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

Leora Friedberg Anthony Webb

WP#2005-13

Abstract

Using the Lee-Carter mortality model, we quantify aggregate mortality risk, the risk that annuitants might live longer than predicted by the model. We calculate that a markup of 4.3 percent on an annuity premium, or else shareholders’ capital equal to 4.3 percent of the expected present value of annuity payments, would reduce the probability of insolvency resulting from uncertain aggregate mortality trends to five percent, and a markup of 6.1 percent would reduce the probability of insolvency to one percent. Using the same model, we find evidence that the projection scale that the insurance industry commonly refers to underestimates aggregate mortality improvements. Consequently, annuities that are priced on that projections scale without any conservative margin will be substantially underpriced.

Insurance companies could deal with aggregate mortality risk by transferring it to the financial markets through newly-available mortality-contingent bonds. We calculate the returns that investors would have obtained on such bonds had they been available previously, and the historical covariance between these bond returns and the growth in per-capita consumption. Using the Consumption Capital Asset Pricing Model (CCAPM), we determine the risk premium that investors would have required on such bonds. At plausible coefficients of risk aversion, investors should be able to hedge aggregate mortality risk via such bonds at very low cost.