Pricing Longevitiy Bond: An Introductory Study

Abstract

The regulations of the financial market have dramatically raised the costs of financing traditional funded pension's schemes. Additionally, life expectancy worldwide has improved, leading to what is referred to as longevity risk. Longevity Risk has occasioned reform on the pension systems, one of which requires insures to reserve a certain amount of money to cover for their risks. This is the basic Solvency Capital Requirement. Insurers can comply with the solvency requirement by transferring longevity risk to the financial market via the so-called longevity-linked securities, which unfortunately are somehow difficult to price for several reasons. Among other reasons, the pricing of these longevity derivatives is linked to reliable stochastic modeling of mortality rate and population life expectancy. Additionally, these products must be priced in such a way that they are financially attractive to both individuals and companies (consistent premium and shared risk. In this research, we start by modeling and forecasting mortality rate in the US population, using two stochastic models. We compare the efficiency of these models. Then, we use them as a basis for computing the amount of capital that an insurer should hold to cover their longevity risk according to the Solvency II.