Andreas Milidonis

Mortality Regimes and Pricing

Abstract Mortality dynamics are characterized by changes in mortality regimes. This paper describes a Markov regime-switching model that incorporates mortality state switches into mortality dynamics. Using the 1901-2005 U.S. population mortality data, we illustrate that regime-switching models can perform better than well-known models in the literature. Furthermore, we extend the 1992 Lee-Carter model in such a way that the time-series common risk factor to all cohorts has distinct mortality regimes with different means and volatilities. Finally, we show how to price mortality securities with this model.

Managerial Incentives, Risk Aversion, and Debt

We investigate the risk choices of risk-averse CEOs. Following recent theoretical work, we expect CEO risk aversion to be more pronounced in firms with high leverage or high default probability. We find that the CEOs of these firms reduce firm risk, even in the presence of strong risk-taking incentives. Our results are robust to controls for the sensitivity of CEO wealth to stock price changes, firm risk determinants, the endogenous feedback effects of firm risk on CEO incentives, unobserved firm and market effects, and debt governance. The impact of CEO risk aversion is economically significant.

Loss Evaluation and Total Ownership Cost of Power Transformers—Part I: A Comprehensive Method

The key techniques employed in this paper reflect on a comprehensive method for calculating the cost of the electric power and energy needed to supply the life-cycle losses of power transformers. The method is applicable to transformer users who possess their own generation and transmission facilities. The proposed loss evaluation method is based on factors derived from relevant historical and forecasted data that are combined to determine the total ownership cost of power transformers. Finally, in a companion paper, the method is evaluated on a small-scale real system.

Do U.S. Insurance Firms Offer the “Wrong” Incentives to Their Executives?

We examine the relation between executive compensation and market-implied default risk for listed insurance firms from 1992-2007. Shareholders are expected to encourage managerial risk-sharing through equity-based incentive compensation. We find that long-term incentives and other share-based plans do not affect the default risk faced by firms. However, the extensive use of stock options leads to higher future default risk for insurance firms. We argue that this is because option-based incentives induce managerial risk-taking behavior, which seeks to maximize managerial payoff through equity volatility. This could be detrimental to the interests of shareholders, especially during a financial crisis.

Tax-Deductible Pre-Event Catastrophe Loss Reserves: The Case of Florida

After Hurricane Andrew the U.S. Congress entertained proposals to allow insurers to employ tax-deferred loss reserves. Interest was strong at first, but as the events receded interest waned. After the most recent hurricane seasons, interest in the proposals has rejuvenated. We examine the use of catastrophic loss reserves in a stylized one period model of insurance. Taking account of the potential changes in consumer behavior due to the institution of catastrophe reserves, we discover large social welfare gains are possible under certain circumstances. The benefits, however, depend on the actuarial assumptions underlying the expected loss distribution.

Loss Evaluation and Total Ownership Cost of Power Transformers—Part II: Application of Method and Numerical Results

The numerical results detailed in this paper reflect on a method proposed to accurately appraise the energy and the demand component of the cost of losses for evaluating the total ownership cost of power transformers. Specifically, the proposed method is evaluated on a small-scale real system, by incorporating realistic financial data and system characteristics through appropriate technoeconomic models as well as statistical evaluations. The calculated loss components of this paper are compared to the methodology detailed in IEEE C.57.120-1991.

Estimation of Distress Costs Associated with Downgrades Using Regime Switching Models

Abstract We use a unique dataset of bond downgrades from a niche rating company that has been found to be reacting faster to publicly available information than its competitors. Using regime-switching models we propose risk measures to quantify stock return disturbances (distress costs) associated with the timing of downgrades. These risk measures are based on the Capital Asset Pricing Model (CAPM) and use the estimated parameters of the regime-switching models. We observe a noticeable switch from a low-volatility to a high-volatility regime one day before the day of downgrades. On average the volatility in stock returns triples around the time of downgrades, and the stock return process remains in the high-volatility regime for about three days. Using our proposed risk measure we find that stock returns are associated with distress costs of about 22*d% (where “d” is the daily market price of risk) over a window of 10 days before and after downgrades. These costs can be further separated between bond-rating companies that are designated by the SEC as nationally recognized to rate debt and those that are not.

The Cross-Section of Asia-Pacific Mortality Dynamics: Implications for Longevity Risk Sharing

We study the dynamics of longevity risk across a subset of countries in the Asia-Pacific (APAC) region. We use hand-collected and existing data on mortality rates from emerging and developed economies, to understand how secular changes in mortality vary within and across APAC countries. We use our results to identify cross-hedging opportunities among longevity risk exposures in the APAC region, and introduce k-forward contracts, hedging instruments offering natural risk sharing opportunities to hedgers in different countries. We consider the example of Korea and Japan as a case study.

Mortality Leads and Lags: MORTALITYLEADS ANDLAGS

Mortality risk varies geographically, especially in the Asia�?Pacific (APAC) region, where economic development is quite diverse. We present a newly collected data set on aggregate population mortality from 11 countries in APAC, which we rank based on their economic development. Using lead-lag analysis, we identify short�?term predictability in mortality risk across countries. Mortality improvements seem to appear faster in more developed than less developed countries. Such predictability is useful for longevity risk financing and in producing cross�?country mortality indices. We propose ways in which our results can benefit institutions manage their exposure in APAC mortality and longevity risk.

An Empirical Investigation of CDS Spreads Using a Regime Switching Default Risk Model

Default risk in equity returns can be measured by structural models of default. In this article we propose a credit warning signal (CWS) based on the Merton Default Risk (MDR) model and a Regime-Switching Default Risk (RSDR) model. The RSDR model is a generalization of the MDR model, comprises regime-switching asset distribution dynamics, and thus produces more realistic default probability estimates in cases of deteriorating credit quality. Alternatively, it reduces to the MDR model. Using a dataset of U.S. credit default swap (CDS) contracts around the 2007-8 crisis we construct rating-based indices to investigate the MDR and RSDR implied probabilities of default in relation to the market-observed CDS spreads. The proposed CWS measure indicates an increase in implied default probabilities several months ahead of notable increases in CDS spreads.