Death Derivatives Emerge From Longevity Risks

[Gone4Good]

Quote:

As insurers reach the limit of how much pension-fund liability they’re willing to shoulder, companies such as JPMorgan and Prudential Plc (PRU) last year set up a trade group aimed at establishing and standardizing a secondary market for so- called longevity risks. They’re also developing indexes that measure mortality rates and securities to let pension funds pay fixed premiums to investors in return for coverage against major deviations from projections.

Article here.

This reminds me a bit of the early/mid - nineties when investment banks were buying up the life insurance policies of AIDS sufferers, securitizing them into bonds, and selling them to investors. The selling angle for the bonds was that these securities were really helping because it gave AIDS patients money upfront that they weren't entitled to until after they die. It was a fair point. But it also created an entire class of investors who were essentially rooting for people to die (investors lost money when the AIDS victims lived longer than forecast, or heaven forbid, didn't die at all. They'd clean up if the pool of people associated with their bonds all died early). With the new drugs that came out later that decade, these folks all lost their shirts and the market essentially vanished.

It will be interesting to see who steps up to bet against medical innovation this time. Or maybe, if these securities take off, we'll get a plurality of voters with a financial incentive to institute 'death panels' for real.

[brewer12345]

While I agree with you that there is latent moral risk with this sort of activity, I am not sure what the alternative might be. There is a very large interest on the part of pension spinsors to lay off longevity risk with insurers, especially when the right circumstances happen (nudge interest rates up and have a reasonable stock market). OTOH, insurers have finite balance sheet capacity and at some point probably cannot service all this demand. So I can see a case for this sort of thing just like property catastrophe bonds. For some large bond investors, a slice of this sort of thing would make a nice diversifier.

[clifp]

Quote:

Originally Posted by Gone4Good Article here. It will be interesting to see who steps up to bet against medical innovation this time. Or maybe, if these securities take off, we'll get a plurality of voters with a financial incentive to institute 'death panels' for real.

I am pretty sure that in 20-30 years, every person below 40 will have a strong incentive to push for death panels.

[Gone4Good]

Quote:

Originally Posted by brewer12345 While I agree with you that there is latent moral risk with this sort of activity, I am not sure what the alternative might be. There is a very large interest on the part of pension spinsors to lay off longevity risk with insurers, especially when the right circumstances happen (nudge interest rates up and have a reasonable stock market). OTOH, insurers have finite balance sheet capacity and at some point probably cannot service all this demand. So I can see a case for this sort of thing just like property catastrophe bonds. For some large bond investors, a slice of this sort of thing would make a nice diversifier.

The nice thing about catastrophe bonds is that investors are rooting against catastrophe. Here, your financial incentives are aligned with the Grim Reaper. 'Due-diligence' on those AIDS bonds included trying to find out the identity of the individuals in the pool and determine how close to death they were.

I don't doubt this kind of financial innovation is useful. That doesn't make it any less sick in its application, though.

[brewer12345]

Quote:

Originally Posted by Gone4Good The nice thing about catastrophe bonds is that investors are rooting against catastrophe. Here, your financial incentives are aligned with the Grim Reaper. 'Due-diligence' on those AIDS bonds included trying to find out the identity of the individuals in the pool and determine how close to death they were. I don't doubt this kind of financial innovation is useful. That doesn't make it any less sick in its application, though.

You could say the same about the sale of unneeded life insurance policies to investors. What needs to happen are good safeguards and policing on the market. The pension close-out business should be inherently less sleazy because it involves large, homogenious groups rather than individuals, so a party to one of these deals can underwrite the same way it is done for a group insurance policy.

You must love the insurance industry: think of all the parties that gain or lose with each bad event, including hurricanes, fires, sattelites falling out of the sky, massive lawsuits, etc. This stuff is already out there and a derivatives market for it is not really changing that.

The bigger issue I see is that this stuff is extremely long duration. In a world of volatile interest rates it would be easy to blow yourself up if you were not really good at managing interest rate risk.

[ziggy29]

It would be a dangerous place to tread. It seems like almost every insurance and pension plan ever created that needs to hedge longevity risk has blown up and hit financial crises, and had to either raise "rates" or reduce benefits, because as we live longer the "price" of the coverage becomes less and less sufficient to make it sustainable.

[Independent]

So what does a security like this look like? If I'm the insurer I want my money up front to minimize counterparty risk. So the buyer pays a lump sum to the issuer, then the issuer makes annual payments back to the buyer based on the mortality rate in the pool? Maybe every death creates a payment?

[dgoldenz]

Quote:

Originally Posted by Gone4Good Article here. This reminds me a bit of the early/mid - nineties when investment banks were buying up the life insurance policies of AIDS sufferers, securitizing them into bonds, and selling them to investors. The selling angle for the bonds was that these securities were really helping because it gave AIDS patients money upfront that they weren't entitled to until after they die. It was a fair point. But it also created an entire class of investors who were essentially rooting for people to die (investors lost money when the AIDS victims lived longer than forecast, or heaven forbid, didn't die at all. They'd clean up if the pool of people associated with their bonds all died early). With the new drugs that came out later that decade, these folks all lost their shirts and the market essentially vanished. It will be interesting to see who steps up to bet against medical innovation this time. Or maybe, if these securities take off, we'll get a plurality of voters with a financial incentive to institute 'death panels' for real.

Life settlements are still done today and sold as investments. Lots of scrutiny and court battles these days...

[brewer12345]

Quote:

Originally Posted by dgoldenz Life settlements are still done today and sold as investments. Lots of scrutiny and court battles these days...

But becoming less of the wild west as they become more common and insurance statutes in an increasing number of states start regulating them and setting the rules of the game.

[chinaco]

This idea has been written about by some academics.

It will be interesting to see how this develops.

Maybe we will eventually see insurance companies annuity business getting some competition from a less regulated competitor (mutual funds) with a hedged, but not guaranteed product (that costs less)?


You have to wonder if eventually these derivatives wind up being used in in Mutual Funds like the VG payout funds as a quasi-assurance of not running out of money.

[traineeinvestor]

At least one solution to longevity risk has been around since 1653: Tontine - Wikipedia, the free encyclopedia

If longevity risk is defined as the risk that someone will live longer than the actuarial tables, then a variant on the tontine would be to pool a group of people with smilar life expectancies, require each one to contribute the same amount of money and distribute the contributions + ROI to the survivors after x% of the participants have died (instead of the last survivor taking all).

No derviatives needed and the risk of loss to the scheme provider due to increased life expectancy goes away.

The practical difficulties would be:

1. knowing when people have died - the bigger the pool the harder that task would be

2. rules against sexual discrimination (like this: EU court bans insurance sex discrimination - BusinessWeek) would require either gender specific pools or act as a disincentive for men to participate

[chinaco]

Now that I think about it... I doubt these instruments would be used in mutual funds.

It would seem that each contract would need to be individually underwritten based on a specific pool of lives. Which implies some sort of lifelong contract. Or at least limited period contract on a pool.

In a way, different banks/insurance companies have approached the problem a little differently.... but it is almost like a reinsurance contract for a block of insurance (in this case pension annuities).


Still, if they are not characterized as insurance (and regulated as such), they might be used in imaginative ways. Hopefully it does not wind up where people that do not have an interest (hedge funds) can place side bets on pension funds they are not associated which would possibly corrupt the integrity of the mechanism.

[brewer12345]

Quote:

Originally Posted by chinaco Now that I think about it... I doubt these instruments would be used in mutual funds. It would seem that each contract would need to be individually underwritten based on a specific pool of lives. Which implies some sort of lifelong contract. Or at least limited period contract on a pool. In a way, different banks/insurance companies have approached the problem a little differently.... but it is almost like a reinsurance contract for a block of insurance (in this case pension annuities). Still, if they are not characterized as insurance (and regulated as such), they might be used in imaginative ways. Hopefully it does not wind up where people that do not have an interest (hedge funds) can place side bets on pension funds they are not associated which would possibly corrupt the integrity of the mechanism.

No, you don't necessarily need to be an insurer to do this, which is a good thing. The way to do it is set up a derivative or a cash instrument (longevity bond) that references an index or a modelled pool. This is done all day long in the catastrophe reinsurance market via cat bonds and derivatives known as industry loss warrants.

Having parties other than insurers play in this pool is actually a good thing. It allows deeper pools of capital to service the risk, which is great. Properly structured and policed, it would be perfectly legit and a social good.

[Independent]

Quote:

Originally Posted by traineeinvestor At least one solution to longevity risk has been around since 1653: Tontine - Wikipedia, the free encyclopedia If longevity risk is defined as the risk that someone will live longer than the actuarial tables, then a variant on the tontine would be to pool a group of people with smilar life expectancies, require each one to contribute the same amount of money and distribute the contributions + ROI to the survivors after x% of the participants have died (instead of the last survivor taking all). No derviatives needed and the risk of loss to the scheme provider due to increased life expectancy goes away. The practical difficulties would be: 1. knowing when people have died - the bigger the pool the harder that task would be 2. rules against sexual discrimination (like this: EU court bans insurance sex discrimination - BusinessWeek) would require either gender specific pools or act as a disincentive for men to participate

Here's a monthly income version. Imagine a mutual fund family designed to provide monthly income.
1. Each month you can withdraw x% of your balance, where x goes up as you age. Note that x is a maximum, you can't get money out any faster.
2. Every time someone dies, that person's balance is distributed to the survivors (call that a "longevity credit). The proportion that each person gets varies by age (also probably by gender and time in the pool).

An actuary can come up with a schedule for (1) and ratios for (2) that will result in level monthly withdrawals if the investment return on the fund is exactly some i and if people die according to some mortality table. If actual returns are bigger than i, the survivors' monthly incomes grow, if they are smaller, the survivors' monthly income shrinks. If people die sooner than the table says, the survivors get increasing payments. If they die later, the survivors get decreasing payments.