Longevity Bonds and Longevity Derivatives
In the previous article, we have already seen how pension funds have been adversely affected by an increasing amount of longevity risk. The increase in the average lifespan of people is definitely a positive development. However, it has an adverse impact on the financial situation of most pension funds. In order to mitigate longevity risks, pension funds across the world have started relying on financial innovation. Longevity bonds and longevity derivatives are financial instruments that allow pension funds to transfer the financial risk from the institution to individuals.
The details regarding the functioning of longevity bonds and longevity derivatives have been explained below:
What are Longevity Bonds?
Longevity bonds are a type of financial instrument in which the coupon rate to be paid is not fixed. Instead, the coupon rate to be paid is variable and depends upon the life expectancy of a group of people.
Since the life expectancy of a group is not easy to measure, the issuers of these bonds create an index for this purpose. This value of this index changes based on the demographic data which is being released by the population. At the same time, the value of this index is the basis for coupon payments being made. As the value of the index keeps on increasing, it means that the mortality rate of a given population is also increasing.
If the mortality rate increases, the coupon payments are also correspondingly reduced. This means that there is an inverse correlation between the mortality rate and coupon payments. As the mortality rate keeps increasing, the coupon payments go on reducing. Finally, when there are no members of the demographic group left, the coupon payments go to zero.
It needs to be understood that these bonds actually function as an annuity. This is because the principal amount on these coupon bonds is never returned. Instead, the investor trades a lump sum for a series of small payments.
What are Longevity Derivatives?
Longevity derivatives are very similar to longevity bonds. In fact, a lot of the time, longevity derivatives are based on longevity bonds. The concept of longevity derivatives includes all types of instruments viz. forwards, options, and swaps.
Longevity derivatives are still quite unique. Hence, there are traded over the counter and not on an exchange. For example, two parties may swap their cashflows based on the value of the mortality rate in the demographic index.
Who Trades in Longevity Derivatives?
Now, the question is why would investors and financial institutions want to invest based on the mortality rate. There are several reasons why investors find longevity derivatives to be useful. Some of these reasons have been mentioned below:
Disadvantages of Longevity Bonds and Longevity Derivatives
Financial institutions and investors have found the concept of longevity bonds to be appealing to some extent. However, they have not invested large sums of money in this idea. Hence, longevity bonds are still not very prevalent in the market. There are some significant disadvantages related to longevity derivatives. Some of these disadvantages have been mentioned below:
The bottom line is that longevity bonds and longevity derivatives are still in the nascent stage. They are very promising when it comes to risk management in pension funds. However, the market is yet to be fully developed.
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