A Model for Longevity Swaps: Pricing life expectancy

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A Model for Longevity Swaps: Pricing life expectancy

by Marco Stoeckle of Dresdner Kleinwort,
Andrea Loddo of Dresdner Kleinwort, and
Domenico Picone of Dresdner Kleinwort

December 2008

Abstract: Designing a hedging tool for pension funds:

In addition to the obvious exposure each and everyone of us has to mortality, economic agents such as pension funds, insurers and governments are exposed to mortality and to its flip-side longevity risk.
OECD pension funds had about USD 18tr of assets under management in 2007, and through their defined benefit pension schemes are massively exposed to longevity risk, as increases in life expectancy create additional costs. They are "short longevity".
In Europe, the UK and the Netherlands, because of the size of their pension fund markets, would be the greatest beneficiaries of a liquid longevity market.
Life settlements and mortality cat bonds have been used in the past to transfer very specific forms of longevity risk. Annuity buyouts have also been offered some form of risk relief for UK DB pension funds.
With regulators also forcing pension funds and life insurers to take a more active stance in managing longevity risk, longevity derivatives are likely to become the instrument of choice to manage this risk.
The longevity swap offers the simplest and easiest way to standardise the transfer of longevity risk between pension funds, insurers and new longevity investors looking at this market for diversification benefits.
With the attached spreadsheet to price the longevity swap, we distribute our implementation of the Lee Carter '92 model, which we used to forecast future German mortality rates, the main input for pricing.