Longevity Risk and Natural Hedge Potential in Portfolios Of Life Insurance Products : The Effect of Investment Risk

Payments of life insurance products depend on the uncertain future evolution of survival probabilities. This uncertainty is referred to as longevity risk. Existing literature shows that the effect of longevity risk on single life annuities can be substantial, and that there exists a (natural) hedge potential from combining single life annuities with death benefits or from investing in survivor swaps. The effect of financial risk on these hedge effects is typically ignored. The aim of this paper is to quantify longevity risk in portfolios of mortality-linked assets and liabilities, taking into account the effect of financial risk. We find that investment risk significantly affects the impact of longevity risk in life insurance products. It also significantly affects the hedge potential that arises from combining life insurance products, or from investing in longevity-linked assets. For example, our results suggest that ignoring the effect of financial risk can lead to severe overestimation of the natural hedge potential from death benefits, and underestimation of the hedge effects of survivor swaps.