What are longevity swaps and how do pension funds use them?
I came across longevity swaps in FRM Part I. I understand that pension funds face longevity risk — people living longer than expected. But how does a longevity swap actually transfer this risk?
Longevity swaps are a clever risk transfer mechanism that allows pension funds and insurance companies to hedge the risk that their beneficiaries live longer than expected — which would increase their payment obligations.
The problem:
A pension fund promises to pay retirees a fixed monthly income for life. If retirees live 3 years longer than projected, the fund must make 3 extra years of payments. For a large pension fund, this can mean billions in additional liabilities.
How a longevity swap works:
Structure:
- Fixed leg (pension pays): Payments based on expected mortality rates — what the pension fund projected when it made its promises
- Floating leg (protection seller pays): Payments based on actual mortality rates — what actually happens
If people live longer than expected:
- Actual mortality < Expected mortality
- Floating leg payments are higher (more survivors = more pension payments needed)
- Net: the protection seller pays the pension fund the difference
- This offsets the pension fund's higher-than-expected obligation
If people die earlier than expected:
- Actual mortality > Expected mortality
- Fixed leg payments exceed floating leg
- Net: the pension fund pays the protection seller
- But the pension fund also has lower obligations, so it's a wash
Example: Cornerstone Pension Fund has 50,000 retirees with an expected mortality rate of 3% per year for the 70-75 age cohort. They enter a longevity swap with a notional based on pension payments.
- Expected annual payments: $200M (based on 3% mortality)
- Actual mortality turns out to be 2.5% (people live longer)
- Actual payments needed: $210M
- Swap payment received: $10M (covers the extra cost)
Who sells protection?
- Reinsurers (Swiss Re, Munich Re)
- Life insurers (natural offset — they benefit from shorter lifespans)
- Capital market investors seeking uncorrelated returns
Key features:
| Feature | Description |
|---|---|
| Reference population | Can be fund-specific or index-based |
| Basis risk | Index-based swaps may not match the fund's actual population |
| Term | Typically very long (20-40 years) |
| Counterparty risk | Significant due to long duration |
| Regulatory treatment | Often receives favorable capital treatment |
Exam tip: FRM tests the structure of longevity swaps, who the natural buyers and sellers are, and the basis risk that arises from using index-based reference populations.
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