Financial Engineering: A Flexible Longevity Bond to Manage Individual Longevity Risk

Abstract

There is a significant potential demand in many countries around the world for a flexible product to manage individual longevity risk arising from the prevalence of defined contribution pensions, uncertainty in improvements in life expectancy, potential reductions in public pensions and a lack of suitable longevity insurance products. The classical insurance product to manage individual longevity risk is the life annuity. Annuity markets remain thin, driven by many factors including lack of transparency in pricing, high product loading, bequest motives, lack of liquidity and loss aversion. This paper proposes an individual longevity bond, not currently available, as a combined investment and insurance product to allow individuals to flexibly manage their longevity risk. The bond is a post-retirement product that combines a lifetime income along with a flexible death benefit to meet bequest and liquidity needs. The longevity bonds are issued through a special purpose vehicle which is fully collateralized with a fixed interest portfolio. We apply financial and actuarial models and techniques that provide transparent pricing for interest rate and mortality risk, the construction of optimally immunized bond portfolios and the determination of a loading and solvency margin for systematic longevity risk. We also quantify the natural hedging benefits of the individual bond cash flows arising from the flexible inclusion of both survival dependent income benefits and mortality dependent bequest benefits payable on death.