Bargaining for Over-The Counter Risk Redistributions: The Case of Longevity Risk

Abstract: Existing literature regarding the natural hedge potential that arises from combining liabilities with different sensitivities focuses on the optimal liability mix, but does not address the question whether and how changes in the liability mix can be obtained. In the absence of a well-functioning market, parties could change their liability mix through Over-the-Counter risk redistributions. This, however, requires that each involved party benefits (weakly) from the redistribution. In this paper we first show that under relatively mild conditions, there is more than one risk redistribution that satisfies this criterion. We then explicitly model the bargaining process by which firms will agree to a particular redistribution. We allow for heterogeneous beliefs regarding the underlying probability distribution, which may arise from using different models to predict future mortality rates. We use this model to quantify the potential benefits.