Thursday, April 14, 2011

Longevity Swaps: Betting on How Long You Will Live

By 2007, the derivatives market had grown globally into a $516 trillion industry,  and, at the time, Warren Buffet warned of the "ticking time bomb".

Buffet wasn't the only one who warned about derivatives. "One month after Henry Paulson left Goldman Sachs as CEO with a net worth of over $500 million to become the new Treasury secretary, he spoke to the White House staff at Camp David: “Paulson held up over-the-counter derivatives as an example of financial innovation that could, under certain circumstances, blow up in Wall Street’s face and affect the whole economy.”

So, after the explosion of complex mortgage-backed securities brought down our financial system in 2008, and the speculators have been bailed out at our expense, they have the balls to speculate on our mortality. That's right, one of Wall Street's latest innovations is longevity swaps...waging in death futures.

What are longevity swaps? Well, it's the practice of hedging people's lives.  Some refer to them as death bonds.

Essentially, they are unconventional assets (little connection to more conventional stock and bond prices). Like mortgage backed securities, longevity swaps, ideally, would consist of policies from those who have diseases such as Leukemia, diabetes, cancer, heart disease, etc., in which investors buy into those life insurance policies and are paid when individuals die. Obviously, in this case, when cures are developed, the value of the life settlement plummets.

Remember, there are no profits in finding cures.

Another type of transaction involves "mortality catastrophe bonds," in which bond buyers contribute to pots of money that insurers can tap into if large numbers of people die in a disaster.

The bonds help insurers limit their exposure. If disaster doesn't strike, the investors get their money back with a preset return, typically a premium above some benchmark interest rate.

Goldman Sachs, of course, has already entered this market. When sick or elderly Americans need cash, they can sell their life insurance policies to companies that will pay them a fraction of the value.

Wall Street pursues profits in life bundles.

The bankers plan to buy “life settlements,” life insurance policies that ill and elderly people sell for cash — $400,000 for a $1 million policy, say, depending on the life expectancy of the insured person. Then they plan to “securitize” these policies, in Wall Street jargon, by packaging hundreds or thousands together into bonds. They will then resell those bonds to investors, like big pension funds, who will receive the payouts when people with the insurance die.

The earlier the policyholder dies, the bigger the return — though if people live longer than expected, investors could get poor returns or even lose money.

Either way, Wall Street would profit by pocketing sizable fees for creating the bonds, reselling them and subsequently trading them. But some who have studied life settlements warn that insurers might have to raise premiums in the short term if they end up having to pay out more death claims than they had anticipated.

Risks in Derivatives Markets

Systemic risk is the aggregation of default risks; since default risk has been exaggerated, so has systemic risk. Finally, this debate seems to have ignored what we call "agency risk." Features of widely used incentive contracts for derivatives traders can induce them to take very risky positions, unless they are carefully monitored.


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