Financial Innovation and the Hedging of Longevity Risk

Longevity risk is one of the remaining frontiers challenging modern financial markets and financial engineering. Financial innovation has yet to successfully master this very significant risk facing many countries internationally. For well over a hundred years this risk has been the domain of life insurance companies, reinsurance companies and actuaries. Traditional hedging approaches to longevity risk have revolved around participating annuities and life insurance policies with guarantees, the actuarial management of an insurer’s surplus (internal capital) and of policyholder expectations. A number of spectacular recent life insurance failures have cast a shadow on this approach. New accounting and regulatory requirements are changing emphasis to market consistent valuation and quantification for all risks including longevity. At the same time, the aging population around the world drives the need for new products for managing longevity risk and new markets for hedging this risk. We consider how financial markets and financial product innovations can ideally be used to hedge longevity risk and also consider lessons from the insurance linked securities market that could be used to successfully fund this risk in financial markets.