Multi-Population Heat Wave Mortality Models for Longevity Risk Pricing and Hedging

Over the past several decades, human life expectancy has been increasing rather consistently, driving concerns about longevity risk for pension plans and annuity providers. While extrapolative methods assume continued mortality declines, recent years have seen stagnation or even declines in life expectancy in some developed countries due to decaying transient mortality reductions. In response, a heat wave mortality model was developed to divide mortality improvements into a background level captured by classical mortality models and temporary improvements described by a heat wave component. We propose two multi-population heat wave models to investigate the impact of stalling mortality improvements on longevity risk management. These models provide a parsimonious way to depict the latest mortality developments and produce forecasts that are more in line with recent observations. A hedging exercise using country-level mortality data reveals that our proposed models suggest a tolerance for higher risk premium embedded in longevity swaps before the hedge becomes financially infeasible. However, hedge effectiveness can decrease by 15% when the reference and book populations involved in a longevity swap do not share the same path of transient mortality rates. Overall, our study emphasises the importance of accounting for stalling mortality improvements when managing longevity risk and provides a practical framework for doing so using multi-population heat wave models