Life is Cheap: Using Mortality Bonds to Hedge Aggregate Mortality Risk

37 Pages Posted: 20 Apr 2006 Last revised: 26 Dec 2022

See all articles by Leora Friedberg

Leora Friedberg

University of Virginia - Department of Economics; National Bureau of Economic Research (NBER)

Anthony Webb

Boston College - Center for Retirement Research

Date Written: January 2006

Abstract

Using the widely-cited Lee-Carter mortality model, we quantify aggregate mortality risk as the risk that the average annuitant lives longer than is predicted by the model, and we conclude that annuity business exposes insurance companies to substantial mortality risk. We calculate that a markup of 3.7% on an annuity premium (or else shareholders' capital equal to 3.7% of the expected present value of annuity payments) would reduce the probability of insolvency resulting from uncertain aggregate mortality trends to 5% and a markup of 5.4% would reduce the probability of insolvency to 1%. Using the same model, we find that a projection scale commonly referred to by the insurance industry underestimates aggregate mortality improvements. Annuities that are priced on that projection scale without any conservative margin appear to be substantially underpriced. Insurance companies could deal with aggregate mortality risk by transferring it to financial markets through mortality-contingent bonds, one of which has recently been offered. We calculate the returns that investors would have obtained on such bonds had they been available over a long period. Using both the Capital and the Consumption Capital Asset Pricing Models, we determine the risk premium that investors would have required on such bonds. At plausible coefficients of risk aversion, annuity providers should be able to hedge aggregate mortality risk via such bonds at a very low cost.

Suggested Citation

Friedberg, Leora and Webb, Anthony, Life is Cheap: Using Mortality Bonds to Hedge Aggregate Mortality Risk (January 2006). NBER Working Paper No. w11984, Available at SSRN: https://ssrn.com/abstract=879249

Leora Friedberg (Contact Author)

University of Virginia - Department of Economics ( email )

P.O. Box 400182
Charlottesville, VA 22904-4182
United States
804-924-3225 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Anthony Webb

Boston College - Center for Retirement Research ( email )

Fulton Hall 550
Chestnut Hill, MA 02467
United States

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