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Assessing basis risk in index-based longevity swap transactions

Published online by Cambridge University Press:  04 July 2018

Jackie Li ,
Johnny Siu-Hang Li ,
Chong It Tan  and
Leonie Tickle
Jackie Li*
Affiliation:
Actuarial Studies and Business Analytics, Macquarie University, Sydney, NSW 2109, Australia
Johnny Siu-Hang Li
Affiliation:
Statistics and Actuarial Science, University of Waterloo, 200 University Avenue West Waterloo, ON, Canada N2L 3G1
Chong It Tan
Affiliation:
Actuarial Studies and Business Analytics, Macquarie University, Sydney, NSW 2109, Australia
Leonie Tickle
Affiliation:
Actuarial Studies and Business Analytics, Macquarie University, Sydney, NSW 2109, Australia
*
*Correspondence to: Jackie Li, Actuarial Studies and Business Analytics, Macquarie University, Sydney, NSW 2109, Australia. Tel: +612 98508576. E-mail: jackie.li@mq.edu.au
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Abstract

In this paper, we carry out an investigation on modelling basis risk and measuring risk reduction in a longevity hedge constructed by index-based longevity swaps. We derive the fitting procedures of the M7-M5 and common age effect+Cohorts models and define the level of longevity risk reduction. Based on a wide range of hedging scenarios of pension plans, we find that the risk reduction levels are often around 50%–80% for a large plan, while the risk reduction estimates are usually smaller than 50% for a small plan. Moreover, index-based hedging looks more effective under a more precise hedging scheme. We also perform a detailed sensitivity analysis on the hedging results. The most important modelling features are the behaviour of simulated future variability, portfolio size, speed of reaching coherence, data size and characteristics, simulation method, and mortality structural changes.

Keywords

Longevity basis riskTwo-population mortality projection modelIndex-based longevity hedgingLongevity swapHedge effectiveness
Type
Paper
Information
Annals of Actuarial Science , Volume 13 , Issue 1 , March 2019 , pp. 166 - 197
Copyright
© Institute and Faculty of Actuaries 2018 

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