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DISCUSSION PAPER PI-1106

Longevity Hedge Effectiveness: A Decomposition

Andrew J.G. Cairns, Kevin Dowd, David, Blake, and Guy D. Coughlan

We use a case study of a pension plan wishing to hedge the longevity risk in its pension liabilities at a future date. The plan has the choice of using either a customised hedge or an index hedge, with the degree of hedge effectiveness being closely related to the correlation between the value of the hedge and the value of the pension liability. The key contribution of this paper is to show how correlation and, therefore, hedge effectiveness can be broken down into contributions from a number of distinct types of risk factor. Our decomposition of the correlation indicates that population basis risk has a significant influence on the correlation. But recalibration risk as well as the length of the recalibration window are also important, as is cohort effect uncertainty. Having accounted for recalibration risk, additional parameter uncertainty has only a marginal impact on hedge effectiveness. Finally, the inclusion of Poisson risk only starts to become signi cant when the smaller population falls below about 10,000 members over age 50.

Our case study shows that, at least for medium and large pension plans, longevity risk can be substantially hedged using index hedges as an alternative to customised longevity hedges. As a consequence, when the hedger's population involves more than about 10,000 members over age 50, index longevity hedges (in conjunction with the other components of an ALM strategy) can provide an effective and lower cost alternative to both a full buy-out of pension liabilities or even to a strategy using customised longevity hedges.

Key words: hedge effectiveness, correlation, mark-to-model, valuation model, simulation, value hedging, longevity risk, stochastic mortality, population basis risk, recalibration risk.