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 signicant 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.