Thomas Post

Stochastic Mortality, Macroeconomic Risks, and Life Insurer Solvency

Motivated by a recent demographic study establishing a link between macroeconomic fluctuations and the mortality index kt in the Lee-Carter model, we assess the impact of macroeconomic fluctuations on the solvency of a life insurance company. Liabilities in our stochastic simulation framework are driven by a GDP-linked variant of the Lee-Carter mortality model. Furthermore, interest rates and stock prices react to changes in GDP, which itself is modeled as a stochastic process. Our results show that insolvency probabilities are significantly higher when the reaction of mortality rates to changes in GDP is incorporated.

How Investor Perceptions Drive Actual Trading and Risk-Taking Behavior

Recent work in behavioral finance showed how investors’ perceptions (i.e., return expectations, risk tolerance, and risk perception) affect hypothetical trading and risk-taking behavior. However, are such perceptions also capable of explaining actual trading and risk-taking behavior? To answer this question, we combine monthly survey data with matching brokerage records to construct a panel data set allowing us to simultaneously examine investor perceptions and behavior. We find that investor perceptions and changes therein are important drivers of actual trading and risk-taking behavior: Investors with higher levels of and upward revisions of return expectations are more likely to trade, have higher turnover, trade larger amounts per transaction, and are more likely to use derivatives. Investors with higher levels of and upward revisions in risk tolerance are more likely to trade, have higher buy-sell ratios, use limit orders more frequently, and hold riskier portfolios. Investors with higher levels of risk perception are more likely to trade, have higher turnover, have lower buy-sell ratios, and hold riskier portfolios.

Stochastic mortality, subjective survival expectations, and individual saving behavior

Theoretical studies suggest that unexpected changes in future mortality and survival probabilities (stochastic mortality) are important determinants of individuals’ decisions about consumption, saving, asset allocation, and retirement timing. Using data on subjective survival expectations elicited in the Survey of Health, Ageing and Retirement in Europe (SHARE) and corresponding life table data from the Human Mortality Database (HMD), we find evidence of respondents’ awareness of stochastic mortality. We also find that respondents’ saving behavior is influenced by stochastic mortality perceptions.

Individual Welfare Gains from Deferred Life-Annuities Under Stochastic Mortality

At the end of the deferment period a deferred annuity’s policyholder can choose between receiving annuity payouts or the capital accumulated. Considering stochastic mortality improvements, this is a valuable option for the policyholder. Whenever mortality improves less than expected at contract inception, the policyholder will choose the lump-sum and buy an annuity at current market prices. Otherwise, he will retain the more favorable deferred annuity. We use a life-cycle model and calculate the welfare gains of deferred annuities considering stochastic mortality improvements. Deferred annuities are found to substantially improve the welfare of an individual. The option feature is especially valuable in the presence of adverse selection problems. The results derived are relevant for individual retirement planning and pension system design.

Portfolio Choice in Retirement - What is the Optimal Home Equity Release Product?

We study the optimal product choice of home equity release products from the homeowner’s perspective in the presence of longevity, long-term care, house price, and interest rate risk. The individual can choose to buy annuities, long-term care insurance, and release home equity using reverse mortgages or home reversion plans. The individual enjoys utility gains from having access to either one of the two equity release products. Higher utility gains are found for the reverse mortgage as its product features allow for higher lump-sum payouts. When given a timing choice, the individual chooses to unlock home equity early in retirement. These key results emerge consistently across a range of cases with different parameter values. The availability of a government-provided LTCI does not change the use of equity release products significantly, but does change the demand for annuities.

Individual Welfare Gains from Deferred Life-Annuities under Stochastic Lee-Carter Mortality

A deferred annuity typically includes an option-like right for the policyholder. At the end of the deferment period, he may either choose to receive annuity payouts, calculated based on a mortality table agreed to at contract inception, or receive the accumulated capital as a lump sum. Considering stochastic mortality improvements, such an option could be of substantial value. Whenever mortality improves less than originally expected, the policyholder will choose the lump sum and buy an annuity on the market granting him a better price. If, however, mortality improves more than expected, the policyholder will choose to retain the deferred annuity. We use a realistically calibrated life-cycle consumption/saving/asset allocation model and calculate the welfare gains of deferred annuities under stochastic Lee- Carter mortality. Our results are relevant both for individual retirement planning and for policymakers, especially if legislation makes annuitization, at least in part, mandatory. Our results also indicate the maximal willingness to pay for the mortality option inherent in deferred annuities, which is of relevance to insurance pricing.

Risk Management in Retirement – What is the Optimal Home Equity Release Product?

We study the optimal product choice of home equity release products from the homeowner’s perspective in the presence of longevity, long-term care, house price, and interest rate risk. The individual can choose to buy annuities, long-term care insurance, and release home equity using reverse mortgages or home reversion plans. The individual enjoys utility gains from having access to either one of the two equity release products. Higher utility gains are found for the reverse mortgage as its product features allow for higher lump-sum payouts. When given a timing choice, the individual chooses to unlock home equity early in retirement. These key results emerge consistently across a range of cases with different parameter values. The availability of a government-provided LTCI does not change the use of equity release products significantly, but does change the demand for annuities.

Measuring the Performance of Life-Cycle Asset Allocation

The United States’ aging population puts pressure on the pension system. Pension reforms consider putting more weight on individually managed retirement savings. Public policy and financial planners, being concerned with households making wise asset allocation decisions, need measures to evaluate individual investment performance. In this chapter, we illustrate two measures for the evaluation of asset allocation performance: a preference-free measure and a preference-based measure. We compare the suitability of both measures along several dimensions. The choice of the measure turns out to be important for the ranking of the performance of asset allocation decisions, and thus great care should be taken when deciding on public policy aimed at improving asset allocation behavior. Furthermore, we show that some classical rules of thumb used to mimic optimal life-cycle asset allocation strategies do not necessarily improve investment performance.

Transparency through Financial Claims with 'Fingerprints': A Mechanism for Preventing Financial Crises

Lack of transparency in securitization transactions contributed significantly to the current global financial crisis. This article proposes an incentive-compatible mechanism for future securitization transactions that would increase transparency: financial claims with “fingerprints.” This mechanism would allow market participants at each stage of the securitization process to easily obtain full information about the underlying original risks and the superior claims that need to be satisfied before receiving their own payoffs. The mechanism would considerably enhance transparency in securitization transactions at the expense of some transaction costs. In 2007, the U.S. housing market bubble burst, triggering a financial crisis that resulted in a worldwide recession. Often mentioned as contributors to the crisis are the securitization of mortgages and the repackaging, or tranching, of mortgage-backed securities (MBSs) into collateralized debt obligations (CDOs). MBSs and especially CDOs exhibit a large degree of opaqueness (i.e., market participants often have limited information about the true nature of the risks of the underlying mortgages). Every additional repackaging has the potential for even more information loss. In the run-up to the crisis, this situation caused the market for these securities to dry up. Furthermore, banks that held these opaque securities faced major refinancing problems. The apparent collapse of the market for MBSs has led many policymakers and commentators to demand stricter regulation of transactions and compulsory trading of asset-backed securities at stock exchanges. Some have even called for a complete ban on MBSs. We propose an incentive-compatible mechanism that takes “fingerprints” of the original mortgages and of MBS and CDO transactions. By fingerprints, we mean a complete record of information concerning the original mortgage transactions and all subsequent securitizations of those mortgages. This mechanism would solve many of the markets’ problems without stricter regulation and without impeding the potential for innovation in the securitization markets. We believe that our proposed mechanism would offer advantages at all stages of the securitization process, albeit with some possibly minor transaction costs. Our mechanism is related to recent proposals by several researchers, including suggestions to create a global risk map and a global credit register, to increase and standardize information on mortgages, and to set up a clearinghouse to support the regulatory authorities. Some proposals address systemic risks stemming from interbank relationships, counterparty risk, and the opaqueness of financial institutions. Our proposal, however, is targeted at the specific, but important, market segment of mortgage-backed securities that has experienced market failure. Our proposal is extensive, covering transparency for MBS and CDO payment structures. Moreover, our proposal does not entail stricter regulation of MBSs and CDOs; instead, it creates incentives for market participants to enhance transparency and thus keep alive the free market and its innovative forces. Despite our nonregulatory approach, our mechanism could be an integral part of a global risk map. Our proposal is based on an idea put forward by Harry Markowitz, who suggested setting up, as part of efforts to address the immediate problems of the financial crisis, a regulatory body that would conduct an in-depth census of institutions that own securitized assets. The information collected would encompass detailed data on security claim structures and underlying mortgage risks. Markowitz also suggested that the information be used to solve some of the more severe problems of the current crisis—no confidence in financial institutions that hold securitized assets and no trade in “toxic assets.” Under our proposal, a systematic collection of securitization transaction data could become the cornerstone of an incentive-compatible mechanism in securitization transactions and thus foster a revival of securitization markets without new regulations.

Well-Appreciated but (Too) Difficult Pensions Choices? Insights from the Swedish Premium Pension System

We analyze preferences and beliefs of members in a DC pension scheme from Sweden, one of the first countries that launched choice-based funded individual pension accounts. Based on a survey among 2,646 members, we study the effect of choice overload, risk tolerance, and subjective knowledge on choice behavior and financial well-being. We find that more risk-averse and less knowledgeable members tend to invest in the default fund – a fund that is, however, one of the riskiest options on the choice menu. On top of this mismatch between members’ risk preferences and their investment choices, we find those members are more likely to feel negative about their future financial well-being. We also find a positive correlation between financial well-being and choice appreciation, whereas the act of choosing a fund has only minor impact.