| Life is Cheap: Using Mortality Bonds to Hedge Aggregate Mortality Risk |
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WP#2005-13 AbstractUsing 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. For full paper in PDF Anthony Webb, Ph.D., (corresponding author) is a research economist at the Center for Retirement Research at Boston College (CRR). He can be reached at 646-662-7254 (phone), at This email address is being protected from spam bots, you need Javascript enabled to view it or, at the CRR (see information above). Leora Friedberg, Ph.D., is an Assistant Professor in the Department of Economics of the University of Virginia. She can be reached at 434-924-3225 (phone), 434-982-2904 (fax), at This email address is being protected from spam bots, you need Javascript enabled to view it , or P.O. Box 400182, Charlottesville, VA 22904-4182. The research reported herein was performed pursuant to a grant from the Actuarial Foundation. The opinions and conclusions are solely those of the authors and should not be construed as representing the opinions or policy of the CRR, Actuarial Foundation or Society of Actuaries. We are grateful to Marric Buessing, Francesca Golub-Sass, Jamie Lee, and Andrew Varani for excellent research assistance, and to Mauricio Soto, seminar participants at the Center for Retirement Research at Boston College, Steve Cooperstein and Bob Triest for their very helpful comments. |