The Cost of Counterparty Risk and Collateralization in Longevity Swaps

44 Pages Posted: 4 Apr 2011 Last revised: 3 Feb 2014

See all articles by Enrico Biffis

Enrico Biffis

Imperial College Business School

David P. Blake

City, University of London

Lorenzo Pitotti

Credit Suisse Securities

Ariel Sun

Imperial College London, Business School; Cranfield University - School of Management; Univesrity of Essex; International Monetary Fund (IMF) - Monetary and Capital Markets Department; Deutsche Bundesbank - Research Centre

Date Written: December 31, 2013

Abstract

Derivative longevity risk solutions, such as bespoke and indexed longevity swaps, allow pension schemes and annuity providers to swap out longevity risk, but introduce counterparty 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.

Keywords: longevity swap, counterparty risk, default risk, collateral, marking-to-market

Suggested Citation

Biffis, Enrico and Blake, David P. and Pitotti, Lorenzo and Sun, Ariel, The Cost of Counterparty Risk and Collateralization in Longevity Swaps (December 31, 2013). Available at SSRN: https://ssrn.com/abstract=1801826 or http://dx.doi.org/10.2139/ssrn.1801826

Enrico Biffis (Contact Author)

Imperial College Business School ( email )

Imperial College London
South Kensington campus
London, SW7 2AZ
United Kingdom

David P. Blake

City, University of London ( email )

106 Bunhill Row
London, EC1Y 8TZX
Great Britain
+44 (0) 20-7040-8600 (Phone)
+44 (0) 20-7040-8881 (Fax)

HOME PAGE: http://www.pensions-institute.org/

Lorenzo Pitotti

Credit Suisse Securities ( email )

One Cabot Square
London, E14 4QJ
United Kingdom

Ariel Sun

Imperial College London, Business School ( email )

South Kensington Campus
Exhibition Road
London SW7 2AZ, SW7 2AZ
United Kingdom

Cranfield University - School of Management ( email )

Bedfordshire, MK43 0AL
United Kingdom

Univesrity of Essex ( email )

Wivenhoe Park
Colchester, CO4 3SQ
United Kingdom

International Monetary Fund (IMF) - Monetary and Capital Markets Department ( email )

United States

Deutsche Bundesbank - Research Centre ( email )

Wilhelm-Epstein-Str. 14
D-60431 Frankfurt/Main
Germany

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