Longevity risk,cost of capital and hedging for life insurers under Solvency II |
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| Institution: | 1. Department of Actuarial Studies and Business Analytics, Macquarie University, Australia;2. Bayes Business School, City, University of London, United Kingdom;3. Department of Econometrics and Business Statistics, Monash University, Australia;1. Department of Economics, University of Crete, Greece;2. College of Business, Bowling Green State University, USA;3. Surrey Business School, University of Surrey, UK;4. Financial Engineering Laboratory, Technical University of Crete, Greece |
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| Abstract: | The cost of capital is an important factor determining the premiums charged by life insurers issuing life annuities. This capital cost can be reduced by hedging longevity risk with longevity swaps, a form of reinsurance. We assess the costs of longevity risk management using indemnity based longevity swaps compared to costs of holding capital under Solvency II. We show that, using a reasonable market price of longevity risk, the market cost of hedging longevity risk for earlier ages is lower than the cost of capital required under Solvency II. Longevity swaps covering higher ages, around 90 and above, have higher market hedging costs than the saving in the cost of regulatory capital. The Solvency II capital regulations for longevity risk generates an incentive for life insurers to hold longevity tail risk on their own balance sheets, rather than transferring this to the reinsurance or the capital markets. This aspect of the Solvency II capital requirements is not well understood and raises important policy issues for the management of longevity risk. |
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| Keywords: | Capital management Solvency Longevity risk Reinsurance Securitisation |
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