A combined analysis of hedge effectiveness and capital efficiency in longevity hedging

Abstract

By hedging longevity exposures, annuity providers can reduce both the uncertainty in future cash flows and capital charges in a cost efficient manner. We argue that a separate analysis of these two aspects cannot provide a full picture of the implications of longevity hedging, in particular when using index-based instruments.Hence, we propose a stochastic modeling framework for a joint analysis of the risk-reducing effect and the economic impact of longevity hedges in terms of hedge effectiveness and capital efficiency, respectively. In an economic capital model under Solvency II, a wide selection of customized and index-based instruments is analyzed. We show that different hedging objectives require different instruments on different index populations and discuss the accompanying trade-off between hedge effectiveness and capital efficiency. While customized hedges naturally outperform their index-based counterparts in terms of hedge effectiveness, we show that cost efficient index-based designs may be more capital efficient.