The Impact of Collateralization on Longevity Swap Transactions

Index-based longevity swaps provide many advantages over the other hedging instruments to life insurance companies and pension plans. Insurers and pension plan providers can transfer their longevity exposures to the capital markets at lower costs by using these securities. Hence, significant growth has been seen in longevity swap transactions in the longevity-linked securities and derivatives markets since 2008. However, since longevity-linked instruments are traded OTC, each involved party is exposed to the counterparty default risk. Therefore, regulators have emphasised the role of credit risk mitigation tools such as collateralization for the improvement of swap contracts’ credit quality. In this paper, our aim is to construct a hedging strategy for longevity risk by using collateral. As the first step, the Lee-Carter with renewal process and exponential jumps model proposed by Özen and Şahin [7] and the Lee-Carter model without jumps are used to project the future mortality rates and to price the index-based longevity swaps. Additionally, re-hypothecation is allowed for the parties of the swap to increase the benefits of the collateralization. As a result, for both mortality models, insurers and pension plan providers obtain more effective risk reduction levels with the inclusion of the collateral. However, the Lee-Carter model with renewal process and exponential jump model provides more risk reduction.