Hedging Longevity Risk with Longevity Swaps

Longevity risk is the risk that people on average grow older than anticipated on; it is the negative effect of changes in mortality rates on the risk measures of companies involved in pensions. As a pension provider, the Group Life department of Nationale-Nederlanden is heavily confronted with this risk. A new possibility to cover (part of) the longevity risk arises with the emergence of a market in longevity derivatives: over-the-counter products based on indices of mortality rates, nalogous to products in the established financial markets. One of these products is the longevity swap. This thesis examines the possibilities longevity swaps might offer in hedging the longevity risk in a standard group pension contract of Nationale-Nederlanden. A portfolio of longevity swaps is attached to the liability stemming from the contract, after which the hedge is evaluated in terms of its effects on a risk margin called the Market Value Margin. Hedging the standard group pension contract results in a reduction of the Market Value Margin of 29%, while the risk capital required to cover the longevity risk decreases substantially as well (20%). However, the hedge is not cost-effective: the decrease in Market Value Margin is smaller than its expected costs.