- ACTUARIAL DATA SCIENCE
- AFIR / ERM / RISK
- ASTIN / NON-LIFE
- BANKING / FINANCE
- CORONA SPECIAL
- DIVERSITY & INCLUSION
- IACA / CONSULTING
In this paper, we develop and implement a model of a longevity risk transfer market that consists of different market participants with individual characteristics and (partly opposing) objectives. Unlike previous studies that are mostly limited to transactions between two parties and typically leave the hedge provider unspecified, we particularly focus on the reinsurance sector with its diversification capacities. Depending on the reinsurers’ risk profile and the prevailing market environment, they can act as either takers or hedgers of longevity risk.
Our numerical case study provides several novel and valuable insights into the dynamics of the longevity risk transfer market. At an early stage of market development, we demonstrate that comprehensive diversification opportunities with other LOBs, in particular with mortality risk, give well-diversified reinsurers a decisive competitive edge. This does not leave room for capital market investors to earn a positive risk premium. These findings are in line with the market-dominating position of reinsurers that has been observed in the global longevity risk transfer market since its inception, cf. Blake et al. (2019). With increasing market saturation, however, this competitive advantage lessens due to shrinking marginal diversification benefits. This constitutes a remarkable anti-monopolistic feature of this market. In particular, it suggests that the market will tend to expand to a wider set of competing risk takers rather than develop towards a ‘winner-takes-it-all’ market. We demonstrate that further longevity risk transfers into the reinsurance sector will ultimately lead to a critical level of saturation beyond which the prices for reinsurance-based longevity hedges become economically unattractive to primary hedgers. This provides clear evidence for a capacity constraint for longevity risk-taking in the reinsurance sector, which has been postulated by several authors including Blake et al. (2019) and Kessler (2021).
The competitiveness of established reinsurers declines with increasing market saturation. This leads to rising market risk premiums for longevity risk-taking, which might attract capital market investors. We show that their optimal entry point is to assume systematic longevity risk from the reinsurance sector rather than taking on longevity risk directly from annuity providers. This is universally beneficial for all market participants. Our findings particularly support the concept of a longevity risk transfer chain as developed and further refined by Blake et al. (2006, 2019), Cairns et al. (2008), and Cairns and El Boukfaoui (2021): A reinsurer acts as intermediary between first writers of longevity risk and the capital markets and first enters into a series of unlimited customized longevity swaps with a diverse set of primary hedgers. Subsequently, the most capital-intensive components of the acquired risks are further passed on to the capital markets by means of a suitable index-based hedge, whereas the more easily diversifiable risk components are retained.
Finally, we analyze the suitability of various hedge designs for each link of this risk transfer chain. While customized cash flow hedges turn out to be superior for transferring longevity risk from primary hedgers to the reinsurance sector, we find that value hedges are better suited for linking the reinsurance sector with the capital market. In particular, we demonstrate that index-based annuity forwards, even with rather short terms below 10 years, offer distinct structural advantages over cash flow hedges. These advantages become increasingly pronounced with progressing market saturation. With respect to the shown capacity constraint in the reinsurance sector, these findings are of particular practical relevance for efficiently expanding the market’s risk absorption capacity. We show that index-based annuity forwards are particularly suited to reconcile longevity hedgers’ demand for a cost efficient and effective risk transfer with the capital market investors’ request for attractive returns, standardization, and manageable contract durations. Such contract designs and any advanced forms or derivatives thereof clearly deserve greater attention in future works.
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