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SOCIAL SCIENCE RESEARCH NETWORK
E M P L O Y E E B E N E F I T S , C O M P E N S A T I O N
& P E N S I O N L A W
Vol. 7, No. 17: June 22, 2006
Editor: PAMELA J. PERUN
Urban Institute
PAMELA@PLANETNOW.COM
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Topic of This Issue:
Insurance Issues
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T A B L E O F C O N T E N T S
"Life-Cycle Asset Allocation with Annuity Markets: Is Longevity
Insurance a Good Deal?"
WOLFRAM HORNEFF
Goethe University Frankfurt - Department of Finance
RAIMOND MAURER
University of Frankfurt - Faculty of Business and
Economics
MICHAEL STAMOS
Goethe University Frankfurt
"Life is Cheap: Using Mortality Bonds to Hedge Aggregate
Mortality Risk"
LEORA FRIEDBERG
University of Virginia - Department of Economics,
National Bureau of Economic Research (NBER)
ANTHONY WEBB
Boston College - Center For Retirement Research
"Testing for Adverse Selection with 'Unused Observables'"
AMY FINKELSTEIN
Massachusetts Institute of Technology (MIT) -
Department of Economics, National Bureau of Economic
Research (NBER)
JAMES M. POTERBA
Massachusetts Institute of Technology (MIT) -
Department of Economics, National Bureau of Economic
Research (NBER)
"Redistribution by Insurance Market Regulation: Analyzing a Ban
on Gender-Based Retirement Annuities"
AMY FINKELSTEIN
Massachusetts Institute of Technology (MIT) -
Department of Economics, National Bureau of Economic
Research (NBER)
JAMES M. POTERBA
Massachusetts Institute of Technology (MIT) -
Department of Economics, National Bureau of Economic
Research (NBER)
CASEY ROTHSCHILD
Affiliation Unknown
"Dynamic Asset Allocation with Annuity Risk"
RALPH S.J. KOIJEN
Tilburg University - Center for Economic Research
THEO E. NIJMAN
Tilburg University - CentER and Faculty of Economics
and Business Administration
BAS J. M. WERKER
Tilburg University - Center for Economic Research
"Optimum Taxation of Life Annuities"
JOHANN K. BRUNNER
University of Linz, CESifo (Center for Economic
Studies and Ifo Institute for Economic Research)
SUSANNE PECH
University of Linz - Department of Economics
"Human Capital, Asset Allocation, and Life Insurance"
PENG CHEN
Ibbotson Associates
ROGER G. IBBOTSON
Yale School of Management
MOSHE ARYE MILEVSKY
York University
KEVIN X. ZHU
Affiliation Unknown
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"Life-Cycle Asset Allocation with Annuity Markets: Is Longevity
Insurance a Good Deal?"
Author: WOLFRAM HORNEFF
Goethe University Frankfurt -
Department of Finance
Email: horneff@finance.uni-frankfurt.de
Auth-Page: http://ssrn.com/author=495528
Contact: RAIMOND MAURER
University of Frankfurt - Faculty of
Business and Economics
Email: Rmaurer@wiwi.uni-frankfurt.de
Auth-Page: http://ssrn.com/author=98155
Co-Author: MICHAEL STAMOS
Goethe University Frankfurt
Auth-Page: http://ssrn.com/author=495541
Full Text: http://ssrn.com/abstract=889362
ABSTRACT: We show how an individual with uninsurable labor
income, borrowing constraints, and Epstein-Zin utility function
optimally spreads her financial wealth across stocks, bonds and
life-annuities over the life-cycle when the finite investment
horizon is stochastic. In spite of asymmetric mortality beliefs,
public pensions, and bequest motives, we find that the individual
starts out with annuitizing 18.59 percent of her accumulated
financial wealth five years prior to retirement and continues
gradually annuitizing thereafter. Our welfare analysis shows that
the presence of an annuity market increases the individual's
welfare by 14.14 percent at age 80 and by 30.07 percent at age 90.
______________________________
"Life is Cheap: Using Mortality Bonds to Hedge Aggregate
Mortality Risk"
NBER Working Paper No. W11984
Contact: LEORA FRIEDBERG
University of Virginia - Department
of Economics, National Bureau of Economic Research
(NBER)
Email: LFRIEDBERG@VIRGINIA.EDU
Auth-Page: http://ssrn.com/author=2209
Co-Author: ANTHONY WEBB
Boston College - Center For
Retirement Research
Email: webbaa@bc.edu
Auth-Page: http://ssrn.com/author=269290
Full Text: http://ssrn.com/abstract=879249
ABSTRACT: Using the widely cited Lee-Carter mortality model, we
quantify aggregate mortality risk as the risk that the average
annuitant lives longer than is predicted by the model, and we
conclude that annuity business exposes insurance companies to
substantial mortality risk. We calculate that a markup of 3.7% on
an annuity premium (or else shareholders' capital equal to 3.7%
of the expected present value of annuity payments) would reduce
the probability of insolvency resulting from uncertain aggregate
mortality trends to 5% and a markup of 5.4% would reduce the
probability of insolvency to 1%. Using the same model, we find
that a projection scale commonly referred to by the insurance
industry underestimates aggregate mortality improvements.
Annuities that are priced on that projection scale without any
conservative margin appear to be substantially underpriced.
Insurance companies could deal with aggregate mortality risk by
transferring it to financial markets through mortality-contingent
bonds, one of which has recently been offered. We calculate the
returns that investors would have obtained on such bonds had they
been available over a long period. Using both the Capital and the
Consumption Capital Asset Pricing Models, we determine the risk
premium that investors would have required on such bonds. At
plausible coefficients of risk aversion, annuity providers should
be able to hedge aggregate mortality risk via such bonds at a
very low cost.
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"Testing for Adverse Selection with 'Unused Observables'"
NBER Working Paper No. W12112
Contact: AMY FINKELSTEIN
Massachusetts Institute of Technology
(MIT) - Department of Economics, National Bureau of
Economic Research (NBER)
Email: afink@mit.edu
Auth-Page: http://ssrn.com/author=173478
Co-Author: JAMES M. POTERBA
Massachusetts Institute of Technology
(MIT) - Department of Economics, National Bureau of
Economic Research (NBER)
Email: poterba@mit.edu
Auth-Page: http://ssrn.com/author=21561
Full Text: http://ssrn.com/abstract=893767
ABSTRACT: This paper proposes a new test for adverse selection in
insurance markets based on observable characteristics of
insurance buyers that are not used in setting insurance prices.
The test rejects the null hypothesis of symmetric information
when it is possible to find one or more such "unused observables"
that are correlated both with the claims experience of the
insured and with the quantity of insurance purchased. Unlike
previous tests for asymmetric information, this test is not
confounded by heterogeneity in individual preference parameters,
such as risk aversion, that affect insurance demand. Moreover, it
can potentially identify the presence of adverse selection, while
most alternative tests cannot distinguish adverse selection from
moral hazard. We apply this test to a new data set on annuity
purchases in the United Kingdom, focusing on the annuitant's
place of residence as an "unused observable." We show that the
socio-economic status of the annuitant's place of residence is
correlated both with annuity purchases and with the annuitant's
prospective mortality. Annuity buyers in different communities
therefore face different effective insurance prices, and they
make different choices accordingly. This is consistent with the
presence of adverse selection. Our findings also raise questions
about how insurance companies select the set of buyer attributes
that they use in setting policy prices. We suggest that political
economy concerns may figure prominently in decisions to forego
the use of some information that could improve the risk
classification of insurance buyers.
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"Redistribution by Insurance Market Regulation: Analyzing a Ban
on Gender-Based Retirement Annuities"
NBER Working Paper No. W12205
Contact: AMY FINKELSTEIN
Massachusetts Institute of Technology
(MIT) - Department of Economics, National Bureau of
Economic Research (NBER)
Email: afink@mit.edu
Auth-Page: http://ssrn.com/author=173478
Co-Author: JAMES M. POTERBA
Massachusetts Institute of Technology
(MIT) - Department of Economics, National Bureau of
Economic Research (NBER)
Email: poterba@mit.edu
Auth-Page: http://ssrn.com/author=21561
Co-Author: CASEY ROTHSCHILD
Affiliation Unknown
Auth-Page: http://ssrn.com/author=620808
Full Text: http://ssrn.com/abstract=900990
ABSTRACT: This paper shows how models of insurance markets with
asymmetric information can be calibrated and solved to yield
quantitative estimates of the consequences of government
regulation. We estimate the impact of restricting gender-based
pricing in the United Kingdom retirement annuity market, a market
in which individuals are required to annuitize tax-preferred
retirement savings but are allowed considerable choice over the
annuity contract they purchase. After calibrating a lifecycle
utility model and estimating a model of annuitant mortality that
allows for unobserved heterogeneity, we solve for the range of
equilibrium contract structures with and without gender-based
pricing. Eliminating gender-based pricing is generally thought to
redistribute resources from men to women, since women have longer
life expectancies. We find that allowing insurers to offer a menu
of contracts may reduce the amount of redistribution from men to
women associated with gender-blind pricing requirements to half
the level that would occur if insurers were required to sell a
single pre-specified policy. The latter "one policy" scenario
corresponds loosely to settings in which governments provide
compulsory annuities as part of their Social Security program.
Our findings suggest that recognizing the endogenous structure of
insurance contracts is important for analyzing the economic
effects of insurance market regulations. More generally, our
results suggest that theoretical models of insurance market
equilibrium can be used for quantitative policy analysis, not
simply to derive qualitative findings.
______________________________
"Dynamic Asset Allocation with Annuity Risk"
Contact: RALPH S.J. KOIJEN
Tilburg University - Center for
Economic Research
Email: r.s.j.koijen@uvt.nl
Auth-Page: http://ssrn.com/author=374406
Co-Author: THEO E. NIJMAN
Tilburg University - CentER and
Faculty of Economics and Business Administration
Email: Nyman@uvt.nl
Auth-Page: http://ssrn.com/author=204454
Co-Author: BAS J. M. WERKER
Tilburg University - Center for
Economic Research
Email: b.j.m.werker@uvt.nl
Auth-Page: http://ssrn.com/author=50141
Full Text: http://ssrn.com/abstract=890730
ABSTRACT: We study a dynamic asset allocation problem over the
investor's life-cycle taking into account annuity risk at the
moment of retirement. Optimally, the investor allocates wealth at
retirement to nominal, inflation-linked, and variable annuities
and conditions the annuity choice on the state of the economy. We
also consider the case in which there are, either for behavioral
or institutional reasons, limitations in the types of annuities
that are available at retirement. Subsequently, we determine how
the investor optimally anticipates the retirement choice in the
period before retirement. We show in particular that i)
conditioning information is important for the optimal annuity
choice, ii) additional hedging demands induced by the annuity
demand due to inflation risk and time-varying risk premia are
economically significant, while the additional demand to hedge
real interest rate risk is negligible in welfare terms, and iii)
restricting the annuity menu to nominal or inflation-linked
annuities is costly for both conservative and more aggressive
investors. More specifically, the welfare costs of not exploiting
conditioning information are estimated to be 4%-9%. Even though
the optimal conditional annuity strategy turns out to be a
complex function of the state variable, we show that it is
possible to design a simple linear portfolio rule, which reduces
the welfare costs by 75%-90%. The welfare costs caused by not
hedging annuity risk in the period before retirement range from
2% to over 10% depending on the risk preferences of the investor
and the annuity strategy implemented at retirement. These results
are obtained in a financial market model, which allows for
stochastic interest and inflation rates as well as time-variation
in equity and bond risk premia.
______________________________
"Optimum Taxation of Life Annuities"
CESifo Working Paper Series No. 1642
Contact: JOHANN K. BRUNNER
University of Linz, CESifo (Center
for Economic Studies and Ifo Institute for Economic
Research)
Email: jk.brunner@jk.uni-linz.ac.at
Auth-Page: http://ssrn.com/author=139368
Co-Author: SUSANNE PECH
University of Linz - Department of
Economics
Email: susanne.pech@jku.at
Auth-Page: http://ssrn.com/author=264099
Full Text: http://ssrn.com/abstract=884335
ABSTRACT: The market for private life annuities is characterised
by adverse selection, that is, contracts offer lower than fair
payoffs to individuals with low life expectancy. Moreover, life
expectancy and income have been found to be positively
correlated. The paper shows that a linear tax on annuity payoffs,
which raises more revenues from long-living than from
short-living individuals, represents an appropriate instrument
for redistribution, in addition to an optimally designed labour
income tax. Further, we find that a nonlinear tax on annuity
payoffs can be directly employed to correct the distortion of the
rate of return caused by asymmetric information. These results
are contrasted with theoretical findings concerning the role of a
tax on capital income.
______________________________
"Human Capital, Asset Allocation, and Life Insurance"
Financial Analysts Journal, Vol. 62, No. 1, pp. 97-109,
January/February 2006
Author: PENG CHEN
Ibbotson Associates
Email: pchen@ibbotson.com
Auth-Page: http://ssrn.com/author=2013
Co-Author: ROGER G. IBBOTSON
Yale School of Management
Email: roger.ibbotson@yale.edu
Auth-Page: http://ssrn.com/author=2315
Co-Author: MOSHE ARYE MILEVSKY
York University
Email: milevsky@yorku.ca
Auth-Page: http://ssrn.com/author=1080
Co-Author: KEVIN X. ZHU
Affiliation Unknown
Email: caphen@sina.com
Auth-Page: http://ssrn.com/author=576421
Abstract: http://ssrn.com/abstract=898651
ABSTRACT: Financial planners and advisors increasingly recognize
that human capital must be taken into account when building
optimal portfolios for individual investors. But human capital is
not simply another pre-endowed asset class; it contains a unique
mortality risk in the form of the loss of future income and wages
in the event of the wage earner's death. Life insurance hedges
this mortality risk, so human capital affects both optimal asset
allocation and demand for life insurance. Yet, historically,
asset allocation and life insurance decisions have been analyzed
separately. This article develops a unified framework based on
human capital that enables individual investors to make these
decisions jointly.