Tuesday, March 06, 2007

Mortality Derivatives

Mortality derivatives is an interesting subject, and the REcapitulator will be publishing a paper (more of a primer on the subject than delving into problems of conditional probability and mortality modeling) that will be available here.  Some excerpts from the paper are given below.

The REcapitulator is also privy to information regarding the launch of Hurricane derivatives, but he doubts that these will catch on as there is major basis risk.  The contracts (initiated by the CME) hedge against hurrican landfall (frequency), but not the severity of a given landfall.  What is an insurance company to do if the severity of a hurricane is not a price factor?  This initial attempt will hopefully spawn new innovation.

Anyway, some excerpts from the opening comments of the forthcoming paper:

The exposure of pension and insurance companies to unexpected decreases in mortality is an important risk, and one that has been increasingly difficult to predict. Actuarial assumptions regarding populations do not take into account secualar increases in life spans. To the extent that this risk can be transferred to the capital markets, it would create a more definable and predictable set of cash flows (and potentially reducing the cost of capital) for insurance and pension concerns.
While insurance companies can internally hedge their exposure to long-tail life insurance contracts through the writing of annuities, this presupposes the ability to sell annuities, a more or less contsant distribution of population, (assuming further that annuity purchasers do not buy life insurance products) and introduces other forms of risk to the overall insurance profile such as interest rate risk.

Mortality Derivatives may also be a more efficient way to price life and annuity contracts. Derivatives markets attract sophisticated participants who may have access to better information and/or more predictive financial models. This phenomenon has not been lost on the Federal Reserve, which routinely scans deriviatives markets and their corresponding implied expectations of the future in order to make policy decisions.  This “tail wagging the dog” effect, due in large part to increased leverage than cash markets,could also provide valuable informational flow with regards to pricing the primary obligations of pension and insurance companies.  These firms would have a competitive advantage versus their peers with mere active partcipation into the mortality derivatives markets.  Information garnered in this fashion could be used for capital allocation and internal hedging purposes, in addition to providing a competitive advantage to firms participating in the mortality derivatives markets by acting as the proverbial “canary in the mineshaft” in detecting unexpected events that effect mortality rates.

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