Academic journal article Journal of Risk and Insurance

Natural Hedging Strategies for Life Insurers: Impact of Product Design and Risk Measure

Academic journal article Journal of Risk and Insurance

Natural Hedging Strategies for Life Insurers: Impact of Product Design and Risk Measure

Article excerpt

INTRODUCTION

Life annuities are recognized as an important product that protects individuals against longevity risk and investment risk in retirement. The recent global financial crisis, which resulted in significant falls and high volatility in equity markets, highlighted the benefits of such products in a retired individual's portfolio. With increasing life expectancies in most developed countries, many retirees face the risk of outliving their retirement funds and savings. Blake, Cairns, and Dowd (2008) highlight how life annuities provide retirees with a stable income that protects against longevity and also protects retirees from investment risk. Despite this, life annuity markets are thin, but hold potential as a growth market for life insurers given the changing demographics in most developed countries.

Longevity risk can have severe financial implications for pension funds and annuity providers since increases in life expectancies lead to payments being made for longer periods on average. The impact of investment and longevity risk on life insurers offering annuities is assessed in Bauer and Weber (2008). Since there are significant social costs if a life insurer or pension fund becomes insolvent, regulations require insurers to hold risk-based capital. The cost of this capital makes the provision of life products more expensive. In order for life annuity products to be attractive to individuals, annuity providers and pension funds have to manage their exposure to longevity risk as efficiently as possible.

Risk management of insurance products involves both managing the costs of capital required to back the liabilities and charging loadings, or risk premiums, that will ensure a viable market. There are limited options available to a life insurer to manage capital for longevity risk. The primary option for life insurers to transfer their exposure to longevity risk is through reinsurance. Recently, there have been attempts to transfer longevity risk from annuity providers and pension funds to capital markets using securitization as covered in Blake, Cairns, and Dowd (2008). Reinsurance capacity is limited and there has yet to be a well-developed securitization market.

Natural hedging, or the offsetting of risks in life insurance and annuity business, provides another way of managing capital as well as improving profitability. Natural hedging has the potential to not only support existing life insurance business and product markets but to also increase the life annuity product market through more efficient use of capital and more effective pricing. In an empirical study Cox and Lin (2007) show how the portfolio composition of an insurer impacts the pricing of annuities. They find that life insurers issuing both annuities and life insurance charged lower premiums compared to life insurers that solely issued annuities.

The rationale for natural hedging is that the values of annuity policies and life insurance policies have opposite exposures to changes in mortality. In general, annuities become more expensive with improving mortality since policyholders will on average live longer. As a consequence, the value of the payments made to annuity holders will increase. On the other hand, life insurance becomes less expensive with improvements in mortality and the value of payments to policyholders will decrease. For whole life insurance, the life insurer will make payments at a later point in time as mortality improves, while for term insurance fewer payments are also made since fewer insured lives will die during the term of the contract. For level-premium life insurance, the premiums are an asset cash flow match to the life annuity payments, also providing a hedge against investment risks.

In countries where there are significant annuity markets, natural hedging has the potential to provide a significant hedge for longevity risk. For example, U.S. life insurers received $124. …

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