Insurance: Mathematics and Economics 46 (2010) 242–253

Contents lists available at ScienceDirect
Insurance: Mathematics and Economics
journal homepage: www.elsevier.com/locate/ime
Mortality risk modeling: Applications to insurance securitization
$
Samuel H. Cox
a,1
, Yijia Lin
b,∗
, Hal Pedersen
a,2
a
University of Manitoba, Winnipeg, Manitoba, R3T 5V4, Canada
b
University of Nebraska, P.O. Box 880488, Lincoln, NE 68588, USA
a r t i c l e i n f o
Article history:
Received December 2008
Received in revised form
September 2009
Accepted 30 September 2009
a b s t r a c t
This paper proposes a stochastic mortality model featuring both permanent longevity jump and tempo-
rary mortality jump processes. A trend reduction component describes unexpected mortality improve-
ment over an extended period of time. The model also captures the uneven effect of mortality events on
different ages and the correlations among them. The model will be useful in analyzing future mortality de-
pendent cash flows of life insurance portfolios, annuity portfolios, and portfolios of mortality derivatives.
We show how to apply the model to analyze and price a longevity security.
©2009 Elsevier B.V. All rights reserved.
1. Introduction
Over the past half century, and especially in the most re-
cent decades, remarkable mortality improvements have led to the
growthof the populationof older people (BourguignonandMorris-
son, 2002; Lakdawalla and Philipson, 2002; Vaupel, 1998). To the
extent that this progress is unexpected, it has a negative impact
on pension plans and annuity providers. In the US, private defined
benefit pension plans currently have close to $6 trillion in liabilities
for future benefits. In addition, US life insurers hold approximately
$2 trillion in annuity reserves (Salou and Hu, 2006; ACLI, 2006).
Uncertainty of longevity improvements increases risk for pension
funds and annuity insurers, since annuity benefits may need to be
paid longer than expected. In a recent study of pension liabilities
of the companies in the UK’s FTSE100 index, Cowling and Dales
(2008) found overly optimistic longevity assumptions for pension
valuations reported at the end of 2007. These authors believe that
companies underestimate future life expectancy by one to three
years and, therefore, understate the aggregate pension deficit of
these companies by as much £40 billion.
$
The paper was presented at the 4th International Longevity Risk and Capital
Market Solutions Symposium in 2008, the 2008 American Risk and Insurance
Association annual meeting, and the 2008 Financial Management Association
annual meeting. We appreciate the helpful comments andsuggestions fromRichard
MacMinn and participants at these meetings. We are especially grateful to Enrico
Biffis and two anonymous referees for their very useful comments.

Corresponding address: Department of Finance, University of Nebraska, P.O.
Box 880488, Lincoln, NE 68588, USA. Tel.: +1 402 472 0093.
E-mail addresses: sam_cox@umanitoba.ca (S.H. Cox), ylin@unlnotes.unl.edu
(Y. Lin), pedersn@cc.umanitoba.ca (H. Pedersen).
1
Tel.: +1 204 474 7426.
2
Tel.: +1 204 474 9529.
In contrast, in modeling life insurance, one naturally looks at
scenarios which are pessimistic about mortality improvement and
often include threats such as epidemics. Several recent articles
focus on management of such mortality risks, including Hardy
(2005), Rogers (2002), Goss et al. (1998), Cox et al. (2006), Cox
and Lin (2007) and Lin and Cox (2008). Genetic analysis has
confirmed that the virus of ‘‘Spanish flu’’ which killed 40 to 100
million people in 1918 developed in birds and was similar to
today’s ‘‘bird flu’’ (Juckett, 2006). Some public health experts think
that a pandemic is overdue and another will inevitably occur
(Dowdle, 2006). Should a pandemic occur, a life insurer will suffer
financially since it will pay more death benefits than expected
when the policies were issued. It seems reasonable that a major
pandemic event could trigger turbulence in the life insurance
industry. Toole (2007) studied this issue in detail and concluded
that the industry as a whole can withstand a severe pandemic,
as severe as the 1918 pandemic, with a loss of about $64 billion
relative to aggregate risk-based capital (RBC) of about $256 billion
in 2005. While the industry as a whole can sustain a severe flu
pandemic, it would nevertheless be disruptive. Companies holding
less than 100 percent of RBC (only 14 companies in 2005) may
become insolvent. As Toole (2007) notes, if a severe pandemic
were to occur when the financial markets are weak (e.g. when
asset values such as mortgage-backed securities are depressed),
then the financial impact could be much worse and the number
of companies near insolvency could be much greater. Thus, it
seems clear that including pandemic effects is an important issue
in modeling mortality for life insurance liabilities.
In light of the above discussion, the terms mortality risk and
longevity risk are opposites in this paper. Mortality risk is the risk of
more deaths than expected, or the risk that observed death prob-
abilities are higher than expected. We usually think that severe,
short-termed events such as pandemics underlie mortality risk.
0167-6687/$ – see front matter ©2009 Elsevier B.V. All rights reserved.
doi:10.1016/j.insmatheco.2009.09.012
S.H. Cox et al. / Insurance: Mathematics and Economics 46 (2010) 242–253 243
On the other hand, more people may survive than expected, or ob-
served death rates may be lower than expected. Unanticipated im-
provements in medicine and health technology may give rise to
longevity risk, leading to a surge in mortality improvement in a
short period (e.g. one or two years) or excess improvement over a
long period (e.g. more than ten years). For longevity events with
a long-term effect, the slope of the mortality curve may deviate
from that of the base trend with normal deviations, as evident, for
example, in the US population mortality dynamics in the 1970’s.
Actual mortality has been improving, so parametric models esti-
mated with actual data will reflect improving mortality. Models
that have a randomdeviation fromthe expected mortality may re-
flect some longevity risk, but this is not a reflection of a fundamen-
tal change in the trend (as we have in mind). Our model, for which
we will provide a detailed discussion later, allows for such funda-
mental changes.
Marocco and Pitacco (1998), Milevsky and Promislow (2001),
Dahl (2004), Miltersen and Persson (2005), Cairns et al. (2006),
Dahl and Møller (2006), Gründl et al. (2006), Ballotta and Haber-
man (2006), Biffis and Millossovich (2006) and Bauer and Kramer
(2007) focus on mortality risk as deviations from a trend. In those
papers, the base trend may reflect mortality improvements, but
longevity risk is not modeled explicitly. On the other hand, pen-
sion and annuity research has focused on longevity risk. Loise and
Serant (2007) model longevity (and mortality) risk use a stationary
Gaussian process. However, this model may not be appropriate for
modeling longevity (and mortality) shocks which may not followa
stationary Gaussian process. To describe the stochastic longevity
trend, Hári et al. (2008) extend the Lee–Carter model with a
time-varying, stochastic drift. Biffis (2005) captures mortality ran-
dom departures around a time-varying target with a longevity
compound Poisson process, but that model cannot guarantee a
nonnegative force of mortality.
US mortality data has only two extreme events, 1918 flu pan-
demic and the change in the rate of improvement of mortality
around1970. However, experts conjecture that we may experience
extreme events of both types in the future. This means that, in in-
vestigating the impact of possible future events, we cannot sim-
ply calibrate our models to the experience. Therefore, we offer a
flexible, although somewhat complex, method of including expert
opinion in forming future mortality scenarios.
Specifically, we propose a newapproach by introducing a trend
reduction jump component to describe longevity risk. Unexpected
longevity improvement, in general, may be less dramatic than that
of a mortality death shock, but in the long run longevity risk may
be just as important. Most longevity risk events in the past seem
to have a pattern; unexpected survival gains often extended over
a long period of time, leading to a steeper downward sloping force
of mortality curve. The traditional one-time jump models such
as the model that combines a geometric Brownian process and
a compound Poisson jump process, cannot provide this kind of
longevity risk.
Moreover, to obtain relevant results, a stochastic mortality
model must reflect three major features of the current mortality
universe: (a) both mortality improvement and deterioration jump
factors, (b) correlation among different ages and over time, and
(c) uneven effects of a mortality jumps across different ages. Our
model attempts to address these issues. In particular, we are
explicitly combining both mortality and longevity risk in a single,
comprehensive model inorder to make a more realistic assessment
of future survivor dependent cash flows. Finally, we show how to
determine a parsimonious version with historical data.
As an application to mortality risk management, Blake et al.
(2006) examine a wide variety of longevity bonds. We continue in
the same vein, but with explicit mortality derivatives such as op-
tions which we think can be important tools in managing mortality
and longevity risk. Derivatives can be written on indices based on
publicly available data like the LifeMetrics index (Coughlan et al.,
2007) offered by Goldman–Sachs
3
and the Credit Suisse index.
4
Our paper is organized as follows. In Section 2 we describe
mortality dynamics as a combination of a Lee–Carter diffusion
process, a permanent longevity jump process and a temporary
mortality jump process. In Section 3 we discuss capital market so-
lutions for mortality and longevity risk, including new structures,
with our proposed longevity index, respectively. We show how
to price those securities with the indifference pricing method in
Section 4. We conclude the article in Section 5.
2. Dynamic mortality model
Stochastic mortality models usually start with the assumption
that there is an ‘‘initial’’ curve for the force of mortality. For a life
(x) at time 0, the remaining life time random variable is denoted
T(x). The force of mortality at time t > 0 is denoted µ(x + t, t).
In effect, the force acting during the life of a person age x at time
t = 0 is a stochastic process {µ(x +t, t) : t ≥ 0} evolving from an
initial curve µ(x, 0) = µ(x). Mathematically speaking, this is very
complex. Inorder to reduce the complexity, the model specifies the
force of mortality as a parametric function of age and time, with a
small number of parameters.
Statistical methods applied in actuarial practice use this same
approach. The expected value, or forecast value, of the force of
mortality µ(x + t, t) acting on (x + t) at time t, given T(x) > t, is
used to price life insurance and annuity polices. However, actual
mortality experience can change in a nondeterministic way and
deviate from expected mortality rates.
Here is howwe will model these events. The aggregate effect on
(x) over the period (0, h) is a random variable since it is the path
integral over the sample path {µ(x +t, t) : 0 ≤ s ≤ h} of the force
of mortality:
_
h
0
µ(x + t, t)dt.
The probability S(x, h) that (x) will attain age x + h is random
at time 0, because it depends on the sample path of the force of
mortality:
S(x, h) = exp
_

_
h
0
µ(x + s, s)ds
_
.
The probability that (x) will attain age x + h is the expected value
of the probability:
Pr [T(x) > h] = E [S(x, h)] .
Among the reasons for changes in the force of mortality are the
following:
• general trends in health and mortality resulting in gradual
improvements to mortality,
• deviations from the general trends,
• relatively rare advances in medical technology resulting in
sudden and permanent improvements in mortality, and
• sudden catastrophic surges in mortality from events such as
pandemics resulting in temporary increases in mortality.
3
http://www.qxx-index.com.
4
http://www.credit-suisse.com/ib/en/fixed_income/longevity_index.html.
244 S.H. Cox et al. / Insurance: Mathematics and Economics 46 (2010) 242–253
Table 1
The estimates of a(x) and b(x) based on the US male population data from 1901 to 2005.
Age a(x) b(x) Age a(x) b(x) Age a(x) b(x)
0 −3.4039 0.1736 35 −5.5990 0.1061 70 −3.0020 0.0392
1 −5.6955 0.2612 36 −5.5442 0.1043 71 −2.9207 0.0398
2 −6.2000 0.2374 37 −5.4851 0.1017 72 −2.8391 0.0400
3 −6.4963 0.2287 38 −5.4259 0.0990 73 −2.7575 0.0396
4 −6.7038 0.2269 39 −5.3661 0.0966 74 −2.6766 0.0393
5 −6.8571 0.2171 40 −5.3015 0.0934 75 −2.5950 0.0384
6 −6.9863 0.2029 41 −5.2354 0.0903 76 −2.5132 0.0378
7 −7.1111 0.1908 42 −5.1666 0.0872 77 −2.4290 0.0377
8 −7.2240 0.1820 43 −5.0960 0.0841 78 −2.3429 0.0381
9 −7.3290 0.1820 44 −5.0242 0.0812 79 −2.2492 0.0371
10 −7.3986 0.1878 45 −4.9509 0.0784 80 −2.1687 0.0391
11 −7.3761 0.1883 46 −4.8750 0.0752 81 −2.0834 0.0391
12 −7.2273 0.1737 47 −4.7995 0.0721 82 −2.0022 0.0384
13 −6.9989 0.1495 48 −4.7227 0.0687 83 −1.9251 0.0370
14 −6.7715 0.1278 49 −4.6471 0.0655 84 −1.8509 0.0352
15 −6.5665 0.1113 50 −4.5699 0.0621 85 −1.7774 0.0335
16 −6.3902 0.0992 51 −4.4928 0.0593 86 −1.7025 0.0319
17 −6.2527 0.0934 52 −4.4151 0.0569 87 −1.6262 0.0309
18 −6.1422 0.0903 53 −4.3380 0.0554 88 −1.5482 0.0303
19 −6.0618 0.0911 54 −4.2612 0.0544 89 −1.4695 0.0298
20 −5.9908 0.0944 55 −4.1827 0.0532 90 −1.3906 0.0295
21 −5.9233 0.0959 56 −4.1041 0.0521 91 −1.3116 0.0290
22 −5.8849 0.0986 57 −4.0249 0.0506 92 −1.2336 0.0282
23 −5.8732 0.1006 58 −3.9452 0.0488 93 −1.1572 0.0274
24 −5.8802 0.1021 59 −3.8663 0.0471 94 −1.0828 0.0265
25 −5.8953 0.1039 60 −3.7859 0.0453 95 −1.0142 0.0269
26 −5.9028 0.1050 61 −3.7063 0.0440 96 −0.9457 0.0265
27 −5.9019 0.1067 62 −3.6267 0.0423 97 −0.8779 0.0265
28 −5.8855 0.1082 63 −3.5503 0.0410 98 −0.8122 0.0267
29 −5.8537 0.1092 64 −3.4739 0.0395 99 −0.7502 0.0268
30 −5.8191 0.1101 65 −3.3970 0.0383 100 −0.6867 0.0270
31 −5.7830 0.1100 66 −3.3189 0.0375 101 −0.6228 0.0277
32 −5.7435 0.1099 67 −3.2396 0.0370 102 −0.5587 0.0262
33 −5.6993 0.1091 68 −3.1614 0.0376 103 −0.5230 0.0222
34 −5.6519 0.1079 69 −3.0822 0.0383
Therefore, it is natural to develop a model for mortality changes
based on the evolution of the force of mortality with a general
trend, diffusion process and jump components. Anumber of recent
studies have sought to model mortality trends involving both
age-dependent and time-dependent terms (Lee and Carter, 1992;
Renshaw et al., 1996; Lee, 2000; Sithole et al., 2000; Milevsky and
Promislow, 2001; Olivieri and Pitacco, 2002; Dahl, 2004; Cairns
et al., 2006). Our model is inspired by, and closely related to, this
stream of research. As an extension, we explicitly model both
mortality and longevity jump processes in a single model (See
Section 2.2).
2.1. Modeling general mortality trends
We adopt the well-known Lee and Carter (1992) mortality
model as a basis. This model captures the evolution of mortality
in mutually exclusive age cohorts, while at the same time a time-
series common risk factor, k(t), links all cohorts together. The force
of mortality µ
LC
(x, t) is modeled as
5
µ
LC
(x, t) = exp [a(x) + b(x)k(t)] . (2.1)
The parameters a(x) and b(x) are age-specific while k(t) is time
varying.
We fit the model to the US male data for ages x = 0, 1, . . . , 103
and times t = 1901, 1902, . . . , 2005, using the technique
5
Lee and Carter use the central death rate rather than the force of mortality. For
reasonable assumptions about the distribution of deaths between age x and x + 1,
the two measures are the same or very close. For example, if the force of mortality
is constant between integral ages, the central death rate at age x and the force of
mortality at age x are equal. The database has values of q(x, t). Under the same
assumption, q(x, t) = 1 − e
−µ(x,t)
so we can easily change from q(x, t) to µ(x, t).
suggested by Lee and Carter (1992). Tables for years 1901 to 1999
are from the Human Life Table Database.
6
Tables for 2000 to
2005 are from the Human Mortality Database.
7
The estimates of
a(x) and b(x) are in Table 1 and the estimated k(t) is shown in
Fig. 1. There are several generalizations of Lee and Carter (1992)
model in the literature. We believe that our ideas illustrated below
could be applied to them as well by using the original Lee–Carter
model.
Following Lee and Carter (1992), the mortality index k(t)
evolves as
k(t + 1) = k(t) + g
1
+ g
2
× Flu + σz(t),
t = 1901, 1902, . . . , 2005 (2.2)
where g
1
, g
2
, and σ are constants and z(1901), z(1902), . . . , z
(2005) are independent standard normal randomvariables. The flu
in 1918 is identified by a dummy variable, Flu, in Eq. (2.2). Specif-
ically, Flu = 1 if t = 1918, and 0 otherwise. Then we obtain
the estimated g
1
= −0.2244, g
2
= 2.2065, and σ = 0.6123.
Simulating mortality scenarios with the Lee–Carter model, in-
volves simulating future mortality index values k(t) for t > 2005.
For convenience we now re-label the years so that year 2005 cor-
responds to t = 0. For a person age x in 2005, we can generate
6
Data source: Human Life Table Database. Max Planck Institute for Demographic
Research (Germany), University of California, Berkeley (USA) and the Institut
national d’études démographiques (France). Available at www.lifetable.de (data
downloaded on June 8, 2008).
7
Data source: Human Mortality Database. University of California, Berkeley
(USA), and Max Planck Institute for Demographic Research (Germany). Available at
www.mortality.org or www.humanmortality.de(data downloadedonJune 8, 2008).
S.H. Cox et al. / Insurance: Mathematics and Economics 46 (2010) 242–253 245
1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001
-15.00
-10.00
-5.00
0.00
5.00
10.00
Fig. 1. Estimated time-series common risk factor k(t) shown in the vertical axis for
year t = 1901, 1902, . . . , 2004, 2005 in the horizontal axis.
Lee–Carter model scenarios for future values of the force of mor-
tality as follows: For x = 0, 1, . . . , 103,
µ
LC
(x, 0) = µ(x) observed in 2005
µ
LC
(x, t) = exp [a(x) + b(x)k(t)] t > 0.
(2.3)
When we use the model to simulate future values of the force
of mortality applying to a life age x at t = 0 over a period of T years
µ
LC
(x, 0), µ
LC
(x + 1, 1), µ
LC
(x + 2, t + 2), . . . , µ
LC
(x + T, T),
we need to provide for the cases for which x+j > 103 and j > 0. In
other words, the way we use the model requires extending Eq. (2.3)
to ages x > 103 after the first year. A natural approach is to simply
extend both functions a(x) and b(x) linearly using the values for
ages 90to 103 as a basis for the extrapolation. This approachresults
in the linear extrapolation of a(x) and b(x),
a(x) = −7.43 + 0.067x
b(x) = 0.055 − 0.0003x
extending Eq. (2.3) to x > 103 for t > 0. This is consistent
with models with linearly changing mortality, as described by
Schoen (2006). In applications for which ‘‘oldest-of-old mortality’’
is critical, other approaches might be necessary.
2.2. Modeling mortality jumps
Our goal is a stochastic mortality model suitable for dynamic
financial analysis, taking into account the complexity of observed
mortality dynamics. We consider two types of mortality shocks:
permanent jump G(x, t) and temporary jump H(x, t).
The unexpected mortality improvement that results from ge-
netic, environmental, behavioral, bio-reliability, and/or hetero-
geneity forces and constraints, often has a long-term effect on
future mortality rates. In contrast, many catastrophe death events,
like the 1918 worldwide flu and the 2008 earthquake in China,
have a more severe but transitory effect on death rates. In many
cases, these short-term events drive up the death rate just for a
couple of years, but the mortality falls back to the normal level
afterwards. Accordingly, we view sharp decreases in mortality as
‘‘permanent’’ events, for instance, associated with aforementioned
medical advances, and view dramatic increases as ‘‘temporary’’
events such as pandemics.
Whenwe addthese two types of mortality jumpevents – G(x, t)
and H(x, t) – to the Lee–Carter force of mortality µ
LC
(x, t), the
initial version of our model takes the form
µ(x, t) = µ
LC
(x, t) × exp (−G(x, t) + H(x, t)) , (2.4)
where µ
LC
(x, t) is the force of mortality fromthe Lee–Carter model
(2.3).
Fig. 2. Medical advancement by age.
2.2.1. Permanent longevity jump G(x, t)
The unexpected mortality improvement process G(x, t) con-
sists of a jump reduction component K(x, t) and a trend reduction
component D(x, t). That is,
G(x, t) = K(x, t) + D(x, t).
The jump reduction component K(x, t) is the one-time long-
evity jump induced by a surge in survival rates over a short period
(for example, a year) with a permanent effect on longevity. It is de-
fined as
K(x, t) =

s=1
y
s
A
s
(x)1
{t≥η
s
}
, (2.5)
where η
s
is the time of jump reduction event s. The time η
s
can
be modeled as the arrival time of the s-th event of a point process,
as described in Daley and Vere-Jones (2003). The simplest version
would be the arrival times of a Poisson process, in which case the
times would have gamma distributions. A second feasible choice
would be a Hawkes process. The primary difference between these
two approaches lies in the ability of a Hawkes process to create
event clustering.
The positive variable y
s
is the maximummortality improvement
of all ages in medical advancement event s. The effect of y
s
is trans-
ferred to the mortality rates through a function A
s
(x) for age x with
0 ≤ A
s
(x) ≤ 1. When A
s
(x) = 0, medical advancement s has no ef-
fect on age x. In contrast, A
s
(x) = 1 means age x enjoys the biggest
mortality improvement (y
s
) among all ages. When 0 < A
s
(x) <
1, it captures the effects that fall between the above two ex-
tremes. That is, the functionA
s
(x) differentially spreads the mortal-
ity improvement across x’s because, when a medical advancement
occurs, the benefits of the technology usually vary by age. For ex-
ample, compared to demography changes of the whole population
in the 1970’s, the annual improvement in mortality of old ages in
the same period is much more dramatic than that of young ages.
In fact, Cutler and Richardson (1998) find that improvement for
the elderly was greater than for the young in the 1970’s as a re-
sult of a decrease in cardiovascular disease deaths. Since cardio-
vascular disease is more prominent later in life than earlier, the
life expectancy gain is greater for the elderly than for the young.
Mortality improvements due to a change in a cause of death may
vary by age.
There is no definitive data set to say what the function A
s
(x)
should look like. Practitioners will use a conservative choice, de-
pending on the products being modeled. If you think the shape
shown in Fig. 2 may be more realistic in the future, you must be-
lieve that there is little mortality improvement for the very young
and very old.
Furthermore, the annual mortality rate over a long period
(e.g. twenty years) may continue to improve at a much higher rate
246 S.H. Cox et al. / Insurance: Mathematics and Economics 46 (2010) 242–253
0.030
0.040
0.050
0.060
0.070
0.080
0.090
0.100
0.110
1901 1921 1941 1961 1981 2001
Fig. 3. Actual force of mortality µ(75, t) for age 75 in year t. The vertical axis stands
for force of mortality and the horizontal axis represents year.
than that in other periods, leading to a steeper downward-sloping
force of mortality curve. For example, the annual percentage de-
crease in death rates for the US population aged 55 and above in
the 1970’s, on average, is about three times that of the same age
cohort in other periods. This type of mortality improvement, in a
certain sense, is more significant than the one-time longevity jump
K(x, t). The data shows no one-time longevity surge across ages
(like a 20 percent decrease in µ(x, t) during one year), but that
does not mean there was no longevity risk. The cumulative effect of
unanticipated mortality improvement over an unexpectedly long
period of time obviously has a devastating effect on the financial
stability of pensions plans and annuity markets.
Therefore, we model this long-term decay in mortality rates
by introducing a trend reduction component D(x, t) defined as
follows:
D(x, t) =

i=1
ζ
i
(t − υ
i
)F
i
(x) exp(−ξ
i
(t − υ
i
))1
{t≥υ
i
}
, (2.6)
where υ
i
is the time of trend reduction event i. The time of the
trend reduction event υ
i
can be modeled like the time η
s
, which
we discussed after Eq. (2.5). The percentage change in µ(x, t) is
the log µ-ratio, log
µ(x,t+1)
µ(x,t)
. When a trend reduction event occurs,
we calculate the difference between its average percentage change
in the trend reduction period and its average level in the whole
observation period. In Eq. (2.6), ζ
i
represents the maximum excess
change across ages given ζ
i
> 0. For instance, consider male
mortality in the 1970’s: age x = 0 had the biggest annual excess
longevity gain, 0.0211 above its average improvement from 1901
to 2005, so ζ
i
= 0.0211.
Like A
i
(x), the function F
i
(x), with 0 ≤ F
i
(x) ≤ 1, distributes age
effects. Given ζ
i
= 0.0211, we have F
i
(0) = 1 in the 1970’s. Based
on the historical data, we can obtain other F
i
(x)’s. For example,
F
i
(75) = 0.3723 for age 75. This means µ(75, t) decreases by
an excess 0.0211 × 0.3723 × 100 = 0.79% per year during this
trend reduction period. Moreover, the factor (t − υ
i
) provides
cumulative mortality improvement as t increases beyond the jump
event time υ
i
.
How long the aforementioned mortality trend reduction will
last in the future is a topic for debate: ten years, twenty years or
even longer? The parameter ξ
i
> 0 specifies the length of trend
reduction event i. Should one believe that history will reflect the
future, when ζ
i
= 0.0211 and F
i
(75) = 0.3723, for example, one
might choose ξ
i
= 0.01. In this case, when an unexpected medical
advancement causes an annual excess decrease in µ(75, t), the
force of mortality curve for age 75 will have a notable steeper
downward slope for about 35–40 years, the pattern similar to the
curve for age 75 after year 1970 in Fig. 3.
Fig. 4. Pandemic effect by age.
2.2.2. Temporary adverse mortality jump H(x, t)
The transitory mortality jump process H(x, t) is defined as
follows:
H(x, t) =

j=1
b
j
B
j
(x) exp(−κ
j
(t − τ
j
))1
{t≥τ
j
}
, (2.7)
where τ
j
is the time of adverse mortality event j. The time of the
adverse mortality event can be modeled like the time η
s
, which we
discussed after Eq. (2.5). The basic effect of a pandemic is modeled
using a Poisson process with a jump size b
j
> 0, where b
j
is
the maximum severity of jump event j. The function B
j
(x), with
0 ≤ B
j
(x) ≤ 1, distributes mortality jump impact across ages. B
j
(x)
can be random to reflect various age effects for different types of
events or it canalsobe deterministic. For example, the specification
of B
j
(x) in Fig. 4 would apply to a pandemic for which the bulk of
the mortality spike is under a certain age (for example, under age
50, as is the case for deaths in the 1918 worldwide flu).
Since modeling the transitory nature of mortality jumps is
important in practice, we introduce a nonnegative deterministic
function exp(−κ
j
(t −τ
j
)) in Eq. (2.7) with κ
j
> 0. The higher κ
j
the
faster the jump effect will die out.
8
We can estimate κ
j
to fit the
historical data and make the mortality jump only have the impact
over a reasonable short period of time.
2.3. Comment on estimation issues
The primary motivation for the model that we have presented is
to provide a flexible and realistic model that can be used to capture
adverse mortality and longevity risks in a business application. In
order to allow for these effects in a manner that can be compared
to the historical data, a fair number of parameters need to be
included. This poses significant estimation challenges. Our method
of estimation/calibration can best be described as follows:
(1) Estimate the original Lee–Carter model based on the available
data;
(2) Calibrate the A, B and F functions to approximate past history.
If the primary focus is on pandemics, one would look at how
the mortality effects were distributed across ages and calibrate
accordingly;
(3) Calibrate the jump frequency for the point processes driving
mortality changes in a range that is consistent with history. For
example, one can use the historical frequency of pandemics as
a guide to setting the jump frequency.
8
In general, κ
j
is much larger than ξ
i
because of the temporary effect of a
catastrophe mortality event and the long-term impact of unexpected mortality
improvement.
S.H. Cox et al. / Insurance: Mathematics and Economics 46 (2010) 242–253 247
0.2
0.4
0.6
0.8
1.0
20 40 60 80 100
0.2
0.4
0.6
0.8
1.0
20 40 60 80 100
Fig. 5. The left figure is the function F(x), the normalized annual excess percentage decrease in µ(x, t) for different ages in the 1970’s. The right figure is the function B(x),
giving the impact of the 1918 worldwide flu on µ(x, t) across ages.
In financial and economic applications of jump-diffusion type
models, one issue that emerges is how to appropriately disentan-
gle the diffusion from the jump dynamics. The problem is acute in
the modelling of stock market returns because one generally intro-
duces jumps into the model with the idea of picking up ‘‘crashes’’
suchas 1929, 1987or 2008, but what canhappenis that the estima-
tion of such a model produces a preponderance of high frequency
lowseverity jumps rather than the intuitively pleasing outcome of
fairly smooth diffusion behavior punctuated by occasional severe
jumps. In our model, we are focused on mortality rather than eq-
uity returns but the same question can be asked. While we do not
have an estimation procedure that simultaneously sorts out the
diffusive and jump parameters of our model, we do feel that the
infrequent occurrence of severe adverse mortality events makes
our imposed reconciliation of the diffusion and adverse mortality
jumps reasonable. In the case of possible longevity jump compo-
nents, we are not able to reliably measure the extent to whichjump
behavior is present. Insofar as the stochastic features of the model
can be ascertained for a given parameterizations, the user of the
model can, at the very least, perform risk management functions
for a range of life insurance products in plausible mortality scenar-
ios.
In sum, while our model can generate a rich set of scenarios,
it does pose a serious estimation challenge. This is especially so
because of the relative paucity of extreme events in mortality data
sets. Indeed our goal is to allow for scenarios reflecting expert
judgment about these events, which may not be the same as the
data. For example, our approach allows one to set the frequency of
a severe 1918-like flu so that it is a 1 in 25 year event, even though
such a flu has been observed only once in 100 years. Therefore,
‘‘estimation’’ of this model requires a combination of traditional
estimation techniques and expert judgment.
2.4. Parsimonious model
For the Lee–Carter base model, substituting in Eq. (2.3) for
µ
LC
(x, t), Eq. (2.4) becomes
µ(x, t) = exp [a(x) + b(t)k(t) − G(x, t) + H(x, t)]
= exp [a(x) + b(t)k(t)] exp
_

s=1
y
s
A
s
(x)1
{t≥η
s
}
_
× exp
_

i=1
ζ
i
(t − υ
i
)F
i
(x) exp(−ξ
i
(t − υ
i
))1
{t≥υ
i
}
_
× exp
_

j=1
b
j
B
j
(x) exp(−κ
j
(t − τ
j
))1
{t≥τ
j
}
_
. (2.8)
A permanent longevity jump can be driven by the one-time
component K(x, t) that substantially reduces µ(x, t) withina short
period of time, but it can also come from the trend reduction com-
ponent D(x, t) that accumulates the excess mortality improvement
over a long time. As discussed in Section 2.2.1, of these two com-
ponents, D(x, t) seems to play a more important role, especially
for ages above 65—the age range we are very interested in for
longevity risk. Accordingly, we provide a parsimonious version of
our model,
µ(x, t) = exp [a(x) + b(t)k(t)]
× exp
_

M(t)

i=1
ζ
i
(t − υ
i
)F
i
(x) exp(−ξ
i
(t − υ
i
))1
{t≥υ
i
}
_
× exp
_
N(t)

i=1
b
j
B
j
(x) exp(−κ
j
(t − τ
j
))1
{t≥τ
j
}
_
. (2.9)
In Eq. (2.9), the permanent longevity jump is only a function of the
trend reduction component. The process M counts mortality trend
reduction jumps; and M(t) is the number of such jumps by time t.
Similarly, the process N(t) counts the number of catastrophe death
events by time t. Evidently, Eq. (2.9) can be further simplified to
this:
µ(x, t) = exp [a(x) + b(x)k(t)]
× exp
_
−ζ F(x)
M(t)

i=1
(t − υ
i
) exp(−ξ(t − υ
i
))1
{t≥υ
i
}
_
× exp
_
bB(x)
N(t)

i=1
exp(−κ(t − τ
j
))1
{t≥τ
j
}
_
, (2.10)
assuming constant mortality and longevity jump effects for age x.
2.5. Example
Belowwe showhowto apply the parsimonious equation (2.10)
to model mortality dynamic process. All of our estimates are based
on the aforementioned US male population mortality tables from
1901 to 2005. As we noted earlier, we begin by using the data to
estimate the Lee–Carter model.
The importance of the impact of medical advancement on
pension plans and annuity insurers should not be underestimated.
Trend reduction factors in our model provide for such mortality
improvements. The 1970’s were the years of accelerating decline
of mortality for most ages, so our trend reduction parameters are
estimated from this period. The left graph of Fig. 5 shows our
estimated F(x) for different ages based on the data from 1970 to
1979. As mentioned in Section 2.2.1, age 0 had the highest average
annual excess mortality decrease rate ζ = 0.0211, so F(0) = 1.
However, we can observe mortality declines at high excess rates
mostly at the older ages. On the other hand, during the 1970s,
248 S.H. Cox et al. / Insurance: Mathematics and Economics 46 (2010) 242–253
5 0 1 2 5 8 0 2 5 6 0 2 5 4 0 2 5 2 0 2 5 0 0 2
0 0 0 . 0
5 0 0 . 0
0 1 0 . 0
Fig. 6. These are simulated sample paths of the force of mortality, based on
Eq. (2.10) and the parameters described earlier. The top path is the simulated force
of mortality µ(60, t), the one just below it is µ(50, t), then µ(40, t) and µ(30, t).
mortality increased for some male young ages, perhaps due to an
increase in homicides, suicides, and accidents. If an age does not
have an excess mortality decrease rate, we set their F(x) = 0. Since
the annuity benefits in general are distributed mostly in the older
age ranges, their unexpected improvement in life expectancy will
have a great bearing on the overall impact of the longevity event.
Furthermore, based on the historical data, we specify the trend
reduction event arrival rate λ
ν
= 0.01 and the duration parameter
ξ = 0.01.
The 1918 worldwide flu is considered the most severe flu
epidemic. Naturally, it serves as the basis for the estimation of our
temporary adverse mortality jump parameters. The right graph of
Fig. 5 presents B(x), the normalized log µ-ratio in 1918 relative to
1917 for different ages. The 1918 fluincreasedthe one-year force of
mortality for different ages very unevenly. The flustruck ages 0–50,
especially ages 20–40, seriously, while there were no excess deaths
at the ages above 53. According to Taubenberger and Morens
(2006), these older people survived earlier flu epidemics and may
have acquired immunity to the flu virus. Among all ages, age 28 has
the highest log µ-ratio, which is the value for b. Specifically, b =
0.9647 and F(28) = 1. Since the 1918 flu is approximately a one-
in-one-hundred-year event, λ
τ
= 0.01. Moreover, this pandemic
only lasted a couple of years so κ = 1 is reasonable.
With the observed force of mortality for age x in year t = 2005
as the base case, sample paths of µ(x, t) for ages 30, 40, 50 and 60
in one simulation iteration are in Fig. 6. They highlight three major
features of our model: first, effects of both mortality improvement
and deterioration jump factors are clear. For example, the curve of
µ(40, t) has a steeper downward slope that starts in year t = 2027
and lasts for about 20 years (its trend reduction longevity jump
D(40, t) illustrated in the left graph of Fig. 7). Moreover, age 40
has a sharp increase in µ(40, t) in year t = 2014 but µ(40, t)
falls back to the normal level afterwards (its temporary jump factor
H(40, t) shown in the right graph of Fig. 7). Second, the movement
of different µ(x, t)’s are correlated among different ages and over
time. This is partially attributed to the functions F(x) and B(x).
Third, F(x) and B(x) also distribute uneven effects of a mortality
jump across different ages. Based on the historical data, in our
model, the adverse mortality jumps mainly strike younger ages
while the older ages enjoy more excess survival gains.
All parameters of the example shown in the above example
are estimated from the historical data. This is a problem that we
will want to carefully consider, as opinions vary widely regarding
future healthcare systemandpandemic. The shape of the mortality
curve often changes in different mortality or longevity jump
events. Toole (2007) concludes that the typical distribution of
excess death rates for seasonal influenza is U-shaped; that is,
‘‘excess deaths are heaped at age 0, quickly decrease to close to
zero until they start to increase again at older ages (typically age
65) with a rapid rise at ages 85 and older’’. However, the 1957
pandemic showed a spike in excess death rates at ages 65 and older
but there were no excess death at age 0 (Luk et al., 2001). Another
exception is the 1918 worldwide flu as mentioned earlier: there
were no excess deaths at ages above 65. It is important to note our
model can flexibly estimate the impact of a particular jump pattern
by adjusting F(x) and B(x) based on different opinions or updated
information.
The parsimonious model (2.10) does not include the jump re-
duction component K(x, t) since there is no clear historical evi-
dence to guide us on its pattern. As long as the estimates of y, A(x)
as well as the jump intensity are developed based on judgment, it
is not difficult to include K(x, t) in a richer model. An illustration
is provided in the next section.
2.6. A simple model
Although we envision the primary role of our model as a risk
management tool for the generation of a robust set of plausible
mortality scenarios, it is possible to calibrate the model to behave
in a manner that is qualitatively similar to the basic Lee–Carter
model. This can be done using jump events in longevity and
adverse mortality and a fixed base mortality rate, resulting in a
simple model of the form
µ(x, t) = µ(x, 0) exp (−K(x, t) + H(x, t)) . (2.11)
We calibrated this model by taking µ(x, 0) as the force of mortality
as of 2005 from the data that we have discussed above. We then
used the forces of mortality for the period 1965 through 2005
to estimate average rates of mortality improvement by age. We
calibrated the adverse mortality effects as was done inthe previous
section. This led to the functions A(x) and B(x) shown in Fig. 8.
One can use the improvement in mortality to identify aver-
age rates but it is not clear how one can identify the frequency
with which longevity events occur. For the purposes of this sim-
ple example, we use a Poisson process with intensity 0.50 to model
0 0 . 0
0 1 . 0
0 2 . 0
0 3 . 0
0 4 . 0
0 5 . 0
0 6 . 0
5 0 1 2 5 8 0 2 5 6 0 2 5 4 0 2 5 2 0 2 5 0 0 2
0 0 . 0
5 0 . 0
0 1 . 0
5 1 . 0
0 2 . 0
5 2 . 0
0 3 . 0
5 3 . 0
0 4 . 0
5 0 1 2 5 8 0 2 5 6 0 2 5 4 0 2 5 2 0 2 5 0 0 2
Fig. 7. This shows the trend reduction longevity jump D(40, t) for age 40 (left) based on Eq. (2.6) and temporary adverse mortality jump H(40, t) (right) based on Eq. (2.7).
These are the ones used in the simulated paths shown in Fig. 6.
S.H. Cox et al. / Insurance: Mathematics and Economics 46 (2010) 242–253 249
0.6
0.8
1.0
0.0
0.2
0.4
0.2
0.4
0.6
0.8
1.0
0 20 40 60 80 100
20 40 60 80 100
Fig. 8. The functions A(x) and B(x) for a very simple calibration process. The left figure is the function A(x), the normalized annual average rates of mortality improvement
in µ(x, t) for different ages. The right figure is the the function B(x), giving the impact of the 1918 worldwide flu on µ(x, t) across ages.
0.000
0.005
0.010
2005 2025 2045 2065 2085 2105
Fig. 9. Evolution of mortality for a simple model, based on Eq. (2.11) and the
parameters described earlier. The top path is the simulated force of mortality
µ(60, t), the one just below it is µ(50, t), then µ(40, t) and µ(30, t).
longevity jumps and a jump size y = 0.06506. Although we know
what the product of these two values ought to be, we cannot iden-
tify them individually. Consequently, one must judge the parame-
ters by the qualitative features of the model.
Fig. 9 shows simulated mortality trajectories for the model
parameters that we have described. If one compares this with the
trajectories from the basic Lee–Carter model, they are similar in
their longevity behavior.
3. Securitization of mortality and longevity risks
3.1. Market development
Financial innovation has led to the development of several
classes of mortality securities. The Swiss Re bond, the first pure
death-risk linked deal, was issued in December 2003 (Stanley,
2003; Swiss Re, 2003; The Actuary, 2004). After successfully issuing
the first-ever pure death-linked security, Swiss Re sold two new
mortality bonds with different tranches in April and December
2006 (Lane, 2006). Following Swiss Re, some life insurers started
to reduce their extreme mortality exposures through financial
markets. For example, in May 2006 Scottish Re sold a mortality
bond with two tranches via a special purpose vehicle called Tartan
Capital Ltd., and in November 2006, AXAissued its first catastrophe
mortality deal—the Osiris bond (Lane and Beckwith, 2007). See
Bauer and Kramer (2007) for more details.
Capital market solutions for unanticipated longevity risk have
been explored relatively recently, first appearing in articles by
Blake and Burrows (2001), Milevsky and Promislow (2001), Lin
and Cox (2005) and others. Possibly inspired by the successful
securitization of catastrophe mortality risks, in November 2004,
the European Investment Bank (EIB) offered the first longevity
bond to provide a solution for pension plans to hedge their long-
term systematic longevity risks. Unlike the Swiss Re mortality
bond, the EIB longevity bond did not sell. The design of the EIB
bond may be problematic. The EIB bond provides ‘‘ground up’’
protection, covering the entire survival payment. Since the plan
can predict the number of survivors to some extent, especially
in the early contract years, a more satisfactory solution may be a
hedge using, for example, J.P. Morganq-forwards witha settlement
date 10 or more years in the future, rather than hedging the whole
benefit liability.
3.2. J.P. Morgan q-forwards
A q-forward contract requires, at maturity, an exchange of a
fixed amount based on the predetermined mortality rate, in return
for a variable amount based on a realized mortality rate published
at a specified future date by J.P. Morgan, in the LifeMetrics system.
9
Coughlan et al. (2007) describe an example with a 10-year q-
forward written on the one-year death rate q
65
for males aged x =
65 in England & Wales. See Table 2 for a summary. The example
provides a longevity hedge for the XYZ pensionplan. The q-forward
was opened on December 31, 2006 with a notional amount of
£50,000,000 and a fixed death rate q
65
= 1.2%. The floating-rate
payer XYZ pays an amount proportional to the mortality rate at
maturity on December 31, 2016, determined by the reference rate
in 2015.
At maturity, the contract is settled at the net amount, which is
the difference between the fixed amount and the floating amount.
For example, if the reference rate is only 1%, then XYZ Pension gets
£10,000,000 at settlement of the q-forward contract, calculated as
the net settlement amount:
Net settlement = Fixed amount − Floating amount
= 50,000,000 × 1.2% × 100 − 50,000,000 × 1% × 100
= £10,000,000.
Better mortality means fewer than 1.2% of those aged 65 in 2015
die within the year, and XYZ will have more than expected pension
benefits to pay if it has a similar experience. If the reference rate is
higher than the fixed rate 1.2%, the settlement is negative and XYZ
pays J.P. Morgan. In this case, mortality increases and it is likely
that the pension plan pays lower pension benefits.
Life insurers canuse q-forwards tohedge mortality risk ina sim-
ilar way. In summary, insurers or pension plans can take a position
9
Available at www.lifemetrics.com.
250 S.H. Cox et al. / Insurance: Mathematics and Economics 46 (2010) 242–253
Table 2
An illustration for a q-forward to hedge longevity risk for a pension plan, described by Coughlan et al. (2007).
Notional amount GBP 50,000,000
Trade date December 31, 2006
Effective date December 31, 2006
Maturity date December 31, 2016
Reference year 2015
Fixed rate 1.2%
Fixed amount Payer J.P. Morgan
Fixed amount GBP 60,000,000 = 0.012 × 50,000,000
Reference rate LifeMetrics male q
65
in the reference year for England & Wales national population
Floating amount Payer XYZ
Floating amount Notional amount × Reference rate × 100
Settlement Net settlement = Fixed amount − Floating amount
(as fixed amount payer or floating amount payer) in q-forwards to
hedge their liability to pay benefits to their clients.
The q-forward contract could be modified to create q-calls
and q-puts. There are two practical problems with the q-forward
(or analogous options). When the q-forward is opened in 2005,
XYZ has to estimate the number of survivors to age 65 in 2015
in order to determine the size of the hedge. While XYZ may be
more concerned about rates 10 years in the future, they also have
longevity risk during the 10year contract periodbeginning in2005.
The example only hedges survivor risk from age 65 to age 66.
The other problem is that it is difficult to extend the q-forward
hedge. The example covers survivor risk only for one year. While
XYZ could opena portfolio of q-forwards on the indices q
64+k,2014+k
for k = 1, 2, . . . , it would also have to forecast the number of
survivors to each age in order to determine the size of each q-
forward contract. This gets more difficult as the hedge is extended
because of the problem of estimating the number of survivors,
exactly the risk the q-forward is supposed to hedge.
3.3. Securities based on a longevity index
Consider the XYZ plan again. As before, XYZ has a liability to
make payments to a plan’s participants who survive to age 66
in 2016. When the longevity security is opened in 2005, those
participants are age 55. XYZ knows the number of participants,
their gender, and projected benefits, so there is no problem in
determining the size of the hedge. Let us consider one participant
with 1 unit of annual benefit paid at age 66 in 2016.
In its funding calculations, XYZ will have an estimate of the
probability that a participant now age 55 survives to age 66,
denoted
11
p
xyz
55
. The index allows XYZ to hedge underestimating
this value (and underfunding its liabilities).
The index for this hedge is based on the government or Lifemet-
rics series of future death probabilities q
55,2005
, q
56,2006
, q
57,2007
,
. . . , q
65,2015
, published each year from 2006 to 2016. The first in-
dex value is p
55,2005
= 1 − q
55,2005
, published in 2006. The second
index value is
2
p
55,2005
=
_
1 − q
56,2006
_
p
55,2005
which is published in 2007. The subsequent index values are
calculated analogously. The index value for hedging the payment
in 2016 is
11
p
55,2005
=
_
1 − q
55,2005
_ _
1 − q
56,2006
_ _
1 − q
57,2007
_
· · ·
_
1 − q
65,2015
_
and it is based on the national population experience during the
hedge period from 2005 to 2015. XYZ can use the index directly
to hedge its payments to the cohort of plan participants age 55
in 2005. Forwards or options can be written on this index just as
easily as they might be written on q
65,2015
but with no problem
in determining the hedge size. Moreover, XYZ could just as easily
extend the hedge to the second benefit payment with an option on
the next index value
12
p
55,2005
.
For example, a call option could pay XYZ when the realized
population index
11
p
55,2005
, published in 2016, exceeds a strike rate
such as
11
p
xyz
55
(which the plan uses in 2005). The population index
is likely to be in the money in the same circumstances that the plan
has experienced unexpected increases in longevity, since the two
groups are subject to some of the same forces of mortality.
Using the population index, based on LifeMetrics or govern-
ment data, reduces moral hazard since the index is transparent
to all investors. However, basis risk may be a problem. Generally
pension plan participants have higher survival rates than the pop-
ulation as a whole. However, XYZ could estimate this relationship
statistically and use this relationship to adjust its hedge. We show
how to price longevity options in the next section.
4. Mortality securitization modeling
Insurance-linked securitization, as an alternative risk manage-
ment method and a newinvestment opportunity, has gained more
and more attention from both scholars and practitioners. Accord-
ingly, to develop this emerging market, actuaries and financial
economists have begun to make considerable efforts to improve its
structure and take on the challenges to connect financial and insur-
ance pricing theories. The well-known capital asset pricing model
(CAPM) lacks the flexibility to be applied appropriately to heavy-
tailed insurance risks. On the other hand, many insurance princi-
ples lack the ability to produce arbitrage-free prices. To address
these problems, we use the indifference pricing method to price
mortality and longevity securities. To illustrate the idea, we com-
bine the indifference pricing method and our proposed stochastic
mortality model. We show how to estimate the risk aversion pa-
rameter, using annuity market data. Then, we use the estimated
parameter to price a longevity option. The same techniques can be
used to price other mortality securities.
4.1. Indifference pricing method
We consider longevity risk in a life-only single premium
immediate annuity (SPIA) for age x. We further assume the annuity
benefit is ¯ s, paid at the end of each period. Thus, the present value
of future annuity benefits for an annuity written on M lives (x
i
) at
time 0, for i = 1, 2, . . . , M is
X
i
= ¯ s

k
e
−kr
k
I
{T(x
i
)≥k}
, (4.1)
where r
k
is the default-free interest yield fromtime 0 to time k and
k runs over the payment times.
10
The aggregate present value is
Y =
M

i=1
X
i
. (4.2)
10
The notation I
A
is the indicator function taking the value 1 if the event A occurs
and the value 0 if not.
S.H. Cox et al. / Insurance: Mathematics and Economics 46 (2010) 242–253 251
The premium P per policy is to be determined from the equation:
E[u(w + MP − Y)] = u(w), (4.3)
where w is the wealth of the insurer prior to accepting the risk to
be priced. We use the exponential utility function,
u(w) =
1 − e
−αw
α
, (4.4)
where α is the risk aversion parameter of the insurer. The random
variable Y depends on the randompath of future force of mortality
values {µ(x + t, t) : t ≥ 0}, which can be simulated with our
model, using Eq. (2.10). The risk aversion parameter α in Eq. (4.3)
can be approximated using known insurance market prices. Under
our exponential utility function, the premiumimplied by (4.3) may
be expressed as
P =
1

log E
_
e
αY
_
. (4.5)
When calibrating to market data, we need to determine α so that
Eq. (4.5) is satisfied.
In the annuity pricing application we are considering, we are
pricing an aggregate annuity exposure for which the component
risks are identical but not necessarily independent. As we have
noted, the indifference premiumunder exponential utility is given
by (4.5). An approximation for P, which can be found in Gerber and
Pafumi (1998), can be made as
P ≈
1

_
αE[Y] +
1
2
α
2
Var(Y)
_
.
Since the aggregate loss is composed of M identical risks, E[Y] =
ME[X] and thus
P ≈ E[X] +
α
2M
Var(Y). (4.6)
The mortality is uncertain but it is reasonable to assume that, given
a mortality scenario Θ, the annuitant lives are independent. In this
case, the variance of Y is the sum of two terms:
Var(Y) = E[Var(Y|Θ)] + Var[E(Y|Θ)]
= E[MVar(X|Θ)] + Var[ME(X|Θ)]
= ME[Var(X|Θ)] + M
2
Var[E(X|Θ)].
The approximation becomes
P ≈ E[X] +
α
2
E[Var(X|Θ)] +

2
Var[E(X|Θ)]. (4.7)
When the mortality scenario is known (as in traditional actuarial
calculations with static tables), there is no variance in E(X|Θ),
the third term is zero, and the premium P per policy does not
depend on the number of polices M. However, in general, mortality
scenarios are uncertain and the premium P will depend on the
portfolio size M as indicated by (4.6). Moreover, even when the
lives are conditionally independent, given the mortality table, the
premium still depends on the size of the portfolio as indicated
by (4.7).
4.2. Estimating α from annuity prices
The Genworth Financial Group sold around $560 million of sin-
gle premiumindividual annuities in the US in 2005 with a monthly
payout rate of $6.40 per $1000 premium(Stern, 2008). We assume
that the policies are identical, issued to males age 65 with a gross
premium of $250,000. Since aggregate premium is $560 million,
then the number of policies is M = 560 million/250,000 = 2240.
0
500
1000
1500
2000
0 1000 2000 3000 4000 5000
Fig. 10. Genworth’s estimated utility function under the exponential utility model
for α = 4.8 × 10
−7
. The vertical axis represents utility and the horizontal axis
represents wealth, both in thousands.
We assume the underlying expense factor is 12.25%, which is
around the industry average, so the net premium per policy to the
insurer is
P = 250, 000 × (1 − 0.1225)
= $219,375.
Eq. (4.1) gives the present value of benefits for one life with ¯ s =
250 × 6.40 = $1600 per month.
We estimate the risk aversion parameter α from Eq. (4.5) by
simulation, with a ‘‘Monte Carlo simulation within a Monte Carlo
simulation’’. We start with a trial value of α = α
0
and estimate the
corresponding value of E(e
α
0
Y
) = E[E(e
α
0
Y
|Θ)]. First we generate
10,000 of scenarios Θ
j
. Then we simulate M = 2240 values of
e
α
0
Y

j
, for each j, and estimate E[e
α
0
Y

j
] with the sample mean.
The estimate of E
_
e
α
0
Y
_
is the mean of these sample means. This
is a very fast calculation. The corresponding model price, from
Eq. (4.1), is
P
0
=
1

0
log E
_
e
α
0
Y
_
.
We repeat the calculation with another trial value α
1
, then obtain-
ing P
1
. Then we use the secant method to find a third approxima-
tion,
α
2
= α
1

α
1
− α
0
P
1
− P
0
(P
1
− P) .
This process converges rapidly to α = 4.8 × 10
−7
. For the value
of α that was determined above, the unscaled utility function for
Genworth is shown in Fig. 10.
In this example, we used the population mortality tables rather
than annuity tables because we do not have a time series of annu-
ity tables. On a static basis, population mortality tables will tend to
underestimate the longevity risk in annuities relative to the appli-
cable set of annuity tables, thereby tending to create an overesti-
mate of α. However, we estimated α using Lee–Carter projections
for mortality fluctuations which embeds longevity risk. As we do
not knowthe mortality assumptions that Genworth used in setting
their annuity rates, this exercise must be viewed as an illustrative
approximation. The reason that we calibrated α using Lee–Carter
projections rather than the full model is that the full model induces
significantly thicker longevity tail risk than Lee–Carter projections
alone. Indeed, if α is estimated under the full model, a significantly
lower value of α is obtained because of the greater tail risk, and the
Genworth annuity premiums do not appear to contain a material
charge for this tail risk. It seems reasonable to believe that our esti-
mated α = 4.8×10
−7
can serve as an upper bound for Genworth’s
risk aversion to annuity longevity risk. Although we show how to
determine α with an annuity market quote, the same technique
can be applied to estimate life insurance risk aversion parameters.
We will use this value in the next section to estimate what
Genworth would pay for a longevity option.
252 S.H. Cox et al. / Insurance: Mathematics and Economics 46 (2010) 242–253
Table 3
10-year longevity call option prices with data generating process driven by our
model.
Strike rate p 0.775 0.780 0.785 0.790 0.795
Call price $1121,364 $924,288 $772,136 $652,506 $553,345
Table 4
10-year longevity call option prices with data generating process driven by the
Lee–Carter model alone.
Strike rate p 0.775 0.780 0.785 0.790 0.795
Call price $191,962 $77,070 $23,864 $5,522 $937
4.3. Longevity option price
Let us now illustrate the pricing of longevity options using in-
difference pricing with the pricing parameter α that we have pre-
viously derived fromannuity prices. Consider a 10-year call option
issued in December 2005 based on our longevity index
10
p
65,2005
as defined in Section 3.3 with a notional amount of $100,000,000
and a strike price of p. The dollar payoff from this longevity call at
maturity in 2015 may be expressed as
C =
_
100,000,000
_
10
p
65,2005
− p
_
if
10
p
65,2005
> p
0 otherwise.
(4.8)
Although one can attribute a ‘‘cohort’’ to the payoff amount, in
practice the owner of the option is most likely concerned with the
total dollar exposure as it relates to a pension fund or annuity pool
liability.
We apply Eq. (4.3) to price this longevity call option for a
mortality data generating process driven by our mortality model
and by the Lee–Carter model alone. In all cases, we assume that
the market risk aversion parameter is α = 4.8 × 10
−7
, in line
withthe estimate that was made for the GenworthFinancial Group.
Table 3 shows longevity call option prices for a range of strikes for
mortality driven by our model. Table 4 shows longevity call option
prices for a range of strikes for mortality driven by the Lee–Carter
model alone. For example, given the strike level p = 0.775 and the
US treasury discount factors for the 2005 calendar year,
11
our 10-
year longevity call option price equals $1121,364 if the mortality
data generating process is driven by our model.
Evidently, the nature of the mortality data generating process
is critical in assessing the risk in a longevity derivative contract.
In the trading of standardized equity and interest rate derivatives,
one discovers that market prices reflect a ‘‘smile’’. In simple terms,
one finds that is it far more expensive to purchase ‘‘lottery tickets’’
on equity indices or interest rates than basic theory suggests. If
the market for longevity derivatives should evolve to a level of
reasonable liquidity, it would not be surprising if similar effects
were observed. While no one can be certain of the true nature of
longevity risk, our model has shown that the presence of relatively
infrequent mortality improvements poses a significant risk. Fig. 11
shows a histogram of simulated values of
10
p
65,2005
for 1 million
draws using the full model. Fig. 12 shows a histogramof simulated
values of
10
p
65,2005
for 1 million draws using the Lee–Carter model
alone. Evidently, it is the right tail behavior that is driving the
differences between the prices of the longevity calls across the two
mortality data generating processes.
11
To be precise, we require discount factors that are representative of interest
rates for 2005. We take the average US treasury coupon-curve yields for 2005 as
published in the Federal Reserve’s H15 data set and strip them to produce zero-
coupon data. We then fit a Nelson-Siegel yield curve to this zero-coupon data which
can be extrapolated beyond the last observation. At this point we have a set of
discount factors that is representative of market conditions in 2005.
x 10
4
0
2
4
6
8
10
12
14
16
18
0.75 0.8 0.85 0.9
10-year Survival Probability for (65)
0.7 0.95
Fig. 11. Range of outcomes for
10
p
65,2005
under the full model.
x 10
4
0.74 0.76 0.78 0.8 0.72 0.82
10-year Survival Probability for (65)
0
1
2
3
4
5
6
7
8
Fig. 12. Range of outcomes for
10
p
65,2005
under the Lee–Carter model alone.
Reinsurance contracts typically have a cap on the reinsurer’s
liability. It is reasonable to anticipate that mortality traders may
follow this tradition. The typical reinsurance contract is analogous
to a call spread, with two calls having different strike prices.
Consider a call spread written on the survivor index
10
p
65,2005
, with
lower strike level, ‘‘attachment point’’, p
1
and an upper strike level,
or ‘‘detachment point’’, p
2
and a notional amount of $100,000,000.
The dollar payoff fromthis longevity call spreadat maturity in2015
may be expressed as
B =
_
_
_
100,000,000 (p
2
− p
1
) if
10
p
65,2005
≥ p
2
100,000,000
_
10
p
65,2005
− p
1
_
if p
1
<
10
p
65,2005
< p
2
0 if
10
p
65,2005
≤ p
1
.
(4.9)
Table 5 shows the longevity call spread option prices for a range
of strikes for mortality driven by our model. Note that the spreads
in Table 5 have different, decreasing seniorities due to decreasing
trigger and exhaustion levels. In particular, spread A has the lower
attachment and detachment points relative to the other spread
options, and thus it demands a higher price.
5. Summary
We have described a mortality model which provides a rich and
realistic space of sample paths of future mortality rates. The model
evolves as a dynamic process that combines a general mortality
S.H. Cox et al. / Insurance: Mathematics and Economics 46 (2010) 242–253 253
Table 5
Prices for 10-year longevity call spread options.
Spread A Spread B Spread C Spread D
Attachment point p
1
0.775 0.780 0.785 0.790
Detachment point p
2
0.780 0.785 0.790 0.795
Price $122,985 $70,405 $39,337 $25,835
trend, a diffusion process, a permanent longevity jump process,
anda temporary mortality jumpprocess. Furthermore, we describe
a parsimonious version of the model based on judgment and
historical mortality data available through the Human Life Table
Database and the Human Mortality Database. Another novel aspect
is that our model includes uneveneffects of a mortality or longevity
shock to different ages. In addition, the model is tractable enough
to allow path-by-path simulation which can be combined with
pricing techniques, as we illustrate with the indifference pricing
method. The model is well-suited to risk management application
where there is a need to test extreme but plausible mortality
scenarios.
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we cannot simply calibrate our models to the experience. h) is a random variable since it is the path integral over the sample path {µ(x + t . Statistical methods applied in actuarial practice use this same approach. Gründl et al. pension and annuity research has focused on longevity risk. Here is how we will model these events. We conclude the article in Section 5. Marocco and Pitacco (1998). Dynamic mortality model Stochastic mortality models usually start with the assumption that there is an ‘‘initial’’ curve for the force of mortality. t ) : t ≥ 0} evolving from an initial curve µ(x. Dahl (2004). we offer a flexible.4 Our paper is organized as follows. for which we will provide a detailed discussion later. In particular. t )..H.g. Finally. Therefore.html. However. Ballotta and Haberman (2006).g. Specifically. a permanent longevity jump process and a temporary mortality jump process. (2008) extend the Lee–Carter model with a time-varying. but in the long run longevity risk may be just as important. h)] . this is very complex. To describe the stochastic longevity trend. may be less dramatic than that of a mortality death shock. more people may survive than expected. the force acting during the life of a person age x at time t = 0 is a stochastic process {µ(x + t . Our model attempts to address these issues. actual mortality experience can change in a nondeterministic way and deviate from expected mortality rates. we propose a new approach by introducing a trend reduction jump component to describe longevity risk. is used to price life insurance and annuity polices. but with explicit mortality derivatives such as options which we think can be important tools in managing mortality and longevity risk. 1918 flu pandemic and the change in the rate of improvement of mortality around 1970. to obtain relevant results. the model specifies the force of mortality as a parametric function of age and time. as evident. In order to reduce the complexity. The force of mortality at time t > 0 is denoted µ(x + t . Models that have a random deviation from the expected mortality may reflect some longevity risk. 0 The probability S (x. The probability that (x) will attain age x + h is the expected value of the probability: Pr [T (x) > h] = E [S (x. h) = exp − 0 µ(x + s. cannot provide this kind of longevity risk. Moreover. The aggregate effect on (x) over the period (0. experts conjecture that we may experience extreme events of both types in the future. 3 http://www. • relatively rare advances in medical technology resulting in sudden and permanent improvements in mortality. respectively. t ) acting on (x + t ) at time t. including new structures. Most longevity risk events in the past seem to have a pattern. in general. t ) : 0 ≤ s ≤ h} of the force of mortality: h µ(x + t . . although somewhat complex. However. stochastic drift. the remaining life time random variable is denoted T (x). for example. of the force of mortality µ(x + t . In effect. because it depends on the sample path of the force of mortality: h S (x. This means that. Actual mortality has been improving. For a life (x) at time 0. • deviations from the general trends. 2007) offered by Goldman–Sachs3 and the Credit Suisse index. Derivatives can be written on indices based on publicly available data like the LifeMetrics index (Coughlan et al. leading to a steeper downward sloping force of mortality curve. Unanticipated improvements in medicine and health technology may give rise to longevity risk. so parametric models estimated with actual data will reflect improving mortality. this model may not be appropriate for modeling longevity (and mortality) shocks which may not follow a stationary Gaussian process. The traditional one-time jump models such as the model that combines a geometric Brownian process and a compound Poisson jump process. but longevity risk is not modeled explicitly. or observed death rates may be lower than expected. a stochastic mortality model must reflect three major features of the current mortality universe: (a) both mortality improvement and deterioration jump factors. Our model. comprehensive model in order to make a more realistic assessment of future survivor dependent cash flows. On the other hand. The expected value.qxx-index. Cox et al. Miltersen and Persson (2005). one or two years) or excess improvement over a long period (e. Loise and Serant (2007) model longevity (and mortality) risk use a stationary Gaussian process. leading to a surge in mortality improvement in a short period (e. Hári et al. (2006). the slope of the mortality curve may deviate from that of the base trend with normal deviations. Mathematically speaking. 2. We show how to price those securities with the indifference pricing method in Section 4.com/ib/en/fixed_income/longevity_index. Biffis (2005) captures mortality random departures around a time-varying target with a longevity compound Poisson process. or forecast value. In those papers. with a small number of parameters. (2006). (b) correlation among different ages and over time. We continue in the same vein. Dahl and Møller (2006). more than ten years). t )dt . (2006) examine a wide variety of longevity bonds. However. 0) = µ(x). h) that (x) will attain age x + h is random at time 0. US mortality data has only two extreme events. unexpected survival gains often extended over a long period of time. Cairns et al. 4 http://www. but that model cannot guarantee a nonnegative force of mortality. Among the reasons for changes in the force of mortality are the following: • general trends in health and mortality resulting in gradual improvements to mortality. in investigating the impact of possible future events. For longevity events with a long-term effect. we are explicitly combining both mortality and longevity risk in a single. in the US population mortality dynamics in the 1970’s. Biffis and Millossovich (2006) and Bauer and Kramer (2007) focus on mortality risk as deviations from a trend. method of including expert opinion in forming future mortality scenarios. and (c) uneven effects of a mortality jumps across different ages.S. In Section 2 we describe mortality dynamics as a combination of a Lee–Carter diffusion process. In Section 3 we discuss capital market solutions for mortality and longevity risk. Unexpected longevity improvement. with our proposed longevity index. Blake et al. s)ds .credit-suisse. given T (x) > t. Milevsky and Promislow (2001). the base trend may reflect mortality improvements. and • sudden catastrophic surges in mortality from events such as pandemics resulting in temporary increases in mortality. As an application to mortality risk management. allows for such fundamental changes.com. but this is not a reflection of a fundamental change in the trend (as we have in mind). / Insurance: Mathematics and Economics 46 (2010) 242–253 243 On the other hand. we show how to determine a parsimonious version with historical data.

9908 −5. q(x.7227 −4.4290 −2.0398 0.244 S.1422 −6.0960 −5. Modeling general mortality trends We adopt the well-known Lee and Carter (1992) mortality model as a basis.0423 0.0822 −3.3986 −7.0295 0.0298 0.0393 0. The force of mortality µLC (x.9509 −4.4259 −5. This model captures the evolution of mortality in mutually exclusive age cohorts.1820 0. For reasonable assumptions about the distribution of deaths between age x and x + 1.0242 −4.8122 −0.6228 −0. Available at www.4695 −1. Cox et al. We believe that our ideas illustrated below could be applied to them as well by using the original Lee–Carter model.1017 0.8732 −5. .0841 0.3116 −1. Following Lee and Carter (1992).3015 −5.9251 −1.0655 0.0453 0. Simulating mortality scenarios with the Lee–Carter model. 1992.1736 0.8509 −1..0396 0. Available at www.8779 −0.0544 0. the two measures are the same or very close. 1.0934 0.0370 0. .2612 −4.2492 −2.0410 0.0903 0.0687 0. t ).1100 0.0828 −1. Under the same assumption.6262 −1.2240 −7.humanmortality.0593 0.0471 0. University of California.4739 −3.2269 0. 2005 (2. and Max Planck Institute for Demographic Research (Germany).0986 0.0352 0.1687 −2.6519 −5.1041 −4. using the technique 5 Lee and Carter use the central death rate rather than the force of mortality.9207 −2. t ). Renshaw et al.0022 −1.0440 0.3380 −4. .3970 −3.1113 0. (2.3661 −5.0269 0. .1091 0.1572 −1.1. 1902.1) The parameters a(x) and b(x) are age-specific while k(t ) is time varying.2). 7 Data source: Human Mortality Database.1614 −3.0303 0.7025 −1.2287 0. we explicitly model both mortality and longevity jump processes in a single model (See Section 2. Our model is inspired by. For example.6 Tables for 2000 to 2005 are from the Human Mortality Database. 103 and times t = 1901. it is natural to develop a model for mortality changes based on the evolution of the force of mortality with a general trend.4851 −5.1495 0. links all cohorts together. . The flu in 1918 is identified by a dummy variable.0618 −5. There are several generalizations of Lee and Carter (1992) model in the literature. Olivieri and Pitacco. z (1902).1278 0.0384 0. 2004.0621 0.3761 −7.5587 −0.0554 0.8537 −5.8663 −3.1883 0.0488 0. 6 Data source: Human Life Table Database. .9863 −7.0020 −2.0384 0. .2244.5230 Therefore.0812 0.1908 0. 2000.5442 −5. .8953 −5.3290 −7.6471 −4.7063 −3. t ) = 1 − e−µ(x.2336 −1.mortality.0375 0.8849 −5.0752 0. t ) = exp [a(x) + b(x)k(t )] .0270 0.7 The estimates of a(x) and b(x) are in Table 1 and the estimated k(t ) is shown in Fig. if the force of mortality is constant between integral ages.0262 0.0784 0.7575 −2. and closely related to. Cairns et al. .2273 −6.0265 0.1079 Age 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 a(x) b (x ) 0.1006 0.9457 −0.2000 −6. Berkeley (USA) and the Institut national d’études démographiques (France).0267 0.0277 0.8750 −4. . t ) is modeled as5 suggested by Lee and Carter (1992).2171 0. .1101 0. Age 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 a(x) b(x) 0.0532 0.1878 0.0282 0.4039 −5.0391 0. diffusion process and jump components. A number of recent studies have sought to model mortality trends involving both age-dependent and time-dependent terms (Lee and Carter.0391 0.de(data downloaded on June 8. . and 0 otherwise. t = 1901.0377 0.0506 0.0370 0.1099 0.0992 0. this stream of research.0274 0. .8191 −5.7830 −5.8855 −5. and σ are constants and z (1901).0966 0.1820 0. g2 = 2.0383 0.0721 0.0335 0. Milevsky and Promislow.t ) so we can easily change from q(x.9452 −3.6993 −5. .de (data downloaded on June 8. For convenience we now re-label the years so that year 2005 corresponds to t = 0.1039 0.2029 0.1092 0.0395 0. 1996. 2002.0265 0.5665 −6.1827 −4.0290 0.9989 −6. Tables for years 1901 to 1999 are from the Human Life Table Database.6955 −6. involves simulating future mortality index values k(t ) for t > 2005.3902 −6. For a person age x in 2005. (2. The database has values of q(x.8571 −6.0265 0.9028 −5.5990 −5. k(t ). . while at the same time a timeseries common risk factor.0934 0.6766 −2. 2001.5132 −2. University of California.6867 −0. Flu.8391 −2. We fit the model to the US male data for ages x = 0. t ) to µ(x.0834 −2.org or www.6267 −3. . Specifically.2354 −5.7715 −6. / Insurance: Mathematics and Economics 46 (2010) 242–253 Table 1 The estimates of a(x) and b(x) based on the US male population data from 1901 to 2005.5699 −4.8802 −5.0392 0.4928 −4.4151 −4.1737 0.5482 −1.5503 −3. Then we obtain the estimated g1 = −0.3429 −2. Sithole et al.1021 0.2527 −6.0268 0. 2008). 2005.6123.1666 −5. As an extension.0376 0.0319 0. 2.7502 −0.0944 0. Flu = 1 if t = 1918.0383 Age 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 a(x) b (x ) 0.1082 0.0142 −0.0381 0.0371 0. z (2005) are independent standard normal random variables. and σ = 0. in Eq.2612 0.1067 0.7435 −5.1043 0.0400 0.7774 −1.3906 −1.0521 0.7995 −4. 1.lifetable. 2006).2396 −3.2065.0222 −3.1111 −7. . 1902.9233 −5. g2 .0911 0.9019 −5.3189 −3..7859 −3.7038 −6.0903 0. Dahl.0959 0. we can generate µLC (x.4963 −6.1050 0.2374 0. the central death rate at age x and the force of mortality at age x are equal.0378 0.0249 −3. 2008). the mortality index k(t ) evolves as k(t + 1) = k(t ) + g1 + g2 × Flu + σ z (t ).0569 0.2) where g1 . Lee. 2000..0872 0.1061 0.0990 0. Max Planck Institute for Demographic Research (Germany).5950 −2.0309 0.H. Berkeley (USA).2).

00 Fig. 1. The simplest version would be the arrival times of a Poisson process. have a more severe but transitory effect on death rates. µLC (x + 2. we view sharp decreases in mortality as ‘‘permanent’’ events. T ). The unexpected mortality improvement that results from genetic. The jump reduction component K (x.3) to ages x > 103 after the first year. as described by Schoen (2006). compared to demography changes of the whole population in the 1970’s. When we add these two types of mortality jump events – G(x. like the 1918 worldwide flu and the 2008 earthquake in China. behavioral. t ). Furthermore. for instance. the annual mortality rate over a long period (e. .3) to x > 103 for t > 0. . t ). . 0). Accordingly. 1). µLC (x + T . 1902. Modeling mortality jumps Our goal is a stochastic mortality model suitable for dynamic financial analysis. t ) is the force of mortality from the Lee–Carter model (2. t ) = µLC (x. The primary difference between these two approaches lies in the ability of a Hawkes process to create event clustering. This approach results in the linear extrapolation of a(x) and b(x). where ηs is the time of jump reduction event s.3) 2. t ) – to the Lee–Carter force of mortality µLC (x. A second feasible choice would be a Hawkes process. often has a long-term effect on future mortality rates. the way we use the model requires extending Eq.055 − 0. . (2. medical advancement s has no effect on age x. t ). 103.5) µ(x. Cox et al. 2004.1. and view dramatic increases as ‘‘temporary’’ events such as pandemics. these short-term events drive up the death rate just for a couple of years. LC (2. a(x) = −7.43 + 0. t ) = exp [a(x) + b(x)k(t )] t > 0. .067x b(x) = 0.00 1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001 -5. . A natural approach is to simply extend both functions a(x) and b(x) linearly using the values for ages 90 to 103 as a basis for the extrapolation. . twenty years) may continue to improve at a much higher rate . t )) .g. When As (x) = 0. .H.00 245 5. t ) and H (x. the life expectancy gain is greater for the elderly than for the young. associated with aforementioned medical advances. When 0 < As (x) < 1. That is. 2005 in the horizontal axis.00 -15. the annual improvement in mortality of old ages in the same period is much more dramatic than that of young ages. taking into account the complexity of observed mortality dynamics. (2. Lee–Carter model scenarios for future values of the force of mortality as follows: For x = 0.00 0. other approaches might be necessary. (2. in which case the times would have gamma distributions. . bio-reliability. the benefits of the technology usually vary by age. t + 2). t ) × exp (−G(x. As (x) = 1 means age x enjoys the biggest mortality improvement (ys ) among all ages. Estimated time-series common risk factor k(t ) shown in the vertical axis for year t = 1901. Fig. Permanent longevity jump G(x. µLC (x + 1. and/or heterogeneity forces and constraints. . t ) The unexpected mortality improvement process G(x. many catastrophe death events. 0) = µ(x) observed in 2005 µLC (x. the function As (x) differentially spreads the mortality improvement across x’s because. t ). but the mortality falls back to the normal level afterwards. a year) with a permanent effect on longevity. . it captures the effects that fall between the above two extremes. (2. The time ηs can be modeled as the arrival time of the s-th event of a point process. .00 -10. 2. t ) is the one-time longevity jump induced by a surge in survival rates over a short period (for example. µLC (x. G(x. 2 may be more realistic in the future. the initial version of our model takes the form K ( x. t ) = s =1 ys As (x)1{t ≥ηs } . There is no definitive data set to say what the function As (x) should look like. For example. Mortality improvements due to a change in a cause of death may vary by age. It is defined as ∞ When we use the model to simulate future values of the force of mortality applying to a life age x at t = 0 over a period of T years µLC (x. The effect of ys is transferred to the mortality rates through a function As (x) for age x with 0 ≤ As (x) ≤ 1. Medical advancement by age. In fact. t ) + H (x. This is consistent with models with linearly changing mortality.3). Since cardiovascular disease is more prominent later in life than earlier. That is.0003x extending Eq. as described in Daley and Vere-Jones (2003). t ) = K (x. we need to provide for the cases for which x + j > 103 and j > 0. t ) consists of a jump reduction component K (x. In contrast. In many cases.2. environmental. In other words. depending on the products being modeled. when a medical advancement occurs. / Insurance: Mathematics and Economics 46 (2010) 242–253 10. In contrast. If you think the shape shown in Fig.S.4) where µ (x. We consider two types of mortality shocks: permanent jump G(x. 1. 2. you must believe that there is little mortality improvement for the very young and very old. Practitioners will use a conservative choice. t ) and temporary jump H (x. t ) and a trend reduction component D(x. The positive variable ys is the maximum mortality improvement of all ages in medical advancement event s.2. t ) + D(x. Cutler and Richardson (1998) find that improvement for the elderly was greater than for the young in the 1970’s as a result of a decrease in cardiovascular disease deaths. In applications for which ‘‘oldest-of-old mortality’’ is critical.

t ) The transitory mortality jump process H (x. In order to allow for these effects in a manner that can be compared to the historical data. when an unexpected medical advancement causes an annual excess decrease in µ(75. is more significant than the one-time longevity jump K (x. t ). The higher κj the faster the jump effect will die out. 3. / Insurance: Mathematics and Economics 46 (2010) 242–253 1921 1941 1961 1981 2001 Fig.8 We can estimate κj to fit the historical data and make the mortality jump only have the impact over a reasonable short period of time. distributes mortality jump impact across ages. Bj (x) can be random to reflect various age effects for different types of events or it can also be deterministic. than that in other periods.7) D(x. The basic effect of a pandemic is modeled using a Poisson process with a jump size bj > 0. Like Ai (x). when ζi = 0. The vertical axis stands for force of mortality and the horizontal axis represents year.100 0. under age 50. the force of mortality curve for age 75 will have a notable steeper downward slope for about 35–40 years. t ) during one year).3723 for age 75.070 0.3723 × 100 = 0. In this case.2. but that does not mean there was no longevity risk. 4 would apply to a pandemic for which the bulk of the mortality spike is under a certain age (for example. t ) for age 75 in year t. Moreover.2. t ) decreases by an excess 0. we calculate the difference between its average percentage change in the trend reduction period and its average level in the whole observation period. t ) = j =1 bj Bj (x) exp(−κj (t − τj ))1{t ≥τj } . Comment on estimation issues The primary motivation for the model that we have presented is to provide a flexible and realistic model that can be used to capture adverse mortality and longevity risks in a business application. (2) Calibrate the A. where τj is the time of adverse mortality event j. the specification of Bj (x) in Fig. Since modeling the transitory nature of mortality jumps is important in practice.040 0. t ) = i =1 ζi (t − υi )Fi (x) exp(−ξi (t − υi ))1{t ≥υi } . one would look at how the mortality effects were distributed across ages and calibrate accordingly. The time of the trend reduction event υi can be modeled like the time ηs . The cumulative effect of unanticipated mortality improvement over an unexpectedly long period of time obviously has a devastating effect on the financial stability of pensions plans and annuity markets. 3. The time of the adverse mortality event can be modeled like the time ηs . Given ζi = 0.0211 × 0. (2. This poses significant estimation challenges. (2.H. Therefore. the factor (t − υi ) provides cumulative mortality improvement as t increases beyond the jump event time υi . distributes age effects. log µ(x. How long the aforementioned mortality trend reduction will last in the future is a topic for debate: ten years.t +1) the log µ-ratio. κ is much larger than ξ because of the temporary effect of a j i catastrophe mortality event and the long-term impact of unexpected mortality improvement.5). with 0 ≤ Fi (x) ≤ 1.3723. we have Fi (0) = 1 in the 1970’s. 0.060 0.79% per year during this trend reduction period. t ) defined as follows: ∞ 2.090 0. 8 In general.0211 above its average improvement from 1901 to 2005. B and F functions to approximate past history. which we discussed after Eq.5). one might choose ξi = 0. in a certain sense. (2. where bj is the maximum severity of jump event j. (2. one can use the historical frequency of pandemics as a guide to setting the jump frequency. for example. Based on the historical data. with 0 ≤ Bj (x) ≤ 1. Cox et al.246 0. The percentage change in µ(x.3. t ) is µ(x. For example. the function Fi (x). The function Bj (x). For instance. The data shows no one-time longevity surge across ages (like a 20 percent decrease in µ(x. For example. In Eq. on average. . Temporary adverse mortality jump H (x. 2. This type of mortality improvement. ζi represents the maximum excess change across ages given ζi > 0. which we discussed after Eq. For example. leading to a steeper downward-sloping force of mortality curve. we introduce a nonnegative deterministic function exp(−κj (t − τj )) in Eq. Fi (75) = 0. Pandemic effect by age. Should one believe that history will reflect the future. consider male mortality in the 1970’s: age x = 0 had the biggest annual excess longevity gain. 4. as is the case for deaths in the 1918 worldwide flu). For example. When a trend reduction event occurs. (3) Calibrate the jump frequency for the point processes driving mortality changes in a range that is consistent with history.0211. is about three times that of the same age cohort in other periods. (2. we can obtain other Fi (x)’s.t ) . Fig. so ζi = 0.0211 and Fi (75) = 0. (2.0211.6).080 0. a fair number of parameters need to be included. the pattern similar to the curve for age 75 after year 1970 in Fig.01. t ).030 1901 S. we model this long-term decay in mortality rates by introducing a trend reduction component D(x. twenty years or even longer? The parameter ξi > 0 specifies the length of trend reduction event i.7) with κj > 0.110 0. the annual percentage decrease in death rates for the US population aged 55 and above in the 1970’s.6) where υi is the time of trend reduction event i. Our method of estimation/calibration can best be described as follows: (1) Estimate the original Lee–Carter model based on the available data. If the primary focus is on pandemics. This means µ(75.050 0. t ) is defined as follows: ∞ H ( x. Actual force of mortality µ(75.

t ).10) to model mortality dynamic process. (2. 5 shows our estimated F (x) for different ages based on the data from 1970 to 1979.6 0.H. age 0 had the highest average annual excess mortality decrease rate ζ = 0.0 1. and M (t ) is the number of such jumps by time t. The left graph of Fig. perform risk management functions for a range of life insurance products in plausible mortality scenarios. we provide a parsimonious version of our model. Example Below we show how to apply the parsimonious equation (2. However. of these two components. (2. the user of the model can.8) A permanent longevity jump can be driven by the one-time component K (x.0 247 0.8 0. Accordingly. (2. we are focused on mortality rather than equity returns but the same question can be asked. Eq. the permanent longevity jump is only a function of the trend reduction component.4 0. µ(x. This is especially so because of the relative paucity of extreme events in mortality data sets. t ) = exp [a(x) + b(t )k(t )] M (t ) × exp − i=1 N (t ) ζi (t − υi )Fi (x) exp(−ξi (t − υi ))1{t ≥υi } .S. we are not able to reliably measure the extent to which jump behavior is present. While we do not have an estimation procedure that simultaneously sorts out the diffusive and jump parameters of our model. The problem is acute in the modelling of stock market returns because one generally introduces jumps into the model with the idea of picking up ‘‘crashes’’ such as 1929. Therefore.8 0. even though such a flu has been observed only once in 100 years. t ) that accumulates the excess mortality improvement over a long time. For example. t ) across ages. 5.9). ‘‘estimation’’ of this model requires a combination of traditional estimation techniques and expert judgment. t ) within a short . Insofar as the stochastic features of the model can be ascertained for a given parameterizations. × exp i=1 bj Bj (x) exp(−κj (t − τj ))1{t ≥τj } (2. In our model. The left figure is the function F (x). In financial and economic applications of jump-diffusion type models.2.1. D(x. t ) that substantially reduces µ(x. substituting in Eq. As mentioned in Section 2.9) can be further simplified to this: µ(x. especially for ages above 65—the age range we are very interested in for longevity risk. which may not be the same as the data. Cox et al. at the very least. Trend reduction factors in our model provide for such mortality improvements. As we noted earlier.2 0. but it can also come from the trend reduction component D(x. The importance of the impact of medical advancement on pension plans and annuity insurers should not be underestimated. Similarly. Parsimonious model For the Lee–Carter base model. t ) = exp [a(x) + b(x)k(t )] × exp −ζ F (x) × exp bB(x) M (t ) (t − υi ) exp(−ξ (t − υi ))1{t ≥υi } . (2.2. we can observe mortality declines at high excess rates mostly at the older ages. the process N (t ) counts the number of catastrophe death events by time t. / Insurance: Mathematics and Economics 46 (2010) 242–253 1. (2. The process M counts mortality trend reduction jumps. µ(x. As discussed in Section 2.4 0. All of our estimates are based on the aforementioned US male population mortality tables from 1901 to 2005. The 1970’s were the years of accelerating decline of mortality for most ages.6 0. one issue that emerges is how to appropriately disentangle the diffusion from the jump dynamics.9) In Eq. t ) for different ages in the 1970’s. t ) + H (x.2 20 40 60 80 100 20 40 60 80 100 Fig.4) becomes LC period of time. giving the impact of the 1918 worldwide flu on µ(x. Eq. the normalized annual excess percentage decrease in µ(x. we do feel that the infrequent occurrence of severe adverse mortality events makes our imposed reconciliation of the diffusion and adverse mortality jumps reasonable.10) i =1 assuming constant mortality and longevity jump effects for age x.0211. our approach allows one to set the frequency of a severe 1918-like flu so that it is a 1 in 25 year event.4. In the case of possible longevity jump components. it does pose a serious estimation challenge. i=1 N (t ) exp(−κ(t − τj ))1{t ≥τj } (2. Evidently. Indeed our goal is to allow for scenarios reflecting expert judgment about these events. t )] ∞ = exp [a(x) + b(t )k(t )] exp − s =1 ys As (x)1{t ≥ηs } ∞ × exp − i =1 ζi (t − υi )Fi (x) exp(−ξi (t − υi ))1{t ≥υi } bj Bj (x) exp(−κj (t − τj ))1{t ≥τj } ∞ × exp j =1 .1. we begin by using the data to estimate the Lee–Carter model. On the other hand. 2. t ) seems to play a more important role. during the 1970s. In sum. so our trend reduction parameters are estimated from this period. while our model can generate a rich set of scenarios. The right figure is the function B(x).5. t ) = exp [a(x) + b(t )k(t ) − G(x.3) for µ (x. 1987 or 2008. but what can happen is that the estimation of such a model produces a preponderance of high frequency low severity jumps rather than the intuitively pleasing outcome of fairly smooth diffusion behavior punctuated by occasional severe jumps. so F (0) = 1. 2.

sample paths of µ(x.50 to model 0 . suicides. As long as the estimates of y. A(x) as well as the jump intensity are developed based on judgment. For example.01.2 5 0 .0 0 2005 2025 2045 2065 2085 2105 Fig. t ) has a steeper downward slope that starts in year t = 2027 and lasts for about 20 years (its trend reduction longevity jump D(40.1 5 0 . t ). (2.. Based on the historical data. these older people survived earlier flu epidemics and may have acquired immunity to the flu virus.0 0 5 0 . which is the value for b. we specify the trend reduction event arrival rate λν = 0. It is important to note our model can flexibly estimate the impact of a particular jump pattern by adjusting F (x) and B(x) based on different opinions or updated information.3 0 0 . their unexpected improvement in life expectancy will have a great bearing on the overall impact of the longevity event. λτ = 0. in our model. Cox et al. An illustration is provided in the next section. the movement of different µ(x. The parsimonious model (2. If an age does not have an excess mortality decrease rate. Since the 1918 flu is approximately a onein-one-hundred-year event. Another exception is the 1918 worldwide flu as mentioned earlier: there were no excess deaths at ages above 65. . However. ‘‘excess deaths are heaped at age 0. F (x) and B(x) also distribute uneven effects of a mortality jump across different ages. This shows the trend reduction longevity jump D(40. We then used the forces of mortality for the period 1965 through 2005 to estimate average rates of mortality improvement by age.1 0 0 .0 0 2005 time.3 5 0 . The 1918 flu increased the one-year force of mortality for different ages very unevenly. The shape of the mortality curve often changes in different mortality or longevity jump events. 7). With the observed force of mortality for age x in year t = 2005 as the base case. Moreover. the adverse mortality jumps mainly strike younger ages while the older ages enjoy more excess survival gains. 2001). the curve of µ(40. quickly decrease to close to zero until they start to increase again at older ages (typically age 65) with a rapid rise at ages 85 and older’’. t ) for ages 30. then µ(40. t ) shown in the right graph of Fig. t ) = µ(x. t )) . effects of both mortality improvement and deterioration jump factors are clear. This is a problem that we will want to carefully consider.10) and the parameters described earlier.6 0 0 . These are the ones used in the simulated paths shown in Fig. it serves as the basis for the estimation of our temporary adverse mortality jump parameters. 6. Toole (2007) concludes that the typical distribution of excess death rates for seasonal influenza is U-shaped.9647 and F (28) = 1. Since the annuity benefits in general are distributed mostly in the older age ranges. based on the historical data. while there were no excess deaths at the ages above 53. it is possible to calibrate the model to behave in a manner that is qualitatively similar to the basic Lee–Carter model. / Insurance: Mathematics and Economics 46 (2010) 242–253 0 .11) We calibrated this model by taking µ(x.6. t ). t ) and µ(30. 5 presents B(x). 6. t )’s are correlated among different ages and over 0 . and accidents. age 40 has a sharp increase in µ(40. All parameters of the example shown in the above example are estimated from the historical data. We calibrated the adverse mortality effects as was done in the previous section. that is.01. 2. t ) falls back to the normal level afterwards (its temporary jump factor H (40.0 1 0 0 . resulting in a simple model of the form µ(x. (2. t ) + H (x. the normalized log µ-ratio in 1918 relative to 1917 for different ages. 0) exp (−K (x. The top path is the simulated force of mortality µ(60. The flu struck ages 0–50.H. 40. mortality increased for some male young ages. the 1957 pandemic showed a spike in excess death rates at ages 65 and older but there were no excess death at age 0 (Luk et al. The 1918 worldwide flu is considered the most severe flu epidemic.0 5 2025 2045 2065 2085 2105 0 . based on Eq.3 0 0 . t ) since there is no clear historical evidence to guide us on its pattern. this pandemic only lasted a couple of years so κ = 1 is reasonable. Moreover. t ) (right) based on Eq. t ) in a richer model.01 and the duration parameter ξ = 0. we use a Poisson process with intensity 0. 0) as the force of mortality as of 2005 from the data that we have discussed above. 50 and 60 in one simulation iteration are in Fig.248 S. especially ages 20–40. Third. perhaps due to an increase in homicides. This is partially attributed to the functions F (x) and B(x).0 0 0 2005 2025 2045 2065 2085 2105 Fig. 7). 6.5 0 0 . This led to the functions A(x) and B(x) shown in Fig. According to Taubenberger and Morens (2006). b = 0. t ) illustrated in the left graph of Fig. 7.4 0 0 .10) does not include the jump reduction component K (x. age 28 has the highest log µ-ratio.6) and temporary adverse mortality jump H (40. seriously. 8. For the purposes of this simple example. t ) for age 40 (left) based on Eq.7). (2. (2. They highlight three major features of our model: first. One can use the improvement in mortality to identify average rates but it is not clear how one can identify the frequency with which longevity events occur. Specifically.2 0 0 . A simple model Although we envision the primary role of our model as a risk management tool for the generation of a robust set of plausible mortality scenarios. it is not difficult to include K (x. Among all ages. we set their F (x) = 0. t ). Furthermore. Naturally. the one just below it is µ(50. as opinions vary widely regarding future health care system and pandemic. These are simulated sample paths of the force of mortality. Second.4 0 0 . The right graph of Fig.1 0 0 . This can be done using jump events in longevity and adverse mortality and a fixed base mortality rate. t ) in year t = 2014 but µ(40.2 0 0 .

Swiss Re. AXA issued its first catastrophe mortality deal—the Osiris bond (Lane and Beckwith. At maturity. The example provides a longevity hedge for the XYZ pension plan. and in November 2006. they are similar in their longevity behavior. The design of the EIB bond may be problematic. the one just below it is µ(50. the EIB longevity bond did not sell. Possibly inspired by the successful securitization of catastrophe mortality risks. In summary. then XYZ Pension gets £10. Cox et al. covering the entire survival payment. For example. Lin and Cox (2005) and others. t ) and µ(30. Although we know what the product of these two values ought to be.6 0. The left figure is the function A(x).2%. in November 2004. Unlike the Swiss Re mortality bond. The right figure is the the function B(x).010 0. For example. the first pure death-risk linked deal.S.H. Market development Financial innovation has led to the development of several classes of mortality securities.2%. at maturity. 3. one must judge the parameters by the qualitative features of the model. (2. The floating-rate payer XYZ pays an amount proportional to the mortality rate at maturity on December 31.000. t ).000 × 1. Securitization of mortality and longevity risks 3.1. Life insurers can use q-forwards to hedge mortality risk in a similar way. Milevsky and Promislow (2001).000 at settlement of the q-forward contract.000 × 1% × 100 = £10.2% of those aged 65 in 2015 die within the year.0 0 20 40 60 80 100 20 40 60 80 100 Fig. Capital market solutions for unanticipated longevity risk have been explored relatively recently. / Insurance: Mathematics and Economics 46 (2010) 242–253 1.P. 2003. Fig.P. Evolution of mortality for a simple model. 2025 2045 2065 2085 2105 Fig. If one compares this with the trajectories from the basic Lee–Carter model. t ). If the reference rate is higher than the fixed rate 1.6 0. 2007). J. The Actuary. 2004).2 0. the European Investment Bank (EIB) offered the first longevity = 50. See Bauer and Kramer (2007) for more details. The functions A(x) and B(x) for a very simple calibration process.06506.000.4 0. we cannot identify them individually. a more satisfactory solution may be a hedge using. some life insurers started to reduce their extreme mortality exposures through financial markets. See Table 2 for a summary. Better mortality means fewer than 1. in May 2006 Scottish Re sold a mortality bond with two tranches via a special purpose vehicle called Tartan Capital Ltd. Consequently.2% × 100 − 50.8 0.P. for example.000. (2007) describe an example with a 10-year qforward written on the one-year death rate q65 for males aged x = 65 in England & Wales. and XYZ will have more than expected pension benefits to pay if it has a similar experience. In this case.11) and the parameters described earlier.000 2005 bond to provide a solution for pension plans to hedge their longterm systematic longevity risks. especially in the early contract years. in the LifeMetrics system.005 0.P. The top path is the simulated force of mortality µ(60.4 249 0. 9 shows simulated mortality trajectories for the model parameters that we have described. which is the difference between the fixed amount and the floating amount. Morgan q-forwards with a settlement date 10 or more years in the future.000. the normalized annual average rates of mortality improvement in µ(x. an exchange of a fixed amount based on the predetermined mortality rate. insurers or pension plans can take a position 9 Available at www.2 0. Following Swiss Re. 3. was issued in December 2003 (Stanley.0 1. The Swiss Re bond.com. The q-forward was opened on December 31.000. the contract is settled at the net amount. if the reference rate is only 1%. The EIB bond provides ‘‘ground up’’ protection. rather than hedging the whole benefit liability. first appearing in articles by Blake and Burrows (2001). 2006 with a notional amount of £50. t ) across ages.. giving the impact of the 1918 worldwide flu on µ(x. based on Eq. After successfully issuing the first-ever pure death-linked security.000 and a fixed death rate q65 = 1.2. Morgan q-forwards A q-forward contract requires. Morgan. t ). the settlement is negative and XYZ pays J. 8. Since the plan can predict the number of survivors to some extent.lifemetrics. in return for a variable amount based on a realized mortality rate published at a specified future date by J.8 0. Morgan. . Swiss Re sold two new mortality bonds with different tranches in April and December 2006 (Lane. 9. then µ(40. 2003.9 Coughlan et al. 2016.0 0.000. 2006). calculated as the net settlement amount: Net settlement = Fixed amount − Floating amount longevity jumps and a jump size y = 0. 0. J. determined by the reference rate in 2015. t ) for different ages. mortality increases and it is likely that the pension plan pays lower pension benefits.

2) 10 The notation I is the indicator function taking the value 1 if the event A occurs A and the value 0 if not. The first index value is p55. we use the estimated parameter to price a longevity option. For example.000. Thus. XYZ has to estimate the number of survivors to age 65 in 2015 in order to determine the size of the hedge. There are two practical problems with the q-forward (or analogous options). 2006 December 31. q65. based on LifeMetrics or government data. Generally pension plan participants have higher survival rates than the population as a whole. We further assume the annuity ¯ benefit is s. (4. we use the indifference pricing method to price mortality and longevity securities. To address these problems. The example covers survivor risk only for one year. .2% J.2006 .H.2015 1 − q56. However. Then.2005 = 1 − q55.10 The aggregate present value is M and it is based on the national population experience during the hedge period from 2005 to 2015. XYZ knows the number of participants. The q-forward contract could be modified to create q-calls and q-puts. When the longevity security is opened in 2005. (2007).2015 but with no problem in determining the hedge size. the present value of future annuity benefits for an annuity written on M lives (xi ) at time 0. While XYZ may be more concerned about rates 10 years in the future. This gets more difficult as the hedge is extended because of the problem of estimating the number of survivors. Morgan GBP 60.012 × 50.000 December 31. Forwards or options can be written on this index just as easily as they might be written on q65. as an alternative risk management method and a new investment opportunity. However. . Let us consider one participant with 1 unit of annual benefit paid at age 66 in 2016. basis risk may be a problem. their gender.000 LifeMetrics male q65 in the reference year for England & Wales national population XYZ Notional amount × Reference rate × 100 Net settlement = Fixed amount − Floating amount (as fixed amount payer or floating amount payer) in q-forwards to hedge their liability to pay benefits to their clients.2006 1 − q57. those participants are age 55. The well-known capital asset pricing model (CAPM) lacks the flexibility to be applied appropriately to heavytailed insurance risks. When the q-forward is opened in 2005. Cox et al. a call option could pay XYZ when the realized population index 11 p55. 3. / Insurance: Mathematics and Economics 46 (2010) 242–253 Table 2 An illustration for a q-forward to hedge longevity risk for a pension plan. The index allows XYZ to hedge underestimating 55 this value (and underfunding its liabilities).2005 . for i = 1. has gained more and more attention from both scholars and practitioners.2005 extend the hedge to the second benefit payment with an option on the next index value 12 p55.000.2005 ¯ Xi = s k e−krk I{T (xi )≥k} . we combine the indifference pricing method and our proposed stochastic mortality model. exactly the risk the q-forward is supposed to hedge. The subsequent index values are calculated analogously.1.000 = 0. published in 2016. . q57.P. 4. .2015 . . . 4. As before. Moreover. . 2. XYZ can use the index directly to hedge its payments to the cohort of plan participants age 55 in 2005. . The example only hedges survivor risk from age 65 to age 66.250 S. denoted 11 pxyz .2005 which is published in 2007. Notional amount Trade date Effective date Maturity date Reference year Fixed rate Fixed amount Payer Fixed amount Reference rate Floating amount Payer Floating amount Settlement GBP 50.000. The population index 55 is likely to be in the money in the same circumstances that the plan has experienced unexpected increases in longevity. since the two groups are subject to some of the same forces of mortality. While XYZ could open a portfolio of q-forwards on the indices q64+k. The same techniques can be used to price other mortality securities. Indifference pricing method We consider longevity risk in a life-only single premium immediate annuity (SPIA) for age x. XYZ will have an estimate of the probability that a participant now age 55 survives to age 66. . paid at the end of each period. XYZ has a liability to make payments to a plan’s participants who survive to age 66 in 2016. Accordingly. We show how to estimate the risk aversion parameter. and projected benefits. described by Coughlan et al. it would also have to forecast the number of survivors to each age in order to determine the size of each qforward contract. q56. using annuity market data. Securities based on a longevity index Consider the XYZ plan again. Using the population index.2014+k for k = 1. The index for this hedge is based on the government or Lifemetrics series of future death probabilities q55. In its funding calculations. published each year from 2006 to 2016. 2006 December 31. (4. . . to develop this emerging market.3. many insurance principles lack the ability to produce arbitrage-free prices. We show how to price longevity options in the next section.2005 1 − q65. M is = 1 − q56.2005 .2007 . exceeds a strike rate such as 11 pxyz (which the plan uses in 2005).1) = 1 − q55. The index value for hedging the payment in 2016 is 11 p55.2005 . XYZ could just as easily Y = i =1 Xi . 2016 2015 1. On the other hand. To illustrate the idea. reduces moral hazard since the index is transparent to all investors. so there is no problem in determining the size of the hedge. . 2. they also have longevity risk during the 10 year contract period beginning in 2005. XYZ could estimate this relationship statistically and use this relationship to adjust its hedge.2007 · · · where rk is the default-free interest yield from time 0 to time k and k runs over the payment times.2006 p55. . published in 2006. The other problem is that it is difficult to extend the q-forward hedge. The second index value is 2 p55. actuaries and financial economists have begun to make considerable efforts to improve its structure and take on the challenges to connect financial and insurance pricing theories.2005 . Mortality securitization modeling Insurance-linked securitization.

An approximation for P. In this example. and estimate E[eα0 Y |Θj ] with the sample mean.6). given a mortality scenario Θ . we used the population mortality tables rather than annuity tables because we do not have a time series of annuity tables. u(w) = 1 − e−αw 1500 1000 α .000 of scenarios Θj .40 = $1600 per month.2. even when the lives are conditionally independent. and the Genworth annuity premiums do not appear to contain a material charge for this tail risk. the premium still depends on the size of the portfolio as indicated by (4. Then we use the secant method to find a third approximation. The risk aversion parameter α in Eq. (4. using Eq. the indifference premium under exponential utility is given by (4.40 per $1000 premium (Stern. The vertical axis represents utility and the horizontal axis represents wealth. Since aggregate premium is $560 million.000 = 2240. which can be simulated with our model. in general. As we have noted. both in thousands. a significantly lower value of α is obtained because of the greater tail risk. It seems reasonable to believe that our estimated α = 4. We assume that the policies are identical.1). As we do not know the mortality assumptions that Genworth used in setting their annuity rates. P1 − P0 α 2 E[Var(X |Θ )] + Mα 2 Var[E(X |Θ )]. In this case. Although we show how to determine α with an annuity market quote. (4. from Eq. Then we simulate M = 2240 values of eα0 Y |Θj . 10. (4. population mortality tables will tend to underestimate the longevity risk in annuities relative to the applicable set of annuity tables. α E[Y ] + α 2 Var(Y ) . t ) : t ≥ 0}. the unscaled utility function for Genworth is shown in Fig. there is no variance in E(X |Θ ). then the number of policies is M = 560 million/250. (2. . (4. In the annuity pricing application we are considering. (4. the same technique can be applied to estimate life insurance risk aversion parameters.8 × 10−7 . We start with a trial value of α = α0 and estimate the corresponding value of E(eα0 Y ) = E[E(eα0 Y |Θ )].375. so the net premium per policy to the insurer is P = 250. This is a very fast calculation.8 × 10−7 .7). / Insurance: Mathematics and Economics 46 (2010) 242–253 251 The premium P per policy is to be determined from the equation: E[u(w + MP − Y )] = u(w). given the mortality table.H.1225) = $219. 4.4) 500 where α is the risk aversion parameter of the insurer. mortality scenarios are uncertain and the premium P will depend on the portfolio size M as indicated by (4. Genworth’s estimated utility function under the exponential utility model for α = 4. (4. Under our exponential utility function. For the value of α that was determined above. The estimate of E eα0 Y is the mean of these sample means. 2008). 000 × (1 − 0. (4. thereby tending to create an overestimate of α . Indeed. which is around the industry average. we need to determine α so that Eq. is P0 = 1 M α0 log E eα0 Y . When calibrating to market data.000.S. and the premium P per policy does not depend on the number of polices M.3) 2000 where w is the wealth of the insurer prior to accepting the risk to be priced. This process converges rapidly to α = 4. We will use this value in the next section to estimate what Genworth would pay for a longevity option. The reason that we calibrated α using Lee–Carter projections rather than the full model is that the full model induces significantly thicker longevity tail risk than Lee–Carter projections alone. with a ‘‘Monte Carlo simulation within a Monte Carlo simulation’’. ¯ Eq.8 × 10−7 can serve as an upper bound for Genworth’s risk aversion to annuity longevity risk.6) The mortality is uncertain but it is reasonable to assume that. the third term is zero.3) can be approximated using known insurance market prices. The random variable Y depends on the random path of future force of mortality values {µ(x + t . the annuitant lives are independent. However. (4. which can be found in Gerber and Pafumi (1998).3) may be expressed as P = 1 Mα log E eα Y . The corresponding model price. (4.5) by simulation. then obtaining P1 .5) 0 0 1000 2000 3000 4000 5000 Fig. On a static basis. The approximation becomes P ≈ E[X ] + α2 = α1 − α1 − α0 (P1 − P ) .25%. Cox et al. However. if α is estimated under the full model. Estimating α from annuity prices The Genworth Financial Group sold around $560 million of single premium individual annuities in the US in 2005 with a monthly payout rate of $6. We use the exponential utility function. We estimate the risk aversion parameter α from Eq. 10. 2 1 Since the aggregate loss is composed of M identical risks. we estimated α using Lee–Carter projections for mortality fluctuations which embeds longevity risk. for each j.5). = E[MVar(X |Θ )] + Var[ME(X |Θ )] = ME[Var(X |Θ )] + M 2 Var[E(X |Θ )]. can be made as P ≈ 1 Mα We assume the underlying expense factor is 12.1) gives the present value of benefits for one life with s = 250 × 6. we are pricing an aggregate annuity exposure for which the component risks are identical but not necessarily independent.7) When the mortality scenario is known (as in traditional actuarial calculations with static tables).10). the variance of Y is the sum of two terms: Var(Y ) = E[Var(Y |Θ )] + Var[E(Y |Θ )] We repeat the calculation with another trial value α1 . E[Y ] = ME[X ] and thus P ≈ E[X ] + α 2M Var(Y ). the premium implied by (4. First we generate 10. (4.5) is satisfied. Moreover. this exercise must be viewed as an illustrative approximation. issued to males age 65 with a gross premium of $250.

For example.76 0. In all cases.H. Reinsurance contracts typically have a cap on the reinsurer’s liability.780 $77. p1 and an upper strike level. Range of outcomes for 10 p65. Note that the spreads in Table 5 have different.2005 > p otherwise.2005 . (4. Fig.864 0.252 S. (4.364 0. . The dollar payoff from this longevity call at maturity in 2015 may be expressed as C = 2 0 0. It is reasonable to anticipate that mortality traders may follow this tradition.2005 < p2 if 10 p65. Table 4 shows longevity call option prices for a range of strikes for mortality driven by the Lee–Carter model alone. or ‘‘detachment point’’.9 0. decreasing seniorities due to decreasing trigger and exhaustion levels.790 $5. 5. (4.000. Cox et al. Evidently. p2 and a notional amount of $100. ‘‘attachment point’’. Range of outcomes for 10 p65. / Insurance: Mathematics and Economics 46 (2010) 242–253 x 10 4 Table 3 10-year longevity call option prices with data generating process driven by our model.85 0.8 0. given the strike level p = 0.2005 under the Lee–Carter model alone.78 0. Strike rate p Call price 0. In the trading of standardized equity and interest rate derivatives.775 and the US treasury discount factors for the 2005 calendar year.000.3 with a notional amount of $100.75 0.000.3) to price this longevity call option for a mortality data generating process driven by our mortality model and by the Lee–Carter model alone.2005 for 1 million draws using the full model.8 0.000.8 × 10−7 . While no one can be certain of the true nature of longevity risk. Consider a 10-year call option issued in December 2005 based on our longevity index 10 p65. In particular.364 if the mortality data generating process is driven by our model.3. one discovers that market prices reflect a ‘‘smile’’.2005 ≥ p2 if p1 < 10 p65. spread A has the lower attachment and detachment points relative to the other spread options.000 0 10 p65. x 10 4 8 7 100.136 0.7 0.288 0.775 $1121.785 $772.506 0. Summary We have described a mortality model which provides a rich and realistic space of sample paths of future mortality rates.522 0. Fig.795 $937 10 8 6 4 4. in practice the owner of the option is most likely concerned with the total dollar exposure as it relates to a pension fund or annuity pool liability. Strike rate p Call price 0. it is the right tail behavior that is driving the differences between the prices of the longevity calls across the two mortality data generating processes. 11 shows a histogram of simulated values of 10 p65.8) 6 5 4 3 2 1 0 0. We then fit a Nelson-Siegel yield curve to this zero-coupon data which can be extrapolated beyond the last observation. 11.000 and a strike price of p.2005 − p1 if 10 p65.82 10-year Survival Probability for (65) Fig.795 $553.9) Table 5 shows the longevity call spread option prices for a range of strikes for mortality driven by our model. and thus it demands a higher price.2005 under the full model. in line with the estimate that was made for the Genworth Financial Group.2005 as defined in Section 3. Longevity option price Let us now illustrate the pricing of longevity options using indifference pricing with the pricing parameter α that we have previously derived from annuity prices. We take the average US treasury coupon-curve yields for 2005 as published in the Federal Reserve’s H15 data set and strip them to produce zerocoupon data. The dollar payoff from this longevity call spread at maturity in 2015 may be expressed as B=  100. If the market for longevity derivatives should evolve to a level of reasonable liquidity. 12.000 0 10 p65.2005 −p if 10 p65.785 $23. one finds that is it far more expensive to purchase ‘‘lottery tickets’’ on equity indices or interest rates than basic theory suggests. the nature of the mortality data generating process is critical in assessing the risk in a longevity derivative contract. The typical reinsurance contract is analogous to a call spread.72 Although one can attribute a ‘‘cohort’’ to the payoff amount.070 0.000. we require discount factors that are representative of interest rates for 2005. At this point we have a set of discount factors that is representative of market conditions in 2005.2005 for 1 million draws using the Lee–Carter model alone. Consider a call spread written on the survivor index 10 p65.95 10-year Survival Probability for (65) Fig.000.11 our 10year longevity call option price equals $1121. with lower strike level.345 18 16 14 12 Table 4 10-year longevity call option prices with data generating process driven by the Lee–Carter model alone. 0.790 $652. The model evolves as a dynamic process that combines a general mortality 11 To be precise. Evidently. In simple terms.962 0. our model has shown that the presence of relatively infrequent mortality improvements poses a significant risk.780 $924. it would not be surprising if similar effects were observed. with two calls having different strike prices. We apply Eq.74 0. we assume that the market risk aversion parameter is α = 4.775 $191.2005 ≤ p1 .000 (p2 − p1 ) 100. 12 shows a histogram of simulated values of 10 p65. Table 3 shows longevity call option prices for a range of strikes for mortality driven by our model.

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