What’s the over / under on longevity? A new financial derivative, also known as the death derivative, is garnering interest at many levels for its benefits for pension funds but also raising concerns about regulation and capital requirements. Pension funds are seeking to quantify and hedge their risk if their members live longer than anticipated. Managing this longevity risk is expected to be a growing area for investment banks as they seek new ways to earn fees but finding a counter-party for the product is proving difficult as few entities want to take a risk for 20+ years.
Financial firms have begun developing mortality-rate indexes that will be used to price and trade these derivatives. The instrument pays out when a retiree dies sooner than expected for a profit but if a senior lives longer than expected, the extended length of life becomes a liability and creates a loss. For large financial firms, the hope is that these derivatives will have regulation similar to insurance products. Even though the derivatives act as a type of insurance, there is limited liquidity with the nascent market.
How can firms adequately value the risk and capital required to account for the positions that they’ve taken? Industry participants state that the products are fully collateralized but the duration risk remains the real gamble. Improvement in medical treatments and the benefits of maintaining a healthy lifestyle will grow over time and the value of these instruments maybe subject to drastic fluctuations based upon headlines promoting new treatments or cures for disease.
Are death derivatives the new financial weapons of mass destruction (WMDs)? Probably not but the moniker of “death derivatives” will catch the ear of regulators and the general public and make everyone do a double-take.
For more details on the growing interest in these products, visit Death Derivatives Emerge From Pension Risks of Living Too Long