Catastrophic Mortality Bonds : Analysing Basis Risk and Hedge Effectiveness

Life insurers are exposed to catastrophic mortality risk. Catastrophic mortality bonds are a recent market innovation that provide an alternative risk management tool to address this risk. However there is little in the way of published studies that examines their effectiveness, given that they are subject to basis risk arising from the use of country-level general population mortality in their construction. By constructing a typical mortality risk portfolio and calibrating a bond for this portfolio, the hedge effectiveness of the instrument is analysed under a wide variety of circumstances. We find that, on a stand-alone basis, hedge effectiveness may be too low to be acceptable to small to medium insurers. However, effectiveness of the bond increases when used in combination with surplus reinsurance and/or when pooling is used to increase portfolio size