The Impact of joint mortality modelling on hedging effectiveness of mortality derivatives

Standardised mortality derivatives are an innovative and practical tool for annuity providers and pension plan sponsors to manage their longevity risk. There is, however, a major concern over the existence of basis risk, which arises from mismatching between the characteristics of the hedging instrument and the portfolio to be hedged. In this project, we compare a variety of joint mortality models and conduct a quantitative evaluation of their impact on assessing the hedging effectiveness of standardised mortality derivatives. We broadly categorise the models into five groups, and apply them to UK assured lives, pensioners, annuitants, and population data to measure the goodness-of fit and conduct an out-of-sample analysis. We then use each model in turn to perform simulation of future outcomes for computing the level of risk reduction for an annuity portfolio in a longevity hedge composed of q-forwards. In the simulations, process error, parameter error, and different portfolio sizes are taken into account, and via the comparison of using different models, the extent of model error is also considered.