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WORKING PAPERS 2013
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Hazel Bateman and Kevin Liu
December 2013

China is experiencing rapid ageing as a result of declines in fertility combined with significant increases in longevity. According to current UN projections, more than a quarter of the population will be over 65 years old by 2050, and the old-age dependency ratio is expected to triple to almost 40 per cent. In recent years, the Chinese government has introduced a number of initiatives to reform the pension system in an attempt to address the issues of profound population aging, social disparity and regional imbalance. However significant issues remain relating to uneven coverage, fragmentation, financing, investment strategy and legacy costs. As well, China faces broader economy-wide challenges due to rapid urbanisation, changes in family structure and globalisation. Using data from the China Household Finance Survey - a new nationally representative survey of 8,438 households we critically assess the Chinese pension system using both individual and economy-wide criteria. We advocate that the key to sustainable reform will be the establishment of a regulatory framework with well-defined governance structures for both publicly and privately managed pension assets.

 
Julie Agnew, Hazel Bateman, Christine Eckert, Fedor Iskhakov, Jordan Louviere and Susan Thorp
December 2013

Using an online incentivized discrete choice experiment, we study how well individuals judge financial advice and whether factors other than advice quality influence their evaluations. We find evidence that some individuals rely on extraneous signals to judge advice quality and observe some persistency in adviser choice over time. Our results also explain how some advisers can maintain trustworthy reputations despite giving bad advice. Finally, we explore whether individuals learn throughout the experiment. Our findings have several public policy implications that are discussed in the conclusion.

 
Ermanno Pitacco
December 2013

We address life annuities and pensions, looking in particular at transfers/sharing of biometric risks, i.e. risks related to the annuitant's lifetime and health status, involved by the policy conditions or the pension plan rules. First, we focus on various arrangements which aim at building the post-retirement income, and involve either the accumulation phase, or the payout phase, or both. Various products are available on financial and insurance markets, each product with a specific guarantee structure (Conventional Life Annuities either immediate or deferred, Variable annuities, withdrawal plans, etc.). We then shift to a range of specific annuity products, stressing the relevant features: Advanced Life Delayed Annuity (ALDA), Ruin Contingent Life Annuity (RCLA), Variable Annuities (VA). Finally, we focus on some arrangements for the payout phase: the life annuity with a guarantee period, the value-protected life annuity (that is, providing "capital protection"), progressive annuitization schemes, life annuities combined with Long Term Care (LTC) benefits. We conclude with a short introduction to the longevity-linked life annuities. 

 
Kostas Mavromaras and Rong Zhu
December 2013

In this paper we estimate the interdependence of labour force participation decisions made by Australian couples from 2001 to 2011. We focus on couples with a mature age husband, and estimate the interdependence of the participation decision of the couple. We fnd that the decision of a wife to work or not influences positively, and in a casual fasion, the decision of her husband to work or not. In our paper we use counterfactual analysis to estimate the impact of the increasing labour force participation of a wife on her husband's participation. We find that the increased labour force participation of married women observed between 2002 and 2011 has been responsible for about 4 percentage points increase in the participation of their mature age husbands.

 
Hazel Bateman, Jeanette Deetlefs, Isabella Dobrescu, Ben Newell, Andreas Ortmann and Susan Thorp
December 2013

Low levels of non-default decision making among superannuation members in Australia are assumed to be evidence of a lack of interest and capability. Using member records and survey data from a large Australian superannuation fund, we test the relationship between attitudes towards retirement savings and observable levels of non-default activities (such as making voluntary contributions, choosing or changing investment options and changing insurance cover). Additional retirement savings contributions by permanent staff are more likely if the staff member is very likely to recommend their superannuation fund. Individuals who rate their own personal interest in superannuation affairs as very high are more likely to be active online. This, however, doesn't extend to choosing a non-default investment or purchasing additional
insurance, where we find no differences between the highly interested and the disengaged. These findings, together with several other differences related to demographics and employment conditions, show that non-default activity is not a reliable proxy for member engagement.

 

 
Craig Blackburn, Katja Hanewald, Annamaria Olivieri and Michael Sherris
25 November 2013

 

This paper assesses the impact of longevity risk management on insurer shareholder value and solvency for an annuity portfolio. The analysis uses a multiperiod stochastic mortality model with both systematic and idiosyncratic longevity risk. We consider both survivor, or longevity, swaps that provide a full longevity risk hedge, and index-based survivor, or longevity, bonds that do not hedge idiosyncratic longevity risk. Shareholder value includes the impact of the costs of transferring longevity risk, policyholder demand elasticity, regulatory capital requirements, capital relief, and frictional costs including the insolvency put option, agency costs, and financial distress costs. Shareholder value uses an Economic Value (EV) and a Market-Consistent Embedded Value (MCEV) approach. Capital management is also assessed based on a recapitalization and dividend strategy that maintains regulatory capital requirements, as defined under Solvency II. We demonstrate how longevity risk management strategies significantly reduce the volatility of shareholder value and frictional costs. Longevity risk management reduces the probability of insolvency, increases policyholder demand and hence increases shareholder value.

 

 
George Kudrna, Chung Tran and Alan Woodland
10 October 2013

In this paper we develop an overlapping generations (OLG) model that incorporates non-stationary demographic transition paths to study the dynamic fiscal effects of demographic shift in Australia. Our main results are summarised as follows. First, demographic shift results in lower per capita output and increased capital outflows. Second, the changes in demographic structure lead to a shift in the tax base from labor income to capital income and consumption. Third, there are substantial increases in old-age related expenditures including health, aged care and pensions. In order to finance the larger old-age related benefits in the future, significant adjustments in other government expenditures and taxes will be required. Particularly, the government will have to either cut other expenditures by around 40 percent or increase consumption taxes by around 34 percent in 2050. Finally, increases in fertility and immigration are not an effective solution to such budget challenges.

 
Ramona Meyricke and Michael Sherris
24 September 2013

The cost of capital is an important factor determining the premiums charged by life insurers issuing life annuities. Insurers will be able to offer more finely priced annuities if they can reduce this cost whilst maintaining solvency. This capital cost can be reduced by hedging longevity risk with longevity swaps, a form of reinsurance. We assess the costs of longevity risk management using longevity swaps compared to costs of holding capital under Solvency II. We show that, using a reasonable market price of longevity risk, the market cost of hedging longevity risk for earlier ages is lower than the cost of capital required under Solvency II. Longevity swaps covering higher ages, around 90 and above, have higher market hedging costs than the saving in the cost of regulatory capital. The Solvency II capital regulations for longevity risk generates an incentive for life insurers to hold longevity tail risk on their own balance sheets, rather than transfer this to the reinsurance or the capital markets. This aspect of the Solvency II capital requirements is not well understood and raises important policy issues for the management of longevity risk.

 
Shang Wu, Ralph Stevens and Susan Thorp
August 2013

Modeling of subjective survival is critical to the use of mortality expectations in economic models and the life insurance industry. Subjective scaling factors that are used to adjust average survival probabilities for individual expectations are often based on a single observation of personal life expectancy and assumed to be constant for any projected target age. Using survey data on subjective survival probabilities over a range of target ages and from an array of age cohorts, we estimate individual subjective scalings of population mortality probabilities. We show that both cohort age and target age matter: comparing subjective survival probabilities with the cohort life table, we show that respondents are generally pessimistic about overall life expectancy, but are optimistic about their probability of surviving to advanced ages; and that older respondents in our middle-aged sample are more optimistic than younger ones. Hence, our data suggests that individuals tend to expect to either die young or to live long. We propose a new model to incorporate cohort- and target age-varying subjective survival beliefs and illustrate the effect of these variations on optimal life cycle consumption plans. The proposed model contributes to the explanation of both the retirement savings puzzle and conservative spending patterns in retirement.

 
Loretti I. Dobrescu
June 2013

This paper develops a dynamic structural life-cycle model to study how heterogeneous health and medical spending shocks affect the savings behavior of the elderly. Individuals are allowed to respond to health shocks in two ways: they can directly pay for their health care expenses (self-insure) or they can rely on health insurance contracts. There are two possible insurance options, one through formal contracts and another through informal care provided by family. Formal contracts may be affected by asymmetric information problems, whereas informal insurance depends on social ties (cohesion) and on bequeathable wealth. I estimate the model on SHARE data using simulated method of moments for four levels of wealth in a sample of single retired Europeans. Counterfactual experiments show that health, medical spending and health insurance are indeed the main drivers of the slow wealth decumulation in old age. I also find that social cohesion rises with age, declines with wealth and is higher in Mediterranean countries than in Central European and Scandinavian countries. Finally, high social cohesion appears typically associated with increased life expectancy.

 
Katja Hanewald, Thomas Post and Michael Sherris
June 2013

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.

 
Joelle H. Fong, Adam W. Shao and Michael Sherris
May 2013

We apply generalized linear models to evaluate disability transitions for individuals in old age based on a large sample of U.S. elderly. We estimate a multi-state model for long-term care insurance applications, and find significant differences in disability rate patterns and levels from the commonly-used Robinson (1996) model. Our results suggest that the elderly face a 10% chance of becoming long-term care disabled only at ages past 90, rather than in their 80s. Furthermore, age patterns of recovery are found to differ significantly between the sexes. These estimates of transition probability are sensitive to the definition of 'long-term care disability', which has implications for the design of benefit triggers for private and public long-term care insurance programs.

 
Michael Sherris and Qiming Zhou
May 2013

Mortality models used to assess longevity risk and retirement funding have been extended to stochastic models with trends and systematic risk. Systematic risk cannot be readily diversified in an insurance pool or pension fund. It is an important factor in assessing solvency and highlighting the tail risk in longevity insurance and pension products. Idiosyncratic risk can be diversified in typical pool sizes, although less effectively at the older ages. Mortality heterogeneity is not usually taken into account in stochastic mortality models. This is a mortality risk that reduces the effectiveness of idiosyncratic mortality risk pooling. Heterogeneity has been modelled with frailty models and more recently with Markov multiple state ageing models. This paper overviews recent developments in models for mortality heterogeneity and uses a model calibrated to both population mortality and health condition data to consider the impact of model risk and heterogeneity in assessing solvency and tail risk for longevity risk products.

 

 
Hal Kendig and Nina Lucas
April 2013

Social change in Australia over the post WW II era -including increasing prosperity, massive immigration, and increasing public support - has brought overall improvements in intergenerational relationships and outcomes for older people. The future, however, is more problematic, especially for vulnerable individuals and families over the life course, in the context of rapid societal ageing, uncertain economic prospects, and changing political ideologies. The vast majority of older Australians choose to live independently and have the means to do so while informal family support networks generally are strong, with support flows both up and down the generations. Governments have increased complementary public support to older people who wish to stay in their own homes, to stay in the workforce, and to save for retirement. New policy directions have reasonable prospects for increasing the well-being of older people and intergenerational sustainability through an increasing focus on human capital, facilitating contributions over the life course, and fundamentally changing attitudes towards ageing.

 
Cagri S. Kumru and Saran Sarntisart
April 2013

Self-control problem is an important determinant of individuals' economic decisions. The decision maker's future utility is affected by unwanted temptation. This implies that implications of various government policies would differ if one incorporates these behavioural aspects. Public finance instruments could, however, be used to correct anomalies created by temptation. The purpose of this paper is to examine the question of optimal taxation when individuals have self-control problems. In order to capture our agents' temptation towards current consumption, our model make use of the preference structure pioneered by Gul and Pesendorfer and further elaborated by Krusell et al. in the context of optimal taxation. We extend by adding labor choice and besides savings tax, we also analyze capital income tax, consumption tax and labor income tax. Results show that when the analysis is restricted to logarithmic preferences separable in consumption and labor supply, the government should subsidize either capital income or investment as it maximizes both an individual's commitment utility for consumption and labor supply at the same time. Because individuals consume and supply labor more than their commitment utility, subsidizing improves welfare as it makes temptation less attractive.

 
Daniel H. Alai, Zinoviy Landsman and Michael Sherris
April 2013

Systematic improvements in mortality increases dependence in the survival distributions of insured lives. This is not accounted for in standard life tables and actuarial models used for annuity pricing and reserving. Furthermore, systematic longevity risk undermines the law of large numbers; a law that is relied on in the risk management of life insurance and annuity portfolios. This paper applies a multivariate Tweedie distribution to incorporate dependence, which it induces through a common shock component. Model parameter estimation is developed based on the method of moments and generalized to allow for truncated observations. The estimation procedure is explicitly developed for various important distributions belonging to the Tweedie family, and finally assessed using simulation.

 
Adam Wenqiang Shao, Michael Sherris and Katja Hanewald
March 2013

This paper estimates and compares methods of constructing disaggregated house price indices from existing house price models using individual sales data for Sydney. Nine alternative house price models are selected to cover the most frequently used methods in the literature: the mean model, median models (standard and stratified), hedonic models (restricted and unrestricted hedonic), repeat-sales models (age-adjusted and Case-Shiller weighted), and a hybrid of the hedonic and repeat-sales model. The unrestricted hedonic model and the hybrid model have an advantage over the other seven models in that they do not require stratification of the data for estimating disaggregated indices. Both models employ the whole sample to estimate implicit prices of house characteristics that are used to construct disaggregated house price indices. These two models eliminate variability arising from small sample sizes and provide more efficient estimates of house price heterogeneity. In addition, house characteristics that are important drivers of the variability of individual house prices are identified in the two models. Disaggregated indices constructed from these two models provide more accurate comparisons with an aggregated house price index. We quantify the extent to which disaggregated house prices indices have significantly more variability than, and differing trends from, the aggregate index.

 
Hazel Bateman, Isabella Dobrescu, Ben R. Newell, Andreas Ortmann and Susan Thorp
March 2013

We report the results of two laboratory experiments that study how university student and staff participants chose retirement savings investment options using 'user‐friendly' information prescribed by regulators. We demonstrate that choices of more than 20% of participants cannot be predicted using any of the prescribed information items but that 30% of participants used all, or almost all, items, frequently in unexpected ways. A pie‐chart showing asset allocation had the largest marginal impact on investment choices. Participants preferred options with more segmented pies (lower concentration) and with equally sized segments (lower deviation from a 1/n allocation). This choice behaviour is consistent with the application of a simple diversification heuristic. Participants cannot choose more than one investment but are guided by the extent to which a pre‐mixed investment option appears evenly balanced across asset classes. This novel application of a 1/n strategy is distinct from existing findings of naïve diversification in 'mix‐it‐yourself' conditions where participants spread resources evenly across funds or categories. The results highlight that information contained in prescribed investment disclosures may not be used in the manner intended by the regulator. The results also pose interesting methodological questions about the way 'user‐friendly' information prescribed by regulators is validated before being legislated.

 
Vanessa Loh and Hal Kendig
March 2013

An uncertain economic outlook and the certitude of an ageing population highlight the importance of productivity across all age groups for Australia's future. This paper provides national findings on both paid, tax-generating and unpaid, voluntary productivity across the life course, focusing primarily on the baby boomer cohort now in late middle age. Findings from Wave 10 (2010) of the Household, Income and Labour Dynamics in Australia (HILDA) Survey are presented showing productive activities including paid work, volunteering, caregiving, childcare, and domestic work. The results indicate that the kinds of productivity vary across age groups for men and women, the potential competition between paid work and other activities, and the importance of health and education for productivity across all ages. The findings reinforce the value of investment in human capital for productivity across the lifespan inclusive of middle and late life. The Government can lead action to enhance and recognise these contributions that benefit the social standing and well being of ageing individuals as well as bring economic and social benefits to the broader community.

 
Shiko Maruyamaya and Meliyanni Johar
March 2013

When siblings are concerned for the well-being of their elderly parents, the costs of care giving and long-term commitment create a free-rider problem. If siblings living near their parents can share the costs, this positive externality exacerbates the under-provision of proximate living. Location decisions allow siblings to make a commitment to not provide long-term support for parents, and if decisions are made in birth order, elder siblings may enjoy the first-mover advantage. To quantify these effects, we study siblings' location decisions relative to parents by estimating a sequential participation game that features rich heterogeneity. We find moderate altruism and cooperation in the US that imply: (1) limited strategic behaviour: more than 90% of children have a dominant strategy; and (2) non-negligible free-riding: of the families with multiple children, had siblings fully internalized externality and jointly maximized their utility, 18.3% more parents would have had at least one child nearby.

 
Daniel H. Alai, Severine Gaille and Michael Sherris
March 2013

Changes in underlying mortality rates significantly impact insurance business as well as private and public pension systems. Individual mortality studies have data limitations; aggregate mortality studies omit many relevant details. The study of causal mortality represents the middle ground, where population data is used while cause-of-death information is retained.We use internationally classified cause-of-death categories and data obtained from the World Health Organization. We model causal mortality simultaneously in a multinomial logistic framework. Consequently, inherent dependence amongst the competing causes is accounted for. This framework allows us to investigate the effects of improvements in, or the elimination of, cause-specific mortality in a sound probabilistic way. This is of particular interest for scenario-based forecasting purposes. We show the multinomial model is more conservative than a force-of-mortality approach. Finally, we quantify the impact of cause-elimination on aggregate mortality using residual life expectancy and apply our model to a French case study.

 
Daniel Cho, Katja Hanewald and Michael Sherris
March 2013

We analyze the risk and profitability of reverse mortgages with lump-sum or income stream payments from the lender's perspective. Reverse mortgage cash flows and loan balances are modelled in a multi-period stochastic framework that allows for house price risk, interest rate risk and risk of delayed loan termination. A VAR model is used to simulate economic scenarios and to derive stochastic discount factors for pricing the no negative equity guarantee embedded in reverse mortgage contracts. Our results show that lump-sum reverse mortgages are more profitable and require less risk-based capital than income stream reverse mortgages, which explains why this product design dominates in most markets. The loan-to-value ratio, the borrower's age, mortality improvements and the lender's financing structure are shown to be important drivers of the profitability and riskiness of reverse mortgages, but changes in these parameters do not change the main conclusions.

 

 
Ramona Meyricke and Michael Sherris
February 2013

It is widely accepted that mortality risk varies across individuals within age- sex bands of a population. This heterogeneity exposes insurers to adverse selection if only the healthiest lives purchase annuities, so standard annuities are priced with a mortality table that assumes above-average longevity. This makes standard annuities expensive for many individuals. To address this issue there has been a shift to underwriting annuities inorder to offer lower prices to individuals with below-average longevity. While underwriting reduces heterogeneity, mortality risk still varies within each risk class due to unobservable individual-specific factors, referred to as frailty. This paper quantities the financial impact of frailty on underwritten annuities. The heterogeneity implied by underwriting factors and frailty is quantified by fitting Generalized Linear Mixed Models to longitudinal data for a large sample of US males. The results show that heterogeneity remains after underwriting, creating significant variation in the fair value of underwritten annuities. We develop a method to adjust annuity prices to allow for frailty.

 

 

 
Andy Wong, Michael Sherris, and Ralph Stevens
January 2013

Changing demographics creates the potential for the expansion of existing and new products to manage longevity risk. Life annuities address this risk, yet these annuity product markets are thin. Insurers are concerned about the long term risks associated with these longevity products and capital requirements. Life insurers also offer life insurance products, whole-of-life and term, that provide an opportunity to offset longevity risks. This can allow capital efficient longevity risk products to be sold as part of a product portfolio. Natural hedging, or the offsetting of risks in life insurance and annuity business, provides a way of managing capital efficiently as well as improving profitability. This paper uses stochastic mortality and interest rate models to assess life and annuity capital requirements and quantify the benefits of natural hedging taking into account relative profit loadings on products. The benefits of offering longevity products, in terms of capital requirements, as well as the importance of the type of life insurance products offered are illustrated using standard life and annuity products. The impact of capital requirements, such as solvency II with a one-year horizon, are considered and compared to multiple period risk measures to confirm the results hold for regulatory capital requirements.

 
Cagri S. Kumru and Saran Sarntisart
January 2013

A significant number of individuals are unwilling to deposit their savings into the banking sector since it does not operate according to their religious beliefs. In this paper we provide a model that aims to answer the following questions: First, under what conditions an alternative banking system would arise? Second, what are the growth, and welfare implications of these banking systems? Our model shows that an alternative banking system would arise if individuals have religious concerns. Moreover, we show that in an economy populated with a certain number of religiously concerned individuals, the existence of an alternative baking system can generate relatively higher growth and improve welfare.

 
Severine Gaille, Michael Sherris
January 2013

Longevity risk is amongst the most important factors to consider for pricing and risk management of longevity products. Past improvements in mortality over many years, and the uncertainty of these improvements, have attracted the attention of experts, both practitioners and academics. Since aggregate mortality rates reflect underlying trends in causes of death, insurers and demographers are increasingly considering cause-of-death data to better understand risks in their mortality assumptions. The relative importance of causes of death has changed over many years. As one cause reduces, others increase or decrease. The dependence between mortality for different causes of death is important when projecting future mortality. However, for scenario analysis based on causes of death, the assumption usually made is that causes of death are independent. Recent models, in the form of Vector Error Correction Models (VECM), have been developed for multivariate dynamic systems and capture time dependency with common stochastic trends. These models include long-run stationary relations between the variables, and thus allow a better understanding of the nature of this dependence. This paper applies VECM  to cause-of-death mortality rates in order to assess the dependence between these competing risks. We analyze the five main causes of death in Switzerland. Our analysis confirms the existence of a long-run stationary relationship between these five causes. This estimated relationship is then used to forecast mortality rates, which are shown to be an improvement over forecasts from more traditional ARIMA processes, that do not allow for cause-of-death dependencies.

 
Daniel Alai, Hua Chen, Daniel Cho, Katja Hanewald and Michael Sherris
January 2013

Equity release products are sorely needed in an ageing population with high levelsof home ownership. There has been a growing literature analyzing risk components andcapital adequacy of reverse mortgages in recent years. However, little research has been doneon the risk analysis of other equity release products, such as home reversion contracts. This is partly due to the dominance of reverse mortgage products in equity release marketsworldwide. In this paper, we compare cash flows and risk profiles from the provider'sperspective for reverse mortgage and home reversion contracts. An at-home/in long-term caresplit termination model is employed to calculate termination rates, and a vector autoregressive (VAR) model is used to depict the joint dynamics of economic variables including interest rates, house prices and rental yields. We derive stochastic discount factorsfrom the no arbitrage condition and price the no negative equity guarantee in reverse mortgages and the lease for life agreement in the home reversion plan accordingly. We compare expected payoffs and assess riskiness of these two equity release products via commonly used risk measures, i.e., Value-at-Risk (VaR) and Conditional Value-at-Risk (CVaR).