Longevity Swaps: Derivatives for Hedging Longevity Risk Embedded in Variable Annuities (Pension Plans)

Longevity risk is becoming an increasing important risk facing individuals in developed economies and financial institutions are busy developing products to hedge this risk. It is a good social development but for pension plans it is a risk because it allows them to make loss as they pay more liabilities than they expected. For many years insurance companies has underestimated the longevity of individuals as survival probabilities increases across the developed world. This improvement has caused unsettlement in the future of the annuity and pension providers as they try to find ways to reduce this risk. This paper proposes the use of longevity swaps as a hedging tool on which a life insurer (annuity provider) can transfer the longevity risk to financial markets. The Lee-Carter model is calibrated on Australian male population to forecast mortality rates and the Monte-Carlo Simulation is used to pricing the swaps. For each sample path continue by calculating the payoff of the longevity index swap by looking at the change in mortality rate with respect to the fixed mortality rate. The fixed mortality rate is obtained from the Australian life tables. At maturity time a settlement is calculated and the risk is transferred to the hedge provider (financial market) through a longevity swaps and thus longevity risk is reduced. The index swap pays out in case the forecasted mortality rate becomes smaller than the fixed mortality rate. In this case the clients of an insurer live longer than expected, which means that the liabilities of the insurer are higher than anticipated on beforehand.