Mortality Risk and Its Effect on Shortfall and Risk Management in Life Insurance

By Gatzert, Nadine; Wesker, Hannah | Journal of Risk and Insurance, March 2014 | Go to article overview

Mortality Risk and Its Effect on Shortfall and Risk Management in Life Insurance


Gatzert, Nadine, Wesker, Hannah, Journal of Risk and Insurance


ABSTRACT

Mortality risk is a key risk factor for life insurance companies and can have a crucial impact on its risk situation. In general, mortality risk can be divided into different subcategories, among them unsystematic risk, adverse selection, and systematic risk. In addition, basis risk may arise in case of hedging, for example, longevity risk. The aim of this article is to holistically analyze the impact of these different types of mortality risk on the risk situation and the risk management of a life insurer. Toward this end, we extend previous models of adverse selection, empirically calibrate mortality rates, and study the interaction among the mortality risk components in the case of an insurer holding a portfolio of annuities and term life insurance contracts. For risk management, we examine natural hedging and mortality contingent bonds. Our results show that particularly adverse selection and basis risk can have crucial impact not only on the effectiveness of mortality contingent bonds, but also on the insurer's risk level, especially when a portfolio consists of several types of products.

INTRODUCTION

Recently, there has been a growing interest in mortality risk and its management in the scientific literature as well as in practice, especially due to the demographic development in most industrialized countries. The increasing life expectancy poses serious problems to life insurance companies selling annuities and to pension funds. These problems are especially severe because of a scarcity of possibilities to hedge against this risk. Due to the limited capacity of reinsurance, several alternative instruments for managing demographic risk, for example, by transferring mortality risk to the capital market or the use of natural hedging, have been discussed in the scientific literature and by practitioners. However, mortality heterogeneity as well as information asymmetries between the insurance company and the insured about these different mortality experiences of individuals can lead to adverse selection. In particular, annuitants generally have a systematically lower mortality than the population as a whole. (1) Mortality heterogeneity and information asymmetries can thus severely limit the usefulness of these risk management tools. Therefore, the aim of this article is to study the interaction among different types of mortality risk--unsystematic mortality risk, basis risk, adverse selection, and systematic mortality risk--with respect to the risk situation of an insurance company. Furthermore, we analyze the impact of mortality risk components on the effectiveness of two risk management tools: (1) a natural hedging strategy, using the opposed reaction toward changes in mortality of term life insurance and annuities for eliminating the impact of systematic mortality risk, and (2) a mortality contingent bond (MCB) for transferring mortality risk to the capital market.

In the literature, mortality risk is generally divided into different subcategories: (1) unsystematic mortality risk that the individual time of death is a random variable with a certain probability distribution (see Biffs, Denuit, and Devolder, 2010); (2) systematic mortality risk, which is the risk of unexpected changes in the underlying population mortality, for example due to common factors impacting the mortality of the population as a whole, which causes dependencies between lives and is thus not diversifiable through enlarging the portfolio (see Wills and Sherris, 2010); and (3) adverse selection, which refers to the fact that the probability distribution differs in the level and trend over age for different populations of insured, for example, for life insurance holders and annuitants (2) (see, e.g., Brouhns, Denuit, and Vermunt [BDV], 2002a). Furthermore, adverse selection, which is due to the mortality heterogeneity of individuals and information asymmetries between the insurance company and the insured, is one important source of basis risk when hedging longevity risk through MCBs or other capital market instruments (see Sweeting, 2007). …

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