Longevity Derivatives

What Are Longevity Derivatives?

Longevity derivatives are a class of securities that provide a hedge for parties exposed to longevity risks through their businesses, such as pension plan managers and insurers. These derivatives are designed to deliver increasingly high payouts as a selected population group lives longer than originally expected or calculated.

Understanding Longevity Derivatives

Derivatives are securities that derive their value from price fluctuations in an underlying asset or group of assets. Aside from speculating on future movements, they are commonly used to hedge, which is a form of insurance that basically involves taking an opposite position in a related security to offset losses.

One of the biggest risks facing pension funds and insurers is that their customers will live longer than anticipated.

Longevity derivatives are designed to offer some protection against these risks by enabling investors to make money on the side from people living longer. In theory, this means entities that lose money when their customers don't die also have an opportunity to profit from longer life expectancies, thereby reducing and maybe even potentially nullifying the impact of one of their greatest threats.

Types of Longevity Derivatives

The first and most prevalent form of longevity derivatives is the longevity or survivor bond.

These fixed-income instruments pay a coupon based on the "survivorship" of a stated population group, which is usually determined by a nominated index responsible for measuring a certain demographic's lifespan. As the mortality rate of the stated population group rises, coupon payments drop until they eventually reach zero.

The longevity derivatives market has expanded to include forward contracts, options, and swaps.

Benefits of Longevity Derivatives

Aside from giving pension funds and certain insurance companies an option to protect themselves against longevity risk, annuity payers being an obvious example, these derivatives also may appeal to other parties.

Speculators choose to acquire longevity derivatives from companies for several reasons. One is that longevity risk has shown low correlations with other types of investment risk, such as market risk or currency risk.

Because longevity derivatives don't tend to move in lockstep with equity or debt market returns, they are potentially attractive investments and an ideal way to diversify portfolios.

Limitations of Longevity Derivatives 

Because they are a new class of product—the first longevity bond was announced in 2004—their effectiveness is still not fully recognized. The best way to package longevity derivatives to investors and insurer groups and how to best capture sample populations and use leverage most effectively remain issues to be resolved.

Longevity derivatives have been accused of being illiquid, difficult to price, and expensive—there aren’t many entities queuing up to be on the other end of the trade. As the market grows and matures, these complaints are gradually being addressed and ironed out.