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Longevity swaps (or mortality swaps)

\lɔnˈʤɛvəti\ \swɑps\

A class of special financial instruments enabling two parties to exchange payments depending upon the actual mortality rates experienced by a particular population.

This enables pension plans to partially or wholly hedge their longevity risk without having to purchase annuities. The instruments are structured in a similar way to interest rate swaps. For example, the pension plan receives a series of variable payments that reflect ‘actual’ mortality patterns (often called the floating leg), in exchange for paying a series of fixed payments to the counter-party (often called the fixed leg). This arrangement is designed to provide certainty to the pension plan regarding the mortality rates of the covered population. 

The effectiveness of any such hedge will depend upon the terms of the swap, including what the ‘actual’ mortality rates are based on and the duration of the swap. 

An indemnity swap is the term for a swap where the ‘actual’ mortality rates are determined by the experience of a specified population. This type of swap should perfectly hedge the idiosyncratic risk, the basis risk and the trend risk in the specified population, although it is likely to be less flexible and contractually more restrictive. Such swaps are usually structured over the whole of life period of the underlying population.

An index-based swap uses the experience of a standard ‘index’ population to determine the ‘actual’ mortality rates. This type of swap is designed to hedge the trend risk for a population, which tends to make up the majority of longevity risk for large pension plans. Such a swap has the potential to be provided on standard terms, opening up the possibility of a tradable longevity market, external capital investment and swap contracts for shorter periods. A number of approaches have been suggested for removing possible basis risk using index-based swaps, including providing indices for different socio-economic groups and tailoring the swap to reflect the make-up of the actual population.

A swap would be considered to be in the money for the party that stands to gain financially should it be settled at that point in time, and out of the money for the party that stands to lose financially.

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