Contract Structure and Risk Aversion in Longevity Risk Transfers

TL;DR

This paper develops an economic framework to analyze how risk aversion influences the structure of longevity risk transfer contracts, explaining market preferences for static or dynamic arrangements and the challenges in establishing a capital market for longevity risk.

Contribution

It introduces a theoretical model linking risk aversion and contract design in longevity risk transfer, highlighting the role of ambiguity and market dynamics.

Findings

Risk-averse buyers prefer static long-term contracts.

Risk-averse sellers favor dynamic short-term contracts.

Ambiguity can lead sellers to withdraw from long-term offerings.

Abstract

This paper introduces an economic framework to assess optimal longevity risk transfers between institutions, focusing on the interactions between a buyer exposed to long-term longevity risk and a seller offering longevity protection. While most longevity risk transfers have occurred in the reinsurance sector, where global reinsurers provide long-term protections, the capital market for longevity risk transfer has struggled to gain traction, resulting in only a few short-term instruments. We investigate how differences in risk aversion between the two parties affect the equilibrium structure of longevity risk transfer contracts, contrasting `static' contracts that offer long-term protection with `dynamic' contracts that provide short-term, variable coverage. Our analysis shows that static contracts are preferred by more risk-averse buyers, while dynamic contracts are favored by more risk-averse sellers who are reluctant to commit to long-term agreements. When incorporating information asymmetry through ambiguity, we find that ambiguity can cause more risk-averse sellers to stop offering long-term contracts. With the assumption that global reinsurers, acting as sellers in the reinsurance sector and buyers in the capital market, are generally less risk-averse than other participants, our findings provide theoretical explanations for current market dynamics and suggest that short-term instruments offer valuable initial steps toward developing an efficient and active capital market for longevity risk transfer.