Natural Hedging Strategies for Life Insurers: Impact of Product Design and Risk Measure

Abstract Natural hedging allows life insurers to manage long‐term longevity and investment risks of life annuity products through offsetting risks in life insurance products. Benefits include a reduction in risk‐based capital. We use stochastic mortality and interest rate models to assess life insurance and annuity capital requirements and to quantify the benefits of natural hedging for a range of different types of life insurance product designs and risk measures based on probability of insurer solvency. We show that level‐premium life insurance products with a medium duration (around 20–30 years) can better hedge annuity products than whole life products. Renewable term life insurance products have less hedge effectiveness than level‐premium term insurance. Results vary with the risk measure used, with the 1‐year horizon Solvency II risk measure showing lower natural hedging benefits of life insurance compared to multiple‐period risk measures.