to the accumulated net cash flows at time t. The claims (and

premiums for a GLWB) are random variables that depend on actual mortality (and market

outcomes for indexed and variable annuities). The insurer is also assumed to purchase

assets in an attempt to hedge (match) the liabilities. These may include bonds, longevity

bonds, and q-Forwards, and will depend on the specific hedging strategy. The hedging

cash flows Ht are a result of the cash flows from these assets.

Each year, premiums are received, claims are paid, and the net cash flows from assets

purchased in the hedging strategy are received or paid. The surplus is assumed to

accumulate at a rate of return RtU , which is detailed in Section 4.1.2. Therefore:

Ut = Ut−1 1 + RtU + Pt − Ct + Ht

(11)

Due to product and model complexity, the analysis was done numerically using simulation

based on the fitted market and mortality models under a real-world probability measure

P . Each simulated path of market and mortality variables and policyholder experience

produces one realisation of the final surplus UT . The risk of the portfolio was assessed

by analysing the simulated distribution of UT , since the final surplus represents the

accumulated profit/loss of the portfolio. The terminal age used in this analysis is ω = 111,

hence T = 46.

15

4. Risk Analysis and Management 16

The investment strategy of the insurer is similar to that used in Bauer and Weber (2008)

[3]. As in Bauer and Weber, the insurer is assumed to have access to risk-free bonds of all

maturities, a savings account (which accumulates at the short rate) and a stock portfolio.

The latter two types correspond to investing in the bond and stock indices (Bt and St )

modelled in Chapter 2.

At time 0, the insurer will receive an initial premium and will purchase a series of assets

in an attempt to hedge the liabilities. The remaining initial premium is then assumed to

be invested in a T -year risk-free bond. Although insurers in practice are unlikely to invest

their remaining capital in long-term assets due to the resulting illiquidity, purchasing

short-term assets will introduce considerable investment risk due to fluctuations in short-

term returns as shown by the results of Bauer and Weber. The use of long-term bonds

will reduce the investment risk, allowing the analysis to focus on longevity risk.

In each future year, the surplus (accumulated net cash flows) is assumed to be invested

in a liquid portfolio of savings which accumulates at the risk-free rate. In contrast to

Bauer and Weber, no investment in stocks is made to reduce investment risk, allowing

the analysis to focus on longevity risk.

Bt

RtU = RtB = −1 (12)

Bt−1

4.1.3 Annuities

The life and indexed annuities involve a single upfront premium paid at time 0 in exchange

for regular annual payments (claims). Australian average market prices were used for the

immediate annuities as in Ganegoda and Bateman (2008) [15]. As there are currently

no deferred annuities available in Australia, the money’s worth ratio from the immediate

annuities were assumed to apply for deferred annuities.

In a variable annuity, the lump-sum payment is invested in a portfolio, with the individual

assuming all the market risk. Withdrawals are made and deducted from the funds

invested. As in Holz et al (2007) [19], the withdrawals are assumed to be level and

made annually. If a GLWB rider is attached, the embedded option will be exercised by

the individual when the funds are depleted, causing withdrawals (claims) to be paid by

16

4. Risk Analysis and Management 17

the insurer. All policies will be invested in an index which contains a proportion α of

shares and 1 − α of savings. The proportion α is assumed to be 75%, which is similar to

the asset allocation observed in the US market and that assumed in Hill et al (2008) [18].

The guarantee fee is assumed to be 40bps. This is reflective of the market price in the

US, and is similar to the fees calculated/assumed by Holz et al (2007) [19] and Hill et al

(2008) [18] in their analyses of the GLWB. The withdrawal percentage for an individual

initially aged 65 is assumed to be 5%. This is representative of the market in the US, and

is also the percentage used by Holz et al (2007) [19] and Hall et al (2008) [18].

The hedging instruments available for the insurer to purchase are zero coupon bonds,

q-Forwards, and longevity bonds, and will be purchased in an attempt to match assets

with liabilities.

As stated in Section 4.1.2, the insurer is assumed to have access to risk-free zero coupon

bonds of all maturities. A zero coupon bond of maturity τ will pay a cash flow of $1 at

time τ , and will involve no transfer of longevity risk.

The first type of mortality-linked securities considered will be q-Forwards. These are

forward contracts which pay an actual (floating) mortality rate qx,t in exchange for a

F

fixed (forward) mortality rate qx,t . q-Forwards are used as building blocks to construct

a longevity swap. This will involve payments in line with the insurer’s expected claims

according to a fixed mortality index, in return for receipts according to a standardised

but variable index. The strategies aim to match the cash flows of the insurer with those

from the swap, however there will be some basis risk as the standardised index does not

align exactly with the insurer’s true experience.

As an alternative, a longevity swap using q-Forwards that are bucketed by 5 year age

groups (65–69, . . . , 105–109) will also be considered. In practice, q-Forwards are bucketed

to improve liquidity by reducing the number of contracts, although this may result in

additional basis risk (Cairns et al, 2008 [11]).

Longevity bonds have been proposed as a possible mechanism through which longevity

risk in an annuity portfolio can be transferred away, possibly to the government (Blake

et al, 2009 [5]). The longevity bond structures that have been proposed (including the

EIB/BNP longevity bond) generally involve payments in line with the survival experience

of a particular cohort (Dowd et al, 2006 [14]; Blake et al, 2006 [8]). Deferred longevity

17

4. Risk Analysis and Management 18

bonds have also been proposed by Blake et al (2006, 2009) [5, 6], who note that deferred

bonds have an advantage in requiring less upfront capital to purchase.

The first type of longevity bonds considered will be coupon bonds which pay (in proportion

to) the actual survival rate Sx (t) at each time t, similar to those analysed in Dowd et al

(2006) [14]. Longevity bonds with maturities of 20 and 40 years will be considered, as

these are approximately the average and maximum term of life annuities for policyholders

initially aged 65. The 20-year bond will be an immediate bond, whereas the 40-year bond

will be deferred for 20 years. Note that an immediate 40-year bond can be constructed

by purchasing both the 20-year immediate and 40-year deferred bonds.

Dowd et al (2006) [14] also consider zero coupon longevity bonds which pay a single

amount proportion to the actual survival rate Sx (τ ) at maturity τ . These were also be

analysed, and were used as building blocks for constructing a longevity swap, similar to

q-Forwards.

The pricing of the hedging instruments involves taking discounted expectations of cash

flows under a risk neutral measure Q, which incorporates a price of risk for both market

and mortality risks. In determining the Q measure, market and mortality risks will be

assumed independent. Due to the incomplete mortality market, the Q measure will not

be unique.

As in Bauer and Weber (2008) [3], market (interest rate) risk is accounted for by discount-

ing cash flows using the current market term structure. Market yield data is available for

terms up to 15 years. For higher maturities, the yield curve is assumed (conservatively)

to be flat. The market yield and spot curves were obtained from market bond yield data

available from the Reserve Bank of Australia (RBA).

The Q measure is calibrated for mortality risk using q-Forward prices, as a q-Forward

F

involves the exchange of a fixed mortality rate qx,t for a variable rate qx,t , and therefore

involves the risk neutral expectation of mortality rates:

F

qx,t = EQ (qx,t |F0 ) (13)

The q-Forward prices are determined using a Sharpe ratio as in Loeys et al (2007) [26]:

F E

qx,t = (1 − Sq σx t)qx,t (14)

18

4. Risk Analysis and Management 19

E

where Sq is the required Sharpe ratio on the q-Forward, qx,t is the expected mortality

rate under the real-world P measure, and σx is the historical (percentage) volatility of

the mortality rates:

E

qx,t = EP (qx,t |F0 ) (15)

The required Sharpe ratio is chosen as 0.20, which is the implied Sharpe ratio from UK

annuity markets as given in Loeys et al. This is consistent with Bauer et al (2008) [1] who

argue that the Sharpe ratio should be less than the 0.25 observed in the equity markets.

The risk in the insurer’s portfolio was assessed by considering the distribution of the final

surplus UT when all contracts have been terminated. 100,000 simulations were performed

for each scenario, obtaining a simulated distribution for UT from which the risks are

assessed.

The insurer’s surplus was simulated under a number of scenarios, including a range of

stress tests which were done to analyse the risk and hedge effectiveness under adverse

conditions. The scenarios analysed were:

1 Stochastic Stochastic

2 Average Stochastic

3 Adverse Stochastic

4 Stochastic Average + Excess Imp. (2%/yr Accumulating)

5 Stochastic Average + Excess Imp. (25% Flat)

Scenario 1 involves simulating 100,000 paths using the stochastic market and mortality

models developed in Chapters 2 and 3. Scenario 2 involves using a deterministic market

(average case from simulated paths) but with stochastic mortality. Scenario 3 involves a

deterministic market based on the historical period of 1930–1975, beginning just prior to

the Great Depression. This scenario is primarily for the purpose of assessing the GLWB,

which was found to insure mainly against (extreme) market risk. Scenario 4 stress tests the

19

5. Results 20

excess improvement above the projected rates. In reality, an underestimate of future

mortality trends is likely to be a gradual underestimation, where the effects of health

improvements (eg. cure for cancer) gradually impact on the mortality rates beyond the

expected level. Thus, Scenario 4 represents an adverse scenario that is quite realistic.

Finally, Scenario 5 stress tests the strategies with a 25% flat shock across mortality rates

of all ages and times. This is the scenario that must be applied in determining the

longevity risk capital charge according to Solvency II.

• No Longevity Hedging

• No Longevity Risk

• q-Forwards

• q-Forwards (Bucketed)

• Longevity Swap

Only the 40yr longevity bond was considered (out of the three longevity bond strategies)

for deferred annuities and the GLWB due to the deferred nature of the claims.

The ‘No Longevity Hedging’ and ‘No Longevity Risk’ strategies involves using (only) zero

coupon bonds to match assets with liabilities and is largely based on the ‘bond strategy’

used in Bauer and Weber (2008) [3]. In the latter strategy, determininstic average-case

mortality rates are used. These provide two benchmarks against which the other longevity

hedging strategies can be evaluated.

20

5. Results 21

●●●●●●●●● ● ●●●●

●● ●

10 20 30 40 50

● ● ●

●●●● ●● ●

3000

●●●● ● ●

●●●●●● ● ● ●

6000

●●●● ● ● ●

● ● ● ●●●●●● ●

●● ●● ●●

Claims ('000)

Claims ('000)

Claims ('000)

● ● ● ● ● ●

● ●● ● ● ●● ●

● ●

●● ●● ● ●

●● ●● ●

● ●

●

● ●

● ● ● ●

● ● ● ● ●

● ●

● ● ●

● ● ● ● ●

● ●

1000

● ●

2000

● ● ● ● ● ●

● ● ● ● ●

● ● ● ● ●

●● ● ● ● ●

●● ● ● ● ●

● ●● ●●

●● ●● ● ●

●●● ●●

●● ●●

● ● ●●●●●●●●●●●●●●●● ●

0

0

0 10 20 30 40 20 25 30 35 40 45 0 10 20 30 40

(Note: Blue = Life Annuity, Green = Indexed Annuity)

0.020

0.008

0.008

Density

Density

Density

0.010

0.004

0.004

0.000

0.000

−600 −200 0 200 600 −150 −50 0 50 100 0.000 0 100 200 300

(Note: Blue = Life Annuity, Green = Indexed Annuity)

5 Results

Figure 9 shows the expected total claims, whereas the simulated distribution of UT for

each annuity is shown in Figure 10.

The difference in claims between life and indexed annuities can be seen in Figure 9. The

difference is most significant for immediate annuities, as the survival probabilities are

large at earlier ages and hence the increase in payments due to indexation is the dominant

effect. Thus, in hedging the indexed annuity (in particular the immediate annuity), it is

important to take into account the increasing nature of the claims, and this is verified by

the results in Section 5.2.

From the distributions in Figure 10, the immediate life annuity and the GLWB appear to

be overpriced, as the surplus distributions are almost always positive. The high price of

21

5. Results 22

Annuity Mean (No Hedging) ES0.05 (No Hedging) ES0.05 (No L Risk)

Life 150.3 54.6 116.2

Indexed Life 81.5 -642.3 -587.9

Deferred 14.7 -30.6 7.7

Def. Indexed 7.5 -133.5 -106.2

VA + GLWB 121.43 40.80 41.27

life annuities is consistent with the results of Bauer and Weber (2008) [3]. One reason for

the apparent high GLWB price is the relatively higher level of interest rates in Australia

compared to many other developed nations. This means that higher (risk-free) returns

can be earned on the investment portfolio, and therefore higher guaranteed withdrawals

could potentially be supported.

Conversely, both indexed annuities and the deferred life annuity may be underpriced, as a

significant portion of the simulated distribution is negative. In particular, the riskiness of

indexed annuities can be seen from the variance of the surplus distribution, with a much

broader range than their fixed counterparts. The inflation risk in an immediate annuity is

also higher than in a deferred annuity, as the immediate annuity involves payments (and

their corresponding inflation risk) over a longer period.

Longevity risk was found to be much more significant for the life annuities than the indexed

and variable annuities. This is intuitive, as the life annuities have payments which depend

only on mortality, whereas the indexed and variable annuities have payments depending

on inflation and market forces. However, the extent to which the products are dominated

by market risk is an interesting observation.

The total risk in indexed annuities consists primarily of inflation risk, while the total risk

in the GLWB is heavily dominated by market risk due to the claim amounts being highly

dependent on market performance. This is consistent with the results of Holz et al (2007)

[19], and is also intuitive due to the higher volatility in market variables as opposed to

changes in mortality rates.

Table 3 shows the expected shortfalls for the no hedging and no longevity risk scenarios,

from which the indexed and variable annuities can be seen to contain relatively little

22

5. Results 23

100%

80%

60%

40%

20%

0%

Life Indexed Life Deferred Ind. Deferred VA + GLWB

Type of Annuity

Figure 11 illustrates the percentage difference in expected shortfall (as a difference from

the mean) under no longevity risk and no hedging. If longevity risk dominates the risk

in a product, then the expected shortfall under no longevity risk should be significantly

closer to the mean than in the no hedging case, resulting in a high percentage difference.

The low significance of longevity risk is shown by the (very) low percentages (7%, 19%,

1%) for indexed and variable annuities when compared to the life annuities (64%, 84%).

The risk remaining in the life annuities consists of unsystematic risk (random mortality

variation within a portfolio) and investment risk (accumulation of surplus). These risks

are lower for deferred annuities due to the shorter period during which claims are paid

and cash flows are accumulated.

The effectiveness of hedging strategies can be assessed by observing their effect on the

risk measures.

ES − ESNH

(16)

ESNR − ESNH

where ESNH and ESNR are the corresponding risk measures under ‘no longevity hedging’

23

5. Results 24

No Hedging

No Longevity Risk

Hedged

ESNR

ESNH ES – ESNH ES

ESNR – ESNH

and ‘no longevity risk’ respectively (See Figure 12). Figures 13-14 show the average

reduction in expected shortfall (1% and 5% levels) for each of the 5 scenarios due to each

hedging strategy.

The results show that all the hedging strategies are useful in transferring longevity risk

away from the insurer. The hedging strategies are most effective for the life annuities,

as their claims do not depend on market forces. Indexed annuities contain less longevity

risk and are more difficult to hedge, with the strategies being significantly less effective.

The GLWB contains relatively little longevity risk and are the most difficult to hedge

as the claim amounts and timing are both significantly influenced by the market. For

a GLWB, the strategies generally do not reduce the longevity risk significantly enough

to compensate for the cost of hedging, as shown by the zero net reduction in expected

shortfall for Scenario 1 (Figure 14).

For indexed annuities, the longevity swap is most effective as it allows for the expected

increase in claims due to inflation. The longevity bonds are still useful, but are less

effective due to the greater mismatch between the claims and bond payouts. q-Forwards

also allow for the expected increase in claims, and perform well in Scenarios 2 to 5, with

the poor performance in Scenario 1 mainly due to its higher cost when compared with

longevity bonds.

The 40yr bond is generally more effective than the 20yr, suggesting that the longevity risk

realised in years 20–40 is more significant than in earlier years (0–20). This is reasonable,

as mortality rates are unlikely to differ significantly from expected in the short term, and

24

5. Results 25

100

80

Percentage

60

40

20

0

1 2 3 4 5 1 2 3 4 5

Annuity/Scenario

q Fwd q Fwd (B) L Bond (20y) L Bond (40y) L Bond (Both) L Swap

100

80

Percentage

60

40

20

0

1 2 3 4 5 1 2 3 4 5 1 2 3 4 5

Annuity/Scenario

q Fwd q Fwd (B) L Bond (40y) L Swap

Figure 14: Avg Reduction in Expected Shortfall (Deferred Annuities and GLWB)

25

5. Results 26

the number of deaths in earlier years is significantly lower. In years 20–40, mortality rates

are likely to differ more significantly, and there is still a significant portfolio size which

is affected by the longevity risk. In addition, the deaths in years 20-40 have also been

subject to longevity improvements in years 20-40, and therefore the 40-year bond also

hedges against some of the longevity risk in earlier years. The only scenario when the

20yr bond performs better is Scenario 5, where a flat shock of 25% is applied to mortality

rates of all ages and times, causing shorter term mortality rates to differ significantly as

well.

q-Forwards are structured in a similar manner to the longevity swap, except that payouts

are based on initial mortality rates instead of survival probabilities. This causes the q-

Forwards to be less effective than the longevity swap, as it introduces additional basis

risk. This is due to a mismatch in timing of cash flows, as the survival probability Sx (t)

depends on all mortality rates qx+s,s (s < t), and therefore the cash flows for hedging the

claim at time t will be received at all times s < t. These must then be invested until time

t, and are therefore subject to investment risk.

The two q-Forward strategies produce very similar results, with only a minor difference in

hedge effectiveness. This suggests there is little basis risk added by bucketing q-Forwards

by 5 year groups, which is an encouraging result as bucketing can help to improve liquidity.

Under the stress test scenarios (4 & 5), the most effective strategies are the longevity swap

(all products), q-Forwards (all products), both longevity bonds (immediate life annuity),

and the 40-year longevity bond (deferred life annuity). These are the strategies which

have mortality-linked payments closely matching all the cash flows, and do not leave a

significant portion (eg. inflation-linked claims, earlier/later claims) of the longevity risk

unhedged. In such scenarios, leaving a portion of the longevity risk unhedged will greatly

reduce the hedge effectiveness, which is intuitive as these are severe adverse scenarios in

terms of longevity risk. These stress tests show that when managing extreme longevity

risk, it is important to implement a strategy that closely matches all cash flows without

leaving a significant portion unhedged.

Basis risk arising from the uncertainty in the relationship between annuitant and popu-

lation mortality is quantified using the model described in Section 3.4. The sensitivity of

hedge effectiveness to basis risk was analysed by considering annuitant-population ratio

26

5. Results 27

0% 6.68% 10.02%

100 No Basis Risk

Basis Risk

80 150% Basis Risk

Percentage

60

40

20

0

q qB L2 L4 LB LS q qB L2 L4 LB LS q qB L4 LS q qB L4 LS q qB L4 LS

Annuity/Strategy

volatilities of 0 and 1.5 times the estimated value θ̂ (Table 4). The first case corresponds

to the situation where basis risk is ignored by assuming the expected ratio of annuitant

to population mortality will hold with certainty. The second case corresponds to the

situation where the level of basis risk is 50% greater than expected.

The effect of basis risk on hedge effectiveness is illustrated in Figure 15. The results

show that basis risk arising from uncertainty in the annuitant-population ratio does not

significantly reduce hedge effectiveness.

The strategies can be very effective in transferring longevity risk, but can also be rather

costly resulting in a significant shift in the surplus distribution towards the negative. As

there is currently an illiquid market for mortality-linked securities, the price at which

hedge instruments can be purchased is rather uncertain, and this could have a significant

27

6. Conclusion 28

Risk Reduction (Expected Shortfall)

100 Sharpe Ratio 0.15

Sharpe Ratio 0.20

Percentage 80 Sharpe Ratio 0.25

60

40

20

0

q qB L2 L4 LB LS q qB L2 L4 LB LS q qB L4 LS q qB L4 LS q qB L4 LS

Annuity/Strategy

A sensitivity analysis was performed to analyse the effect of using a higher/lower price of

risk (Sharpe ratio) when pricing the mortality-linked securities. Sharpe ratios of 0.15 and

0.25 were considered for comparison with the base case of 0.20. The results in Figure 16

show that the hedge effectiveness is sensitive to the price, although the longevity bond

and swap strategies still remain very effective for the life annuities (both immediate and

deferred) when the Sharpe ratio is increased to 0.25. However, the effectiveness of q-

Forwards is highly sensitive to the price of risk, with the effectiveness falling significantly

when the Sharpe ratio is increased. This is because the mortality-linked payments from

the q-Forward strategies are affected by the Sharpe ratio, as opposed to a longevity bond.

The effectiveness is also more sensitive to price for indexed annuities as longevity risk is

less significant in these products, and therefore the absolute reduction in expected shortfall

due to an increase in price will have a severe effect on the percentage risk reduction.

6 Conclusion

Longevity risk was found to be most significant in life annuities. Inflation risk is the

dominant risk in indexed annuities, while market risk is extremely dominant in the GLWB

28

6. Conclusion 29

due to its strong influence on the amounts and timing of claims. Longevity risk is also

more dominant in deferred annuities than in immediate annuities, as the claims focus on

the higher ages where mortality improvements are more likely to differ from expected,

and will have a larger impact on the number of lives remaining.

Longevity bonds were found to be very effective in hedging the longevity risk in life

annuities. Zero coupon longevity bonds allow more flexibility in constructing a hedge

strategy, and are able to better hedge the longevity risk in indexed annuities. q-Forwards

are also effective in hedging longevity risk, but contain a significant amount of additional

basis risk over longevity bonds.

The cost of hedging was investigated, with all strategies shown to be sensitive to the price

of risk. Given the current illiquidity in the market for mortality-linked securities, the

cost of hedging may vary significantly, and thus the costs and benefits must be analysed

carefully by insurers seeking to manage their longevity risk.

Two sources of basis risk were analysed, and were found to have minimal impact on

the hedge effectiveness. The first source arises from the uncertainty in the relationship

between annuitant and population mortality, which was quantified based on UK data. The

second source arises from the bucketing of q-Forwards by 5-year age groups. The minimal

impact of these sources of basis risk is encouraging, and allows insurers to hedge their

longevity risk using mortality-linked securities with greater effectiveness and confidence.

This paper has further developed the work of Bauer and Weber (2008) [3] in providing

a more rigorous analysis of longevity risk for an annuity portfolio. Improved market

models have been used to better account for the underlying risks, incorporating the work

of Krolzig (1997) [22]. The work of Dowd et al (2006) [14] was also applied and extended

through an analysis of longevity risk hedging using the improved market and mortality

models. The effectiveness of q-Forwards were also investigated in addition to longevity

bonds.

more complex products such as indexed annuities and the GLWB. These products have

potential in insuring against individual longevity risk, and are attractive due to their

flexibility (GLWB) and their insurance against a rising cost of living (indexed annuities).

Thus, these annuities could become useful tools in solving the ageing population problem.

Given the dominance of market risk in these annuities, insurers will need to have appro-

priate market risk management techniques in place, such as the use of inflation-indexed

bonds for hedging inflation risk.

29

References 30

A rigorous analysis of the underlying risks is vital in the development of a market for

longevity risk insurance. As shown by the recent financial crisis, it is important that

financial institutions understand their risks to ensure a smoothly functioning financial

system. This analysis of longevity risk has resulted in a greater understanding of the risks

involved in a range of annuities, and the extent to which these risks can be managed.

Finally, note that this paper focused on static hedging due to their simplicity, lower cost,

and practicability. As the market for mortality-linked securities develops further, dynamic

hedges may become more implementable. Dynamic hedges are likely to be more useful

in hedging indexed annuities and the GLWB, as the strategy can potentially match the

market-dependent claims more closely. Thus, the investigation of dynamic hedges and

their effectiveness would be a useful area for further research, especially in regards to

indexed annuities and the GLWB which were found to be significantly affected by market

risk.

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