The Cost of Counterparty Risk and Collateralization in Longevity Swaps

• Author: David Blake,Enrico Biffis,Lorenzo Pitotti,Ariel Sun
• DOI: http://doi.org/10.1111/jori.12055
• Date: 01 June 2016
• Published date: 01 June 2016

©2014 The Journal of Risk and Insurance. Vol.83, No. 2, 387–419 (2016).

DOI: 10.1111/jori.12055

The Cost of Counterparty Risk and

Collateralization in Longevity Swaps

Enrico Biffis

David Blake

Lorenzo Pitotti

Ariel Sun

Abstract

Derivative longevity risk solutions, such as bespoke and indexed longevity

swaps, allow pension schemes, and annuity providers to swap out longevity

risk, but introducecounterparty credit risk, which can be mitigated if not fully

eliminated by collateralization. We examine the impact of bilateral default

risk and collateral rules on the marking to market of longevity swaps, and

show how longevity swap rates must be determined endogenously from

the collateral flows associated with the marking-to-market procedure. For

typical interest rate and mortality parameters, we find that the impact of

collateralization is modest in the presence of symmetric default risk, but more

pronounced when default risk and/or collateral rules are asymmetric. Our

results suggest that the overall cost of collateralization is comparable with,

and often much smaller than, that found in the interest rate swaps market,

which may then provide the appropriate reference framework for the credit

enhancement of both indemnity-based and indexed longevity risk solutions.

Enrico Biffisand Ariel Sun are at the Imperial College Business School, Imperial College London,

South Kensington Campus, London SW7 2AZ, United Kingdom. Biffis can be contacted via

e-mail: E.Biffis@imperial.ac.uk. Sun can be contacted via e-mail: jingjing.sun08@imperial.ac.uk.

David Blake is at the Pensions Institute, Cass Business School, 106 Bunhill Row, London EC1Y

8TZ, United Kingdom. Blake can be contacted via e-mail: D.Blake@city.ac.uk.Lorenzo Pitotti is

at Credit Suisse Securities Ltd, One Cabot Square,London E14 4QJ, United Kingdom. Pitotti can

be contacted via e-mail: Lorenzo.Pitotti@credit-suisse.com. We benefited from comments and

suggestions received from participants at the Longevity 6 conference(Sydney), AXA Longevity

Risk and Pension Funds conference (Paris), Risk Minds Insurance (Geneva), Global Derivatives

(Barcelona), Pension Research Council (Wharton), and at seminars at the universities of Ulm,

Georgia State, Bologna, Copenhagen, and at Collegio Carlo Alberto. We are grateful to the

editor, two anonymous referees, as well as to Damiano Brigo and an anonymous longevity

swaps dealer for valuable feedback. Disclaimer: The views and opinions expressed in this study

are those of the authors and are not those of Credit Suisse. The authors and Credit Suisse do

not accept any liability in respect of the content of this study or any claims, losses or damages

arising from the use of, or reliance on, all or any part of this study.

387

388 The Journal of Risk and Insurance

Introduction

The market for longevity-linked securities and derivatives has recently experienced

a surge in transactions in longevity swaps (Blake et al., 2013). These pure longevity

hedges are agreements between two parties to exchange fixed payments against vari-

able payments linked to the number of survivors in a reference population (see Dowd

et al., 2006). Table 1 presents the full list of deals that have been publicly disclosed in

the United Kingdom. So far,transactions have mainly involved pension funds and an-

nuity providers wanting to hedge their exposure to longevity risk1but without having

to bear any basis risk. The variable payments in such longevity swaps are designed to

match precisely the mortality experience of each individual hedger, hence the name

“bespoke longevity swap.” This is essentially a form of longevity risk insurance, simi-

lar to annuity reinsurance in reinsurancemarkets. Indeed, most of the longevity swaps

executed to date have been bespoke, indemnity-based swaps of the kind familiar in

reinsurance markets. This is true despite the fact that some of the swaps listed in

Table 1 have been arranged by investment banks: the banks have worked with insur-

ance companies (in some cases their own insurance company subsidiaries) in order to

deliver a solution in a format familiar to the counterparty. A fundamental difference

from other forms of reinsurance, however, is that longevity swaps are typically col-

lateralized, whereas standard insurance/reinsurance transactions are not.2The main

reason is that longevity swaps are often part of a wider derisking strategy involving

other collateralized instruments (e.g., interest rate and inflation swaps), and also the

fact that hedgers have been increasingly concerned with counterparty risk3in the

wake of the Global Financial Crisis of 2008–2009. In this article, we provide a frame-

work to quantify the trade-off between the exposure to counterparty risk in longevity

swaps and the cost of credit enhancement strategies such as collateralization.

As there is no accepted framework yet for marking to market/model longevity swaps,

hedgers and hedge suppliers have looked to other markets to provide a reference

model for counterparty risk assessment and mitigation. In interest rate swap mar-

kets, for example, the most common form of credit enhancement is the posting of

collateral. According to the International Swap and Derivatives Association (ISDA),

almost every swap at major financial institutions is “bilaterally” collateralized (ISDA,

2010a), meaning that either party is required to post collateral depending on whether

the market value of the swap is positive or negative.4The vast majority of transactions

1By longevity risk we mean exposure to the systematic risk of mortality improvements, which

cannot be mitigated by pooling together large numbers of lives.

2One rationale for this is that reinsurers aggregate several uncorrelated risks, and pool-

ing/diversification benefits compensate for the absence of collateral (e.g., Cummins and

Trainar, 2009; Lakdawalla and Zanjani, 2012; Kessler, 2013). Insurers/reinsurers are still re-

quired by their regulators to post regulatory or solvency capital, which plays a similar role to

collateral but at aggregate level.

3Basel II (2006, Annex 4) defines counterparty risk as “the risk that the counterparty to a trans-

action could default before the final settlement of the transaction’s cash flows.” The new

Solvency II standard makes explicit allowance for a counterparty risk module in its “standard

formula” approach; see CEIOPS (2009).

4“Unlike a firm’s exposure to credit risk through a loan, where the exposure to credit risk is

unilateral and only the lending bank faces the risk of loss, counterparty credit risk creates a

The Cost of Counterparty Risk and Collateralization in Longevity Swaps 389

Table 1

Publicly Announced Longevity Swap Transactions In the UK 2007–2014

Date Hedger Size Term (Years) Type Interm./Hedge

Supplier

Apr. 2007 Friends’ Provident GBP 1.7bn Run-off Bespoke Swiss Re

Jan. 2008 Lucida N.A. 10 Indexed JP Morgan

ILS funds

Jul. 2008 Canada Life GBP 500 m 40 Bespoke JP Morgan

ILS funds

Feb. 2009 Abbey Life GBP 1.5 bn Run-off Bespoke Deutsche Bank

ILS funds, Partner Re

Mar. 2009 Aviva GBP 475 m 10 Bespoke Royal Bank

of Scotland

Jun. 2009 Babcock GBP 750 m 50 Bespoke Credit Suisse

International Pacific Life Re

Jul. 2009 RSA GBP 1.9 bn Run-off Bespoke Goldman Sachs

(Rothesay Life)

Dec. 2009 BerkshireCouncil GBP 750 m Run-off Bespoke Swiss Re

Feb. 2010 BMW UK GBP 3 bn Run-off Bespoke Deutsche Bank

Paternoster

Feb. 2011 Pall (UK) GBP 70 m 10 Indexed JP Morgan

Pension Fund

Aug. 2011 ITV GBP 1.7 bn N.A. Bespoke Credit Suisse

Nov.2011 Rolls Royce GBP 3 bn N.A. Bespoke Deutsche Bank

Dec. 2011 BritishAirways GBP 1.3 bn N.A. Bespoke Goldman Sachs

(Rothesay Life)

Jan. 2012 Pilkington GBP 1 bn N.A. Bespoke Legal & General

Apr. 2012 Berkshire Council GBP 100 m Run-off Bespoke Swiss Re

May 2012 Akzo Nobel GBP 1.4 bn N.A. Bespoke Swiss Re

Dec. 2012 LV=GBP 800 m N.A. Bespoke Swiss Re

Feb. 2013 BAE Systems GBP 3.2 bn N.A. Bespoke Legal & General

(30%), Hannover

Re (70%)

May 2013 Bentley Pension

Scheme (owned

by VW)

GBP 400m N.A. Bespoke Deutsche Bank

(Abbey Life)

Dec. 2013 Carillion GPB 1 bn N.A. Bespoke Deutsche Bank

Dec. 2013 AstraZeneca GBP 2.5 bn N.A. Bespoke Deutsche Bank

Dec. 2013 BAESystems

(Royal Ordnance/

Shipbuilding

Industries)

GBP 1.8 bn N.A. Bespoke Legal & General

Hannover Re (85%

ofRO), Reinsurance

Group of America

(70% of SI)

Mar. 2014 Aviva Staff Pension

Scheme

GBP 5bn N.A. Bespoke Munich Re, Scor and

Swiss Re

May 2014 Royal London GBP 1bn N.A. Bespoke RGA International

July 2014 BT Pension Scheme GBP 16bn N.A. Bespoke Prudential Insurance

Co. of America