Abstract
Index-based hedging solutions are used to transfer the longevity risk to the capital markets. However, mismatches between the liability of the hedger and the hedging instrument cause longevity basis risk. Therefore, an appropriate two-population model to measure and assess longevity basis risk is required. In this paper, we aim to construct a two-population mortality model to provide an effective hedge against the basis risk. The reference population is modelled by using the Lee–Carter model with the renewal process and exponential jumps, and the dynamics of the book population are specified. The analysis based on the U.K. mortality data indicate that the proposed model for the reference population and the common age effect model for the book population provide a better fit compared to the other models considered in the paper. Different two-population models are used to investigate the impact of sampling risk on the index-based hedge, as well as to analyse the risk reduction regarding hedge effectiveness. The results show that the proposed model provides a significant risk reduction when mortality jumps and sampling risk are taken into account.
Highlights
Longevity risk can be defined as the risk that members of some reference population might live on average longer than anticipated
It is crucial to incorporate these trends since the mortality trends of the reference population support the hedging instrument, while the trends in the book population are significant for longevity basis risk to be hedged
All of the examples provided in the paper utilise historical U.K. mortality data, which were collected from the Continuous Mortality Investigation (CMI) and the Human Mortality Database (HMD)
Summary
Longevity risk can be defined as the risk that members of some reference population might live on average longer than anticipated. A potential mismatch would arise between the portfolio and the hedging instrument due to certain demographic differences, such as socioeconomic status, sex, and age profile This might give rise to longevity basis risk, a topic that the recent actuarial literature has been investigating (Li et al 2018). Incorporating the jumps into the modelling process enables us to estimate the probability of mortality deterioration, which is required for pricing the instruments to hedge catastrophic mortality risk (Zhou et al 2013). The aim of this paper is to build an appropriate two-population mortality model incorporating mortality jumps to assess longevity basis risk for pricing longevity-linked financial products. Such a model provides a basis for effective risk management strategies.
Sign-in/Register to view highlights & summary Sign-in/Register to access full text options 
Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a callDisclaimer: All third-party content on this website/platform is and will remain the property of their respective owners and is provided on "as is" basis without any warranties, express or implied. Use of third-party content does not indicate any affiliation, sponsorship with or endorsement by them. Any references to third-party content is to identify the corresponding services and shall be considered fair use under The CopyrightLaw.
