Asset Liability Management of Longevity and Interest Rate Risks: Using Survival–Mortality Bonds

Abstract

In this article, we propose to attach a mortality index to a conventional bond, called a survival–mortality (SM) bond. Its cash flow pattern is like a conventional bond but it can be separated into a survival (S) part and a mortality (M) part; the cash flow pattern in the former is like an annuity or a longevity bond and that in the latter is like a mortality–catastrophe bond. We further propose to split it into S, M, and SM zero-coupon STRIPS (Separate Trading Registered Interest and Principal Securities). We apply these S, M, and SM issues to hedging longevity risk and interest rate risk of 1-year and multiple-year annuity exposures for the asset liability management of an annuity provider by adopting mortality, interest, mortality–interest duration, and convexity matching strategies. Numerical illustrations show that using SM STRIPS rather than S STRIPS can be sufficient to hedge the risks embedded in 1-year annuity exposures, whereas for multiple-year annuity exposures using S issues is more effective to reduce longevity risk and interest rate risk than using SM issues. We can infer that mortality-linked bonds play an essential role in asset liability management; the proposed survival–mortality bonds will be a feasible way to develop an efficient market for longevity risk.