TY - JOUR AU - Friedberg,Leora AU - Webb,Anthony TI - Life is Cheap: Using Mortality Bonds to Hedge Aggregate Mortality Risk JF - National Bureau of Economic Research Working Paper Series VL - No. 11984 PY - 2006 Y2 - January 2006 UR - http://www.nber.org/papers/w11984 L1 - http://www.nber.org/papers/w11984.pdf N1 - Author contact info: Leora Friedberg Department of Economics University of Virginia P.O. Box 400182 Charlottesville, VA 22904-4182 Tel: 434/924-3225 Fax: 434/982-2904 E-Mail: lfriedbe@nber.org Anthony Webb Center for Retirement Research Boston College 258 Hammond Street Chestnut Hill MA 02467 Tel: 6466627254 E-Mail: Webbaa@bc.edu AB - Using the widely-cited Lee-Carter mortality model, we quantify aggregate mortality risk as the risk that the average annuitant lives longer than is predicted by the model, and we conclude that annuity business exposes insurance companies to substantial mortality risk. We calculate that a markup of 3.7% on an annuity premium (or else shareholders%u2019 capital equal to 3.7% of the expected present value of annuity payments) would reduce the probability of insolvency resulting from uncertain aggregate mortality trends to 5% and a markup of 5.4% would reduce the probability of insolvency to 1%. Using the same model, we find that a projection scale commonly referred to by the insurance industry underestimates aggregate mortality improvements. Annuities that are priced on that projection scale without any conservative margin appear to be substantially underpriced. Insurance companies could deal with aggregate mortality risk by transferring it to financial markets through mortality-contingent bonds, one of which has recently been offered. We calculate the returns that investors would have obtained on such bonds had they been available over a long period. Using both the Capital and the Consumption Capital Asset Pricing Models, we determine the risk premium that investors would have required on such bonds. At plausible coefficients of risk aversion, annuity providers should be able to hedge aggregate mortality risk via such bonds at a very low cost. ER -