Natural Hedging Strategies for Life Insurers: Impact of Product Design and Risk Measure

• Author: Michael Sherris,Andy Wong,Ralph Stevens
• DOI: http://doi.org/10.1111/jori.12079
• Published date: 01 March 2017
• Date: 01 March 2017

©2015 The Journal of Risk and Insurance. Vol.84, No. 1, 153–175 (2017).

DOI: 10.1111/jori.12079

Natural Hedging Strategies for Life Insurers:

Impact of Product Design and Risk Measure

Andy Wong

Michael Sherris

Ralph Stevens

Abstract

Natural hedging allows life insurers to manage long-term longevity and in-

vestment risks of life annuity products through offsetting risks in life in-

surance products. Benefits include a reduction in risk-based capital. Weuse

stochastic mortality and interest rate models to assess life insurance and an-

nuity capital requirements and to quantify the benefits of natural hedging

for a range of different types of life insurance product designs and risk mea-

sures based on probability of insurer solvency. We show that level-premium

life insurance products with a medium duration (around 20–30 years) can

better hedge annuity products than whole life products. Renewable term life

insurance products have less hedge effectiveness than level-premium term

insurance. Results vary with the risk measure used, with the 1-year hori-

zon Solvency II risk measure showing lower natural hedging benefits of life

insurance compared to multiple-period risk measures.

Introduction

Life annuities are recognizedas an important product that protects individuals against

longevity risk and investment risk in retirement. The recent global financial crisis,

which resulted in significant falls and high volatility in equity markets, highlighted

the benefits of such products in a retired individual’s portfolio. With increasing life

expectancies in most developed countries, many retirees face the risk of outliving

their retirement funds and savings. Blake, Cairns, and Dowd (2008) highlight how

life annuities provide retirees with a stable income that protects against longevity

and also protects retirees from investment risk. Despite this, life annuity markets

Andy Wong,Michael Sherris, and Ralph Stevens are at the Risk and Actuarial Studies, CEPAR,

UNSW Business School, University of New South Wales. They can be contacted via e-mail:

andywong89@hotmail.com, m.sherris@unsw.edu.au, and ralph.stevens@unsw.edu.au. Andy

Wongacknowledges support from the UNSW Honours Scholarship and the 2012 ARC Linkage

Project Managing Risk with Insurance and Superannuation as Individuals Age Honours Schol-

arship. The authors would like to also acknowledge the financial support of the Australian Re-

search Council Centre of Excellence in Population Ageing Research (Project No. CE110001029).

The comments of the editor and anonymous referees led to a much improved paper and are

gratefully acknowledged.

153

154 The Journal of Risk and Insurance

are thin, but hold potential as a growth market for life insurers given the changing

demographics in most developed countries.

Longevity risk can have severe financial implications for pension funds and annuity

providers since increases in life expectancies lead to payments being made for longer

periods on average. The impact of investment and longevity risk on life insurers

offering annuities is assessed in Bauer and Weber (2008). Since there are significant

social costs if a life insurer or pension fund becomes insolvent, regulations require

insurers to hold risk-based capital. The cost of this capital makes the provision of

life products more expensive. In order for life annuity products to be attractive to

individuals, annuity providers and pension funds have to manage their exposure to

longevity risk as efficiently as possible.

Risk management of insurance products involves both managing the costs of capital

required to back the liabilities and charging loadings, or risk premiums, that will

ensure a viable market. There are limited options available to a life insurer to manage

capital for longevity risk. The primary option for life insurers to transfer their exposure

to longevity risk is through reinsurance. Recently, there have been attempts to transfer

longevity risk from annuity providers and pension funds to capital markets using

securitization as covered in Blake, Cairns, and Dowd (2008). Reinsurance capacity is

limited and there has yet to be a well-developed securitization market.

Natural hedging, or the offsetting of risks in life insurance and annuity business,

provides another way of managing capital as well as improving profitability. Nat-

ural hedging has the potential to not only support existing life insurance busi-

ness and product markets but to also increase the life annuity product market

through more efficient use of capital and more effective pricing. In an empirical

study Cox and Lin (2007) show how the portfolio composition of an insurer im-

pacts the pricing of annuities. They find that life insurers issuing both annuities and

life insurance charged lower premiums compared to life insurers that solely issued

annuities.

The rationale for natural hedging is that the values of annuity policies and life insur-

ance policies have opposite exposures to changes in mortality. In general, annuities

become more expensive with improving mortality since policyholders will on average

live longer.As a consequence, the value of the payments made to annuity holders will

increase. On the other hand, life insurance becomes less expensive with improvements

in mortality and the value of payments to policyholders will decrease. For whole life

insurance, the life insurer will make payments at a later point in time as mortality im-

proves, while for term insurance fewer payments are also made since fewer insured

lives will die during the term of the contract. For level-premium life insurance, the

premiums are an asset cash flow match to the life annuity payments, also providing

a hedge against investment risks.

In countries where there are significant annuity markets, natural hedging has the

potential to provide a significant hedge for longevity risk. For example, U.S. life

insurers received $124.6 billion in life insurance premiums and $231.6 billion in