A longevity derivative in which regular payments are made to a firm (investment bank, insurance company, pension fund, etc.) based on negotiated or mutually agreed assumptions about the mortality rate of a specified population group in return for payments based on actual mortality rates. This implies that longevity swaps may be structured in a way that longevity risk can be partially or wholly transferred among the parties.
For example, an insurance firm could enter into a swap agreement with a reinsurer where both agree to exchange a series of payments based on two different rates: the fixed rate is a projection of the annual mortality rate over a certain period of time (say, 10, 15.. 25, etc). The floating rate is usually calculated against a longevity index which refers to the actual figure observed during the period. Both parties work out on a projected mortality rate, and if the actual figure is proved to be higher than the projected one, one party will be required to post collateral. In the opposite case, the other party has to put that collateral.
The arrangement structure followed in this type of swaps is similar to that of other types, especially the interest rate swap, inflation-indexed swap, equity swap, and so on. However, they differ substantially from other swaps in the sense that a modification to address regulatory issues would be needed in longevity swaps in addition to any additional arrangements in terms of liability calculations and payment of obligations.
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