Using bootstrapping to incorporate model error for risk-neutral pricing of longevity risk

Abstract

Where mortality projection is concerned, it is essential to quantify the extent of the prediction error. This is especially important in light of the aggravating risk of longevity and as a result the increasing demand for longevity-linked products. In the literature so far, only parameter error and process error have been considered jointly while the issue of model error has yet been systematically studied. In this paper, we propose a method to account for process error, parameter error and model error in an integrated manner by modifying the semi-parametric bootstrapping technique. We apply the method to two data sets from the Continuous Mortality Investigation (CMI) and use the simulated scenarios to price the qq-forward contracts via the maximum entropy approach. We find that model selection has a significant impact on the risk-neutral valuation results and thus it is crucial to incorporate model error in mortality projection.