Hedging Longevity Risk in Life Settlements Using Biomedical Research‐Backed Obligations

• Author: Nan Zhu,Richard D. MacMinn
• Date: 01 April 2017
• Published date: 01 April 2017
• DOI: http://doi.org/10.1111/jori.12200

©2017 The Journal of Risk and Insurance. Vol.84, No. S1, 439–458 (2017).

DOI: 10.1111/jori.12200

Hedging Longevity Risk in Life Settlements Using

Biomedical Research-Backed Obligations

Richard D. MacMinn

Nan Zhu

Abstract

In the life settlement market, mortality risk is transferred from life insurance

policyholders to third-party life settlement firms. This risk transfer occurs in

conjunction with an information transfer that is relevant not only for pricing,

but also for risk management. In this analysis, we compare the efficiency

of two different hedging instruments in managing the mortality risk of the

life settlement firm. First, we claim and then demonstrate that conventional

longevity-linked securities do not perform as effectively in the secondary life

market, that is, life settlement market, as in the annuity and pension markets

due to the basis risk that exists between the general population and the

life settlement subgroup. Second, we show that the unique risk exposure of

the life settlement firm can be specifically targeted using a new instrument—

the biomedical research-backed obligations. Our finding connects two

seemingly independent markets and can promote the healthy development

of both.

Introduction

Life settlements are transactions in a secondary life insurance market. In a life set-

tlement, the owner of a life insurance policy transfers the stream of future premium

payments and, upon the death of the original insured, the death benefit to the life

settlement firm in exchange for a lump sum payment from the life settlement firm.

The lump sum payment is larger than the policy’s surrender value and this creates

the incentive for life policyholders to participate in this secondary market. The life

settlement market is the successor to the viatical settlement market that grew in the

late 1980s due to the AIDS epidemic.

Richard D. MacMinn is a Senior Research Fellow at The University of Texas and National

Chengchi University.MacMinn can be contacted via e-mail: richard@macminn.org. Nan Zhu is

an Assistant Professor in the Risk Management Department, Smeal College of Business, Penn-

sylvania State University.Zhu can be contacted via e-mail: nanzhu@psu.edu. We are indebted

to two anonymous reviewers whose comments helped to significantly improve the article. We

would also like to thank participants in the 2014 International Longevity Risk and Capital Mar-

kets Solutions Conference in Santiago, Chile, and the 2015 WorldRisk and Insurance Economics

Congress in Munich, Germany for helpful discussions. All remaining errors are ours.

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440 The Journal of Risk and Insurance

The profitability and sustainability of the life settlement market depend on the ability

of market participants, that is, life settlement companies, to generate accurate forecasts

of the insureds’ life expectancies. While mortality forecasts can be improved with the

employment of state-of-the-art stochastic mortality forecasting models (Hunt and

Blake, 2014), not all of them allow for longevity jumps. The possibility of a biomedical

breakthrough that dramatically changes life expectancy (LE) is crucial to the cash

flows and solvency of life settlement firms; this is a risk that must be managed. The

failure of the viatical settlement market has been attributed to the medical research

that yielded the drug/therapy for AIDS patients; that drug and therapy prolonged the

lives of AIDS patients and resulted in losses and bankruptcies in the viatical settlement

market (Stone and Zissu, 2006). Successful invention of new drugs and treatments for

other (chronic) diseases will also increase the life expectancies of the impacted patients

and so impose an (adverse) longevity shock on the life settlement market.

The current life settlement market deals with this issue by hiring professional LE

companies to provide tailored assessment for each individual transaction. In partic-

ular, the LE companies employ physicians and medical experts when furnishing an

estimation to make sure that the estimation not only covers best estimate from the in-

dividual’s current medical profile, but also contains professional insights on how the

forecast would be impacted by potential advancements that are disease specific. In a

recent contribution, Brockett et al. (2013) also illustrate how to price life settlements by

generating a mortality table that reflects the underwriter’s medical information and

using a double exponential jump diffusion mortality model first developed by Deng,

Brockett, and MacMinn (2012). As this can be used to price contracts for unhedged

life settlement firms, the question of how a life settlement company can effectively

manage its longevity risk remains open, interesting, and important.

The capital market solutions for longevity risk have steadily evolved over the years;

for example, see Blake et al. (2014) and Tan,Blake, and MacMinn (2015) for recent up-

dates.1As existing longevity-linked securities differ among each other in their explicit

forms, they are in general designed with payments dependent upon the longevity

prospect of certain underlying populations or,equivalently, large demographic cohorts.

This reduces asymmetric information and promotes such securities in the capital mar-

ket and is overall well received by market participants like insurance companies and

pension funds as their tools to manage longevity exposures. However, we argue that

these conventional products might not be equally effective as hedging tools in the life

settlement market, due to the considerable basis risk that exists between the general

population and the smaller group of settled insureds. In particular, it is unlikely that

a longevity shock that impacts the life settlement market, for example, the potential

biomedical breakthrough in certain diseases, will be systematically picked up by a

population longevity index.

1In what follows, we will use the terms longevity risk and mortality risk interchangeably to de-

note uncertainty in future mortality experience, although frequently researchers separate the

concepts with respect to the direction of the shock.