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To Hedge or Not to Hedge: Managing Demographic Risk in Life Insurance Companies

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  • Helmut Gründl
  • Thomas Post
  • Roman N. Schulze

Abstract

Demographic risk, i.e., the risk that life tables change in a nondeterministic way, is a serious threat to the financial stability of an insurance company having underwritten life insurance and annuity business. The inverse influence of changes in mortality laws on the market value of life insurance and annuity liabilities creates natural hedging opportunities. Within a realistically calibrated shareholder value (SHV) maximization framework, we analyze the implications of demographic risk on the optimal risk management mix (equity capital, asset allocation, and product policy) for a limited liability insurance company operating in a market with insolvency‐averse insurance buyers. Our results show that the utilization of natural hedging is optimal only if equity is scarce. Otherwise, hedging can even destroy SHV. A sensitivity analysis shows that a misspecification of demographic risk has severe consequences for both the insurer and the insured. This result highlights the importance of further research in the field of demographic risk.

Suggested Citation

  • Helmut Gründl & Thomas Post & Roman N. Schulze, 2006. "To Hedge or Not to Hedge: Managing Demographic Risk in Life Insurance Companies," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 73(1), pages 19-41, March.
    • Handle: RePEc:bla:jrinsu:v:73:y:2006:i:1:p:19-41
    DOI: 10.1111/j.1539-6975.2006.00164.x
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    Cited by:

    1. Juan Pablo Atal & Hanming Fang & Martin Karlsson & Nicolas R. Ziebarth, 2019. "Exit, Voice, or Loyalty? An Investigation Into Mandated Portability of Front‐Loaded Private Health Plans," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 86(3), pages 697-727, September.
    2. Maathumai Nirmalendran & Michael Sherris & Katja Hanewald, 2012. "Solvency Capital, Pricing and Capitalization Strategies of Life Annuity Providers," Working Papers 201213, ARC Centre of Excellence in Population Ageing Research (CEPAR), Australian School of Business, University of New South Wales.
    3. Schlütter, Sebastian & Gründl, Helmut, 2011. "Who benefits from building insurance groups? A welfare analysis of optimal group capital management," ICIR Working Paper Series 08/11, Goethe University Frankfurt, International Center for Insurance Regulation (ICIR).
    4. Post, Thomas, 2009. "Individual welfare gains from deferred life-annuities under stochastic Lee-Carter mortality," SFB 649 Discussion Papers 2009-022, Humboldt University Berlin, Collaborative Research Center 649: Economic Risk.
    5. Bohnert, Alexander & Gatzert, Nadine, 2012. "Analyzing surplus appropriation schemes in participating life insurance from the insurer’s and the policyholder’s perspective," Insurance: Mathematics and Economics, Elsevier, vol. 50(1), pages 64-78.
    6. Berdin, Elia, 2016. "Interest rate risk, longevity risk and the solvency of life insurers," ICIR Working Paper Series 23/16, Goethe University Frankfurt, International Center for Insurance Regulation (ICIR).
    7. Katja Hanewald & Thomas Post & Helmut Gründl, 2011. "Stochastic Mortality, Macroeconomic Risks and Life Insurer Solvency," The Geneva Papers on Risk and Insurance - Issues and Practice, Palgrave Macmillan;The Geneva Association, vol. 36(3), pages 458-475, July.
    8. Li, Jackie & Haberman, Steven, 2015. "On the effectiveness of natural hedging for insurance companies and pension plans," Insurance: Mathematics and Economics, Elsevier, vol. 61(C), pages 286-297.
    9. Burren, Daniel, 2013. "Insurance demand and welfare-maximizing risk capital—Some hints for the regulator in the case of exponential preferences and exponential claims," Insurance: Mathematics and Economics, Elsevier, vol. 53(3), pages 551-568.
    10. Chen An & Mahayni Antje B., 2008. "Endowment Assurance Products: Effectiveness of Risk-Minimizing Strategies under Model Risk," Asia-Pacific Journal of Risk and Insurance, De Gruyter, vol. 2(2), pages 1-29, March.
    11. Berdin, Elia & Pancaro, Cosimo & Kok Sørensen, Christoffer, 2016. "A stochastic forward-looking model to assess the profitability and solvency of European insurers," SAFE Working Paper Series 137, Leibniz Institute for Financial Research SAFE, revised 2016.
    12. Cox, Samuel H. & Lin, Yijia & Pedersen, Hal, 2010. "Mortality risk modeling: Applications to insurance securitization," Insurance: Mathematics and Economics, Elsevier, vol. 46(1), pages 242-253, February.
    13. Franca Glenzer & Bertrand Achou, 2019. "Annuities, long-term care insurance, and insurer solvency," The Geneva Papers on Risk and Insurance - Issues and Practice, Palgrave Macmillan;The Geneva Association, vol. 44(2), pages 252-276, April.
    14. repec:hum:wpaper:sfb649dp2009-015 is not listed on IDEAS
    15. repec:hum:wpaper:sfb649dp2009-022 is not listed on IDEAS
    16. Qi Ming, 2013. "The Impact of Mortality Risk on the Asset and Liability Management of Insurance Companies," Asia-Pacific Journal of Risk and Insurance, De Gruyter, vol. 7(2), pages 81-104, July.
    17. Thomas Post & Helmut Gründl & Lisa Schmidl & Mark S. Dorfman, 2007. "Implications of IFRS for the European Insurance Industry—Insights From Capital Market Theory," Risk Management and Insurance Review, American Risk and Insurance Association, vol. 10(2), pages 247-265, September.
    18. Zimmer, Anja & Schade, Christian & Gründl, Helmut, 2009. "Is default risk acceptable when purchasing insurance? Experimental evidence for different probability representations, reasons for default, and framings," Journal of Economic Psychology, Elsevier, vol. 30(1), pages 11-23, February.
    19. Zimmer, Anja & Gründl, Helmut & Schade, Christian, 2012. "Be as safe as possible: A behavioral approach to the optimal corporate risk strategy of insurers," ICIR Working Paper Series 06/11, Goethe University Frankfurt, International Center for Insurance Regulation (ICIR).
    20. Post Thomas, 2012. "Individual Welfare Gains from Deferred Life-Annuities under Stochastic Mortality," Asia-Pacific Journal of Risk and Insurance, De Gruyter, vol. 6(2), pages 1-26, June.
    21. Tsai, Jeffrey T. & Wang, Jennifer L. & Tzeng, Larry Y., 2010. "On the optimal product mix in life insurance companies using conditional value at risk," Insurance: Mathematics and Economics, Elsevier, vol. 46(1), pages 235-241, February.

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