Hedging Annuity Risks with the Age-Period-Cohort Two-Population Gravity Model

We consider the effectiveness of an illustrative annuity hedging problem in which a forward annuity predicated on one population is hedged by a position in a forward annuity predicated on another population. Our analysis makes use of the age-period-cohort two-population gravity model that takes account of the observed interdependence between the two populations’ mortality rates; it also considers the implications of parameter uncertainty, individual death or Poisson risk, and interest-rate risk for hedge effectiveness. We consider horizons of up to 20 years. For the most part, our results are robust and indicate strong hedge effectiveness, with estimates of relative risk reduction varying from about 70% in the least effective case to well over 95% in the most effective cases.