Dollars and Jens
Wednesday, November 29, 2006
longevity derivatives
London is set to become the centre of a potentially huge new global market in trading so-called "longevity" risk faced by pension funds, industry experts predict.

Leading investment banks and insurance companies are working on the design of new securities expected to be launched next year. The moves come as the pension industry is frantically looking for ways to meet its growing obligations.


The market is expected to start in London rather than New York partly because of a favourable regulatory regime. Analysts say prescriptive pensions legislation and the threat of class-action lawsuits make US pension schemes nervous of innovation.


The new securities are likely to include variations of "mortality bonds" (whose value falls if deaths occur earlier than expected) and "longevity bonds" (which move the opposite way). Banks such as Deutsche Bank and BNP Paribas are working on so-called "mortality derivatives".

The move comes as the pension industry is facing a growing asset-liability mismatch, partly because pensioners are living longer, and new accounting rules are encouraging companies to reduce their exposure to pension risks.
What the pension funds are looking to buy was actually sold a couple years ago by a life-insurance company, which faces a risk opposite to that that the pension funds face. The risks don't exactly offset — life-insurance is more concerned with mortality rates in younger demographic than the one to which pensions are more exposed. But risks can be at least partially cancelled through some financial engineering here.

In the article it's compared to the credit derivatives market, and I could see it evolving into a similar sort of thing as CDOs and other basket-like credit derivatives, in which certain broad indices are fairly liquid, while more bespoke derivatives that might more closely match a given company's specific risks would be available but less liquid.

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