Longevity Risk and Annuity Pricing with the Lee-Carter Model

Abstract

ABSTRACTSeveral important classes of liability are sensitive to the direction of future mortality trends, and this paper presents some recent developments in fitting smooth models to historical mortality-experience data. We demonstrate the impact these models have on mortality projections, and the resulting impact which these projections have on financial products. We base our work round the Lee-Carter family of models. We find that each model fit, while using the same data and staying within the Lee-Carter family, can change the direction of the mortality projections. The main focus of the paper is to demonstrate the impact of these projections on various financial calculations, and we provide a number of ways of quantifying, both graphically and numerically, the model risk in such calculations. We conclude that the impact of our modelling assumptions is financially material. In short, there is a need for awareness of model risk when assessing longevity-related liabilities, especially for annuities and pensions.