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The Cost of Counterparty Risk and Collateralization in Longevity Swaps

Enrico Biffis, David Blake, Lorenzo Pitotti, and Ariel Sun

Derivative longevity risk solutions, such as bespoke and indexed longevity swaps, al-
low pension schemes and annuity providers to swap out longevity risk, but introduce
counterparty credit risk, which can be mitigated if not fully eliminated by collat-
eralization. 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 asymmet-
ric. 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 (as a
result of the offsetting effects of interest rate and longevity risks), 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-