To Hedge or Not to Hedge: Managing Demographic Risk in Life Insurance Companies

Demographic risk, i.e., the risk that life tables change in a nondeterministic way, is a serious threat to the financial stability of an insurance company having underwritten life insurance and annuity business. The inverse influence of changes in mortality laws on the market value of life insurance and annuity liabilities creates natural hedging opportunities. Within a realistically calibrated shareholder value (SHV) maximization framework, we analyze the implications of demographic risk on the optimal risk management mix (equity capital, asset allocation, and product policy) for a limited liability insurance company operating in a market with insolvency‐averse insurance buyers. Our results show that the utilization of natural hedging is optimal only if equity is scarce. Otherwise, hedging can even destroy SHV. A sensitivity analysis shows that a misspecification of demographic risk has severe consequences for both the insurer and the insured. This result highlights the importance of further research in the field of demographic risk.