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DISCUSSION PAPER PI-0901

Mortality-Linked Securities and Derivatives

Enrico Biffis and David Blake

In the last few years, the risk of mortality improvements has become increasingly
capital intensive for pension funds and annuity providers to manage.
The reason is that longevity risk has been systematically underestimated,
making balance sheets vulnerable to unexpected increases in liabilities. The
traditional way of transferring longevity risk is through insurance and reinsurance
markets. However, these lack the capacity and liquidity to support
an estimated global exposure in excess of $20tr (e.g., Loeys et al., 2007).
Capital markets, on the other hand, could play a very important role, offering
additional capacity and liquidity to the market, leading in turn to more
transparent and competitive pricing of longevity risk.
Blake and Burrows (2001) were the first to advocate the use of mortalitylinked
securities to transfer longevity risk to the capital markets. Their
proposal has generated considerable attention in the last few years, and major
investment banks and reinsurers are now actively innovating in this space
(see Blake et al., 2008, for an overview). Nevertheless, despite growing enthusiasm,
longevity risk transfers have been materializing only slowly. One
of the reasons is the huge imbalance in scale between existing exposures
and willing hedge suppliers. Another reason is that a traded mortalitylinked
security has to meet the different needs of hedgers (concerned with
hedge effectiveness) and investors (concerned with liquidity and with receiving
adequate compensation for assuming the risk), needs that are difficult
to reconcile when longevity risk, a long-term trend risk that is difficult to
quantify, is involved. Our aim is to provide an overview of the recent developments
in capital markets aimed at overcoming such difficulties and at
creating a liquid market in mortality-linked securities and derivatives.