Investors may soon be able to bet on life expectancies as pension funds search for ways to reduce "longevity risk"
Perhaps Wall Street has simply resigned itself to not caring what the public thinks. It is working to develop a new product sure to anger its critics: death derivatives. They sound just like what they are: investors would essentially bet that people will die sooner than later. This idea certainly sounds morbid at best and morally repugnant at worst. Essentially, those investors would profit from untimely death. Is it wrong for banks to create such products?
What's a Death Derivative?
First, a little more explanation is warranted here. The investor side of the bet has already been described. On the other side of the transaction would be pension funds that worry their clients are going to live longer than anticipated and consequently collect more payments than their accrued balance would provide for. If the people in question die quickly, then investors get paid. If people live longer, then the pension funds are covered. Think of death derivatives as a way for pension funds to hedge against their clients living a very long time.
I actually had an idea similar to this, but broader, more involved, and with greater profit potential, about six years ago when I was working in finance.* I didn't pursue it, however, because I wasn't sure the market was ripe yet and thought public outrage would be significant. Apparently, Wall Street must believe the time is right and is prepared to endure any outrage. Oliver Suess, Carolyn Bandel and Kevin Crowley at Bloomberg report that this new market is forming. Its size could be enormous: $23 trillion of assets are in pension funds. The trouble, however, is finding investors to take on this risk.
Here's one part of the solution:
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.
Ah, "longevity risks." That certainly sounds a lot nicer than "the risk of people living too long." At any rate, these measures would begin to help investors to better understand how to think about the risk that death derivatives would contain.
The plot thickens as the article continues. It turns out that the mechanism that these death derivatives are best compared to is the synthetic collateralized debt obligation. Yes, the same derivatives-based asset-backed security that played a part in the financial crisis. Perhaps Wall Street figures that if it's going to go down the death derivatives road, it might as well utilize a product that many people claim is dangerous and impossible to legitimately analyze.
How They'd Work
Here's how the market would work. Let's say Anywhere County Sheriff's Pension Fund wants to hedge the longevity of its retirees. They hire an investment bank to sell a death derivative to investors who want to bet that those retirees will die sooner than some given life expectancy (think of it as the "break even price"). Let's say that's an average age of 75 years old. It would also have a term, let's say 20 years. Also, the average initial age of retirees in the reference pool is 70 years old.
It's hard to explain how this works for a big pool of retirees, so let's simplify it to a single person. You'd just aggregate from there. Let's say the derivative is struck when the person is 70. Each month/quarter/year/whatever the investors pay a premium to the pension fund to cover the person's pension distribution. Here are the scenarios:
- If the person lives to be 90 or older, then the investor paid their pension and gets nothing in return. This is great news for the pension fund.
- If the person lives to be 75, then the investors paid for five years, but they get a lump sum payment from the pension fund approximately equal to what they had paid over those five years. This is break-even.
- If the person lives to be 80, then the investors take a loss, as the lump sum is less than what they had paid for 10 years.
- If the person lives to be 72, the investors have a gain, because the lump sum is larger than the amount paid for two years.
You get the idea. Now let's think about this potential new market.
What Investors Might Buy?
First of all, what investors might be interested in these derivatives? Will the market be purely speculative? In other words, is there any sort of investor that could have a legitimate reason to hedge longevity?
There sort of could be. One example could be big pharmaceutical company investors. If the pharmaceutical company is doing well, then it has probably developed drugs that will prolong the lifespan of Americans. Its success is correlated to longevity. If it is having trouble developing potent new drugs, however, then life expectancy will fail to rise. In that case, death derivatives could provide a good hedge for these firms' equity.
In general, any industry aimed at the elderly will be better off if people life longer. So these death derivatives could serve as a reasonable hedge for any investors who own shares in such firms.
New Sorts of Insider Trading Concerns
How might an insider tip work in the death derivatives market? Imagine that you're a medical researcher, and you just learned that there will be shortage of the flu vaccine. That likely means many elderly people's lives could be threatened. Suddenly, you can profit on having this information by purchasing death derivatives.
Of course, chances are that these derivatives will only be purchased by large, institutional investors. The Securities and Exchange Commission just has to make sure none of those investors have close relatives in the medical industry who might be privy to knowing this sort of information before the public does.
Is This Really So Morally Questionable?
Finally, there's the moral question. In a sense investors in death derivatives would cheer on the grim reaper's speedy arrival. Are death derivatives just plain wrong? Some people might say so, but there are a few reasons why they might not be so bad.
For starters, there are already industries that profit from death. Think about the casket industry. It will certainly slow down if a cure for cancer is suddenly found. We generally don't find it morally problematic that there's a death industry. But is that different from betting on someone's suffering for pure financial gain? The death industry, as it is today, provides some product or service to the deceased or their families. Death derivative investors would provide no such benefit, though they would potentially help more more pensions to survive.
Perhaps this does make death derivatives different, but the idea that investors could be benefiting through human suffering isn't entirely new. Take, for example, bets against the mortgage market by some investors towards the end of the housing bubble. These investors believed that home prices would decline and foreclosures would soar. Those outcomes aren't quite death, but they're certainly terrible for those homeowners. Of course, the same people who might find death derivatives morally repugnant might also find shorting housing market nearly as bad.
Of course, that might not stop Wall Street and investors from trying to make these securities work. If there is a market for death derivatives and they can find mechanisms that create a robust, liquid market, then it could thrive.
* Anyone interested in my idea who have access to capital to create something huge, feel free to e-mail me. Obviously, I won't share the details, as I don't want anyone to steal it, but I can provide some explanation of what it would entail for truly interested investors or bankers. It would be a multi-trillion dollar market that would create opportunities on both Wall Street and Main Street. It may, however, run into some moral objections, as I alluded to!
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