Basis risk in static versus dynamic longevity-risk hedging

Abstract

This paper provides a tractable, parsimonious model for assessing basis risk in longevity and its effect on the hedging strategies of Pension Funds and annuity providers. Basis risk is captured by a single parameter, that measures the co-movement between the portfolio and the reference population’s longevity. The paper sets out the static, full and customized swap-hedge for an annuity, and compares it with a dynamic, partial, and index-based hedge. We calibrate our model to the UK and Scottish populations. The effectiveness of static versus dynamic strategies depends on the rebalancing frequency of the second, on the relative costs, and on basis risk, which does not affect fully-customized, static hedges. We show that appropriately calibrated dynamic hedging strategies can still be reasonably effective, even at low rebalancing frequencies.