@article {LLMA39, author = {LLMA}, title = {Basis Risk in Longevity Hedging: Parallels with the Past }, volume = {2012}, number = {1}, pages = {39--45}, year = {2012}, publisher = {Institutional Investor Journals Umbrella}, abstract = {Index-based longevity hedges have the potential to bring the transparency and standardization needed to develop a liquid longevity market and facilitate the risk management of longevity. However, derivatives linked to mortality indices remain underutilized as risk management tools. The main reason seems to be the presence of basis risk: as the reference population of the index is not identical to the target population being hedged, the resulting cash flows from an index hedge will not be perfectly matched to the liabilities.The obstacle market participants are facing is that in order to make an informed decision regarding the hedging of longevity risk, the differences between the two populations must be understood and analyzed and the theoretical reduced costs of such a transaction assessed against the reduced effectiveness of the hedge. The analysis is not simple, and for the market to develop further, practitioners need to become comfortable with the amount of risk reduction that can be achieved using an index-based hedge. This requires an understanding and assessment of each of the components of basis risk: demographic risk, sampling risk, and structural risk.There is a significant body of academic research currently focusing on the subject of basis risk in longevity hedging and solid frameworks for assessing the risk are materializing. As more practitioners take the time to translate these theoretical solutions into practical application, a broader understanding of the risk will be developed and diffused across the industry, much as it was for the market for hedging financial risks such as inflation.For market participants who are considering the use of index-based longevity hedges, the current status of the market presents both a risk and an opportunity. Although a potential mismatch between the target and index populations{\textquoteright} mortality experience will always exist, there is a significant and growing body of evidence that suggests that a well chosen index and hedge structure can minimize this basis risk and provide an effective and flexible solution to mitigate longevity risk. In the absence of cost effective alternatives for these types of target populations, index-based hedges have the potential to prove their worth and pave the way for more mainstream longevity hedging.}, URL = {https://guides.pm-research.com/content/2012/1/39}, eprint = {https://guides.pm-research.com/content/2012/1/39.full.pdf}, journal = {Special Issues} }