Saturday, November 25, 2006

Sharing Demographic Risk - Hedging our Bets?

Update: I have completely missed the fact that Felix Salmon actually has handed over his blog to Stefan Geens for a couple of weeks. This of course means that I cannot quote Felix below because he in fact is not the author :), the post has been corrected accordingly.

One of the many effects of the current demographic transition and subsequent ageing (rising longevity is the one to watch out for here!) is that pension funds are looking to new ways to meet their growing obligations; I mean why won't people just die eh?

However, what if they could trade that risk through a derivative? Nonsense you say? Far from it actually ...

(The FT reports - hat tip Stefan Geens (guestblogger over at RGE's Felix Salmon))

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.


David Blake, professor of pension economics at City University, forecast the new market would eventually outstrip credit derivatives, which have ballooned to $26,000bn. “The potential is enormous and it will start to happen very soon.”

Stefan even takes it a step further musing about hedging against low fertility;

The idea of trading in demographic risk as a way of sharing it is intriguing. But if you can trade in longevity, why not trade in fertility as well? Can we soon expect financial instruments derived from fertility rates, so that institutions can insure against people not being born, in addition to not dying?

Of course the interesting thing here is the market trend of this potential new market. It is huge as a function of the sustained demographic transition (rising longevity) we are witnessing almost all around the world. More in tune with the traditional postings here at DM Stefan ends his post by pointing us to a paper by Alexander Ludwigy and Michael Reiterz focusing on Germany and how to share demographic (intergenerational) risk in the reform process of pension systems. The paper will probably demand more attention at a later point but for now I will leave you with the conclusion (as quoted by Stefan).

The current baby boom-bust cycle implies severe welfare losses for the baby boom generations, even under optimal policy. Our calculations are based on some relatively pessimistic assumptions (no immigration, low fertility rate for a very long time, high labor supply distortion forever). In this case, the baby boomers loose the equivalent of about 5 percent of lifetime consumption, compared to a steady state with constant population.


Stefan Geens said...

Hi Claus,

Just want to clarify -- Felix is off to Antarctica for a few weeks so that post was written by me, Stefan Geens, the guest blogger. I mention it only to spare Felix the discovery upon his return that he said things with which he may not at all agree.

CV said...

Whoops ... thanks a lot. This is important! I will correct it accordingly above the fold.