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Static Hedging Effectiveness for

Longevity Risk with

Longevity Bonds and Derivatives

Andrew Ngai
26 January 2010

The material in this report is copyright of Andrew Ngai.

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
Static Hedging Effectiveness for Longevity Risk with
Longevity Bonds and Derivatives
Andrew Ngai
January 26, 2010


This paper contributes towards a solution to the ageing population problem

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. 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]).

To ensure a smoothly functioning financial system, it is vital that financial institutions

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.

A potential flow of longevity risk is illustrated in Figure 1. Individuals have a need to

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

1. Introduction 3

Capital Mkts

Annuities MLS
Individuals Life Insurers


Figure 1: Role of Institutions in the Transferral of Longevity Risk


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
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,

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.

Insurers are gradually turning to standardised hedging using mortality-linked securities

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

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

2.1 Model Specification

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.

A general RS-VECM with an underlying lag of p is expressed as:

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

2. Market Model 6

where yt is a d-dimensional vector of observations, ∆yt = yt − yt−1 is the first differenced

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

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

where the probabilities p0 and p1 are assumed to be constant over time.

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

The financial and economic series included in the model are:

ln Gt = Log Gross Domestic Product (GDP)

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)

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

Table 1: Summary Statistics for Market Log Quarterly Returns

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

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.

A statistical summary of the data (log quarterly returns) is provided in Table 1.

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

3. Mortality Model 8








500 1000

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

Year Year Year Year

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










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

Year Year Year Year

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.

3. Mortality Model 9









−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

Return Return Return Return

Figure 4: Overall Distribution of Simulated Annual Returns

(Note: Red = Historical Distribution)

Statistic ∆Gt ∆Bt ∆St ∆Ft

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

Table 2: Summary Statistics for Simulated Quarterly Returns

Male Mortality Female Mortality

1 1
0 0
−1 −1


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)

3. Mortality Model 10

3.1 Model Specification

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:
∆ 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:

∆ logit µx,t = logit µx,t − logit µx−1,t−1 (6)

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)

where σ is a deterministic volatility parameter, and Wt ∼ NN (0, D). The matrix D

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.

3. Mortality Model 11
Male Force of Mortality Female Force of Mortality

0.6 0.6

0.4 0.4


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.

3.4 Annuitant Mortality

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:
ρx,t = (8)

3. Mortality Model 12

Force of Mortality Initial Death Rate








0 10 20 30 40 0 10 20 30 40

Years Years

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

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:

ρx,t = α + βx + νx,t (9)

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

4. Risk Analysis and Management 13

Male Female
1.4 1.4

1.2 1.2

1.0 1.0

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

Figure 8: Observed Ratios of Annuitant/Pensioner to Population Mortality

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.

4 Risk Analysis and Management

The following products were stochastically analysed using the market and mortality
models developed in the previous sections:

• Fixed Life Annuity (Immediate)

• Fixed Life Annuity (Deferred to Age 85)

• Inflation-Indexed Life Annuity (Immediate)

• Inflation-Indexed Life Annuity (Deferred to Age 85)

• Variable Annuity with GLWB

4. Risk Analysis and Management 14

These products have potential in insuring individuals against longevity risk as they involve
an income stream for life.

Longevity hedging strategies involving mortality-linked securities were considered due

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.

4.1 Annuity Portfolio

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

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.

4. Risk Analysis and Management 15

4.1.1 Insurer Surplus

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.

Define the following notation:

Ut = insurer’s surplus at time t

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


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.

4. Risk Analysis and Management 16

4.1.2 Investment Strategy

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.

RtU = RtB = −1 (12)

where RtB is the return on the bond index.

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

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].

4.2 Hedging Instruments

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
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

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

4.3 Pricing of Hedging Instruments

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
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:

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

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

qx,t = (1 − Sq σx t)qx,t (14)

4. Risk Analysis and Management 19

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:

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.

4.4 Risk Assessment

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

4.4.1 Scenario Analysis

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:

Scenario Market Assumption Mortality Assumption

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

5. Results 20

longevity hedging strategies by applying a deterministic mortality but with 2% annual

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.

4.4.2 Hedge Strategies

The following hedge strategies were considered for each scenario:

• No Longevity Hedging

• No Longevity Risk

• q-Forwards

• q-Forwards (Bucketed)

• 20yr Longevity Bond

• 40yr Longevity Bond

• Both Longevity Bonds

• 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.

5. Results 21

Immediate Annuities Deferred Annuities VA + GLWB

●●●●●●●●● ● ●●●●
●● ●

10 20 30 40 50
● ● ●
●●●● ●● ●

●●●● ● ●
●●●●●● ● ● ●

●●●● ● ● ●
● ● ● ●●●●●● ●
●● ●● ●●
Claims ('000)

Claims ('000)

Claims ('000)
● ● ● ● ● ●
● ●● ● ● ●● ●
● ●
●● ●● ● ●
●● ●● ●
● ●

● ●
● ● ● ●
● ● ● ● ●
● ●
● ● ●
● ● ● ● ●
● ●

● ●

● ● ● ● ● ●
● ● ● ● ●
● ● ● ● ●
●● ● ● ● ●
●● ● ● ● ●
● ●● ●●
●● ●● ● ●
●●● ●●
●● ●●
● ● ●●●●●●●●●●●●●●●● ●

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

Year Year Year

Figure 9: Expected Total Claims of Portfolio

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

Immediate Annuities Deferred Annuities VA + GLWB







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

Surplus Surplus Surplus

Figure 10: Simulated Distribution of Final Surplus UT

(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

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

Table 3: Change in 5% Expected Shortfall (No Hedging vs No Longevity Risk)

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.

5.1 Significance of Longevity Risk

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

5. Results 23

Significance of Longevity Risk






Life Indexed Life Deferred Ind. Deferred VA + GLWB
Type of Annuity

Figure 11: Percentage Difference in 5% ES (No Hedging vs No Longevity Risk)

longevity risk compared to other risks.

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.

5.2 Hedge Effectiveness

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

The percentage reduction in expected shortfall can be measured as:


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

5. Results 24

No Hedging
No Longevity Risk


Figure 12: Illustration of Relative Reduction in Expected Shortfall

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

5. Results 25

Risk Reduction (Expected Shortfall)






1 2 3 4 5 1 2 3 4 5

Life Indexed Life

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

Figure 13: Avg Reduction in Expected Shortfall (Immediate Annuities)

Risk Reduction (Expected Shortfall)






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

Deferred Indexed Deferred VA + GLWB

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

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

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

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.

5.3 Sensitivity to Basis Risk

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

5. Results 27

No Basis Risk Basis Risk 150% Basis Risk

0% 6.68% 10.02%

Table 4: Standard Deviation of Error Term in Annuitant-Population Ratio Model

Risk Reduction (Expected Shortfall)

100 No Basis Risk
Basis Risk
80 150% Basis Risk




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

Life Indexed Life Deferred Ind. Deferred VA + GLWB


Figure 15: Reduction in Expected Shortfall: Effect of Basis Risk

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.

5.4 Sensitivity to Price of Risk (Sharpe Ratio)

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

6. Conclusion 28
Risk Reduction (Expected Shortfall)
100 Sharpe Ratio 0.15
Sharpe Ratio 0.20
Percentage 80 Sharpe Ratio 0.25




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

Life Indexed Life Deferred Ind. Deferred VA + GLWB


Figure 16: Reduction in Expected Shortfall: Sensitivity to Sharpe Ratio

impact on the hedge effectiveness.

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

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

A further contribution involves the investigation of a larger range of annuities, including

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.

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

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