fixed-rate debt instruments and, in the case of fixed real annuities, to long-term inflationindexed instruments is of paramount importance.

3.23 To enhance investment returns and thus offer better terms on their annuity products, insurance companies invest in corporate and mortgage bonds that offer higher yields, although they are exposed to credit risk and often prepayment risk. This exposure needs to be closely monitored and to be taken into account in determining the capital requirement of providers of retirement products.

3.24 Prepayment risk can be effectively managed by access to interest rate options, bond futures, swaptions, and callable debt, but most of these instruments are not usually available in developing countries. The lack of hedging facilities suggests a moderate use of callable debt instruments despite their higher yields.

3.25 Extensive use of corporate and mortgage bonds raises the question of the appropriate rate of interest for calculating the value of annuity contracts. If there is a government guarantee of annuity payments in cases of provider insolvency, the correct rate to use is the yield curve on risk-free government bonds for the guaranteed amounts and the corporate and mortgage bond yield curves for amounts in excess of the guarantees. Use of risk-free rates when providers of annuities invest heavily in corporate and mortgage bonds overstates the value of annuities by a significant factor.

3.26 Recent years have seen the growing use of long-term interest rate swaps and swaptions in some advanced countries for hedging the liabilities of life annuities. This is a promising approach, although it raises important questions about the credit quality and adequate availability of trustworthy counterparties. The widespread use of customized over-the-counter products rather than standardized exchange-traded contracts enhances the flexibility and efficiency of these hedging facilities, but increases exposure to the creditworthiness of counterparties which may be difficult to ensure over the very long duration of these contracts.

3.27 Dealing with longevity risk requires reliable projections of the expected future survivorship of annuitants, taking into account various personal characteristics as well as expected health improvements. Estimating future improvements in longevity is one of the most challenging tasks faced by annuity providers due to the sharp advances in medical technology and the stricter health standards that have been introduced. Faced with these difficulties, annuity providers use conservative assumptions about future improvements in longevity and tend to apply higher margins on younger annuitants and on deferred annuities.

3.28 Adverse regulations may also complicate the management of longevity risk. For instance, insurers may be required to use outdated mortality tables, which would be particularly detrimental in annuity pricing but would also cause problems for reserving policies. The use of outdated mortality tables is more prevalent in developing countries because of the lack of comprehensive local data and extensive reliance on mortality data from foreign countries. The compulsory use of unisex life tables, which is imposed in EU 26