Definition of longevity swap

This is a derivative contract that offsets the risk of pension scheme members living longer than expected.

This is a scheme that makes regular payments based on agreed mortality assumptions to an investment bank or insurer and, in return, the bank or insurer pays out amounts based on the scheme’s actual mortality rates. [1]. This mirrors the structure of an interest rate or inflation swap. [2]

For example, the fixed rate of interest here is an agreed projection – say, over 25 years – of the annual mortality rate. The floating rate is the actual outcome. Both parties agree that – for instance – of 100,000 65-year olds, 2,000 should die in year one and so forth. If the figure turns out higher, one party has to put up collateral, and vice versa.

The mortality projections used are the result of complex actuarial calculations – in other words, a model. [3]

Pension schemes keep assets and so retain investment and inflation risks. The swap counterparty is usually an investment bank, which then lays off most, if not all, of the risk to a reinsurer or into the capital markets. Trustees pay a fixed regular premium to offload the risks that they will have to keep paying out pensions to retirees for longer than planned for. Investment bank and reinsurer pay a floating premium in return, which increases the longer people live. [4]

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