Longevity Hedging 101: A Framework For Longevity Basis Risk Analysis And Hedge Effectiveness

Guy D. Coughlan, Marwa Khalaf-Allah, Yijing Ye, Sumit Kumar, Andrew J. G. Cairns, David Blake, and Kevin Dowd

Basis risk is an important consideration when hedging longevity risk with instruments based on
longevity indices, since the longevity experience of the hedged exposure may differ from that of
the index. As a result, any decision to execute an index-based hedge requires a framework for (1)
developing an informed understanding of the basis risk, (2) appropriately calibrating the hedging
instrument, and (3) evaluating hedge effectiveness. We describe such a framework and apply it
to a U.K. case study, which compares the population of assured lives from the Continuous Mor-
tality Investigation with the England and Wales national population. The framework is founded
on an analysis of historical experience data, together with an appreciation of the contextual re-
lationship between the two related populations in social, economic, and demographic terms.
Despite the different demographic profiles, the case study provides evidence of stable long-term
relationships between the mortality experiences of the two populations. This suggests the impor-
tant result that high levels of hedge effectiveness should be achievable with appropriately cali-
brated, static, index-based longevity hedges. Indeed, this is borne out in detailed calculations of
hedge effectiveness for a hypothetical pension portfolio where the basis risk is based on the case
study. A robustness check involving populations from the United States yields similar results.

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