Quantifying and Hedging Economic Risk in Disability Income Insurance Portfolios

Abstract

The association between economic variables and the frequency and duration of disability income insurance (DII) claims is well established. Across many jurisdictions, heightened levels of unemployment have been associated with both a higher incidence and a longer duration of DII claims. This motivated us to derive an asset portfolio for which the total asset value moves in line with the level of unemployment, thus, providing a natural match for the DII portfolio liabilities. To achieve this, we develop an economic tracking portfolio where the asset weights in the portfolio are chosen so that the portfolio value changes in a way that reflects, as closely as possible, the level of unemployment. The methodology put forward to establish this asset-liability matching portfolio is illustrated using DII data from the UK between 2004 and 2016. The benefits of our approach for claims reserving in DII portfolios are illustrated using a simulation study.

Keywords: Disability income insurance, Moral hazard risk, Economic tracking portfolio, Hedging portfolio

JEL Classification: C65, D91, G22