Economic Pricing of Mortality-linked Securities in the Presence of Population Basis Risk

Rui Zhou, Johnny Siu-Hang Li and Ken Seng Tan
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Rui Zhou: Statistics and Actuarial Science, University of Waterloo, 200 University Ave. W., Waterloo, Ontario, N2L3G1, Canada
Johnny Siu-Hang Li: Statistics and Actuarial Science, University of Waterloo, 200 University Ave. W., Waterloo, Ontario, N2L3G1, Canada
Ken Seng Tan: Statistics and Actuarial Science, University of Waterloo, 200 University Ave. W., Waterloo, Ontario, N2L3G1, Canada

The Geneva Papers on Risk and Insurance - Issues and Practice, 2011, vol. 36, issue 4, 544-566

Abstract: Standardised mortality-linked securities are easier to analyse and more conducive to the development of liquidity. However, when a pension plan relies on standardised instruments to hedge its longevity risk exposure, it is inevitably subject to various forms of basis risk. In this paper, we use an economic pricing method to study the impact of population basis risk, that is, the risk due to the mismatch in the populations of the exposure and the hedge, on prices of mortality-linked securities. The pricing method we consider is highly transparent, allowing us to understand how population basis risk affects the demand and supply of a mortality-linked security. We apply the method to a hypothetical longevity bond, using real mortality data from different populations. Our illustrations show that, interestingly, population basis risk can affect the price of a mortality-linked security in different directions, depending on the properties of the populations involved.

Date: 2011
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