Hedging longevity risk using longevity swaps

Abstract

Longevity-linked securities provide the desirable hedging instruments to insurers and annuity providers, and on the other hand, diversification benefits to their counter parties such as the reinsurers and banks. In Kenya however, the longevity market is not in existence and as such this paper seeks to model a longevity swap in the Kenyan context and determine its effectiveness in hedging longevity risk. The longevity swap is modeled using the distortion approach; Wang transform. With the projected cash flows for the floating and the fixed leg, the swap value is calculated, which gives the amount the insurer or annuity provider will have to pay to get into the contract. In determining the hedge effectiveness, sensitivity analysis was conducted on the parameters including the interest rates, cohort ages, term of the swap against the swap premium and the swap value. The results were that the premium increases with the term and entry age of the reference cohort. In terms of the swap value which is the difference between the present values of the floating against the fixed leg, as the population gets older the swap gets cheaper and therefore becomes more effective to hedge for lower ages.