The market for longevity-linked securities and derivatives has recently experienced a surge in transactions in longevity swaps. These are agreements between two parties to exchange fixed payments against variable payments linked to the number of survivors in a reference population (see Dowd et al., 2006). Table 1 presents a list of recent deals that have been publicly disclosed. So far, transactions have mainly involved pension funds and annuity providers wanting to hedge their exposure to longevity risk but with out having to bear any basis risk: the variable payments in such longevity swaps are designed to match precisely the mortality experience of each individual hedger (hence the name indemnity-based, or bespoke, longevity swaps).
This is essentially a form of longevity risk insurance, similar to annuity reinsurance in reinsurance markets. A funda mental difference, however, is that longevity swaps are typically collateralized, whereas insurance/reinsurance transactions are not. The main reason is that longevity swaps are often part of a wider de-risking strategy involving other collateralized instruments (interest-rate and inflation swaps, for example), and also the fact that hedgers have been increasingly concerned with counterparty risk in the wake of the Global Financial Crisis. In this article, we provide a framework to quantify the trade-off between the exposure to counterparty risk in longevity swaps and the cost of credit enhancement strategies such as collateralization.
As there is no accepted framework yet for marking to market/model longevity swaps, hedgers and hedge suppliers look to other markets to provide a reference model for counterparty risk assessment and mitigation. In interest-rate swap markets, for example, the most common form of credit enhancement is the posting of collateral. According to the International Swap and Derivatives Association (ISDA) almost every swap at major financial institutions is ‘bilaterally’ collateralized (ISDA, 2010b), meaning that either party is required to post collateral depending on whether the market value of the swap is positive or negative.
The vast majority of transactions is collateralized according to the Credit Support Annex to the Master Swap Agreement introduced by ISDA (1994). The Global Financial Crisis of 2008-09 highlighted the importance of bilateral counterparty risk and collateralization for over-the-counter markets, spurring a number of responses (e.g, ISDA, 2009; Brigo and Capponi, 2009; Assefa et al., 2010; Brigo et al., 2011). The Dodd-Frank Wall Street Reform and Consumer Protection Act (signed into law by President Barack Obama on July 21, 2010) is likely to have a major impact on the way financial institutions will manage counterparty risk in the coming years. The recently founded Life and Longevity Markets Association (LLMA) has counterparty risk at the center of its agenda, and will certainly draw extensively from the experience garnered in fixed income and credit markets.
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The cost of counterparty risk and collateralization in longevity swaps
