The New Goldman Sachs Tradeable Mortality Index

On Friday, Goldman Sachs announced it was going to create the first tradeable index based on mortality risk.

From the press release:

The Goldman Sachs Group, Inc. today announced that it has       launched the first index that will allow market participants to measure,       manage, and trade exposure to longevity and mortality risks in a       standardized, transparent, and real-time manner.

Longevity and mortality are the risks that realized lifespan differs       from expected lifespan, creating an economic consequence, often a price       change in an asset or liability. Holders of mortality risk -- typically       institutions such as insurance carriers and reinsurers -- are       economically exposed to a decrease in lifespan, while holders of       longevity risks -- pension funds, annuity writers, the social security       trust fund or life settlement investors -- are exposed to an increase.

The index, called QxX, is supposedly the first of many to come.  I have included some additional information from its website below:

QxX is designed to allow market participants to measure, manage, and trade exposure to longevity and mortality risks in a standardized, transparent, and real-time manner

QxX.LS, the first in an expected series of indices, is a representative sample of the US senior insured population over the age of 65. The initial index references a pool of 46,290 de-identified lives

• Reference pool consists of a rules-based set of lives, medically underwritten by AVS Underwriting, LLC
• Published monthly, providing real-time mortality information
• Mortality tracked by independent, third-party agent, based on the Social Security Death Index
• Indices will roll on an annual basis, providing a continually updated reference pool, capturing market evolution and underwriting trends

Participants will be able to initiate swaps based on the index where they swap mortality risk.  The website explains:

QxX.LS index swaps are designed to allow market participants to hedge or gain exposure to longevity and mortality risks, providing reliable, real-time pricing information and execution

• “Fixed Receiver” sells mortality protection and is “long” mortality risk – receives a spread and makes mortality-contingent payments
• “Fixed Payer” buys mortality protection and is “short” mortality risk / exposed to longevity risk – pays a spread and receives contingent payments
• Spread to represent market-implied mortality of the reference pool
• Net cashflows exchanged, representing the difference between the spread and the realized mortality
• Swaps will trade with a defined term profile – swap maturities will be certain at the outset of each trade

Before I go into some thoughts on the index, let me explain my background in insurance linked securities.

A few years back I worked for a major reinsurance broker structuring capital market solutions for our reinsurance clients.  When I say capital markets solutions, I mean any type alternative risk transfer of insurance risk including Industry Loss Warranties, Catastrophe Bonds, and Weather Derivatives.  This market exists because there is a major problem with capacity for insurance risk (in some areas more than others).  Most insurers and reinsurers have far too little capital and credit ratings that are suspect at best.  After Hurricane Andrew, Katrina, and 9/11, insurance linked securities such as Cat Bonds started to pop up.  These enabled insurerers and reinsurers, as well as some non-insurance companies to securitize some sort of catastrophe risk that is on their balance sheet through a bond that pays the holder on the  occurence of some event - a hurricane in Florida with winds in excess of 100mph, an earthquake in California greater than 7.0, or some aggregate industry or indemnity based loss due to an event.  The holder of the bond (usually hedge funds) receives LIBOR plus a very juicy spread and the issuer receives a fully collateralized form of reinsurance, and don't have to worry about time to assess and collect claims.  Many very big hedge funds play in this market - one enormous one is Citadel.  Hedgies, such as Citadel, like the fact that is essentially a zero beta asset class - it has no correlation to the markets.  They can also accept the risk that a bond can be totally wiped out (though it has only happened once I believe and that was a crappy deal done the year before Katrina).  Some in the industry envision a future where there are tradeable insurance products and the retail investor could hold a say 10% position in insurance in his portfolio.  A few believe that area will eventually replace the traditional insurance market altogether. 

One reason I left the job was that I did not see it taking off at the reinsurance broker worked for, for one reason - we didn't take risk.  We would advise on deals, but couldn't underwrite and distribute, and in the world of Wall Street that means you get paid very little.   I also saw one big Wall Street name in the market on every deal, slowly cutting us out of fees for advising on relationships and business that we brought them.  This company was Goldman Sachs.  Goldman has slowly been inching into the insurance business for years.  They are now the lead underwriter on many Cat Bond deals and them and Swiss Re (which is also makes a market in this stuff) have become much bigger players than the Guy Carpenters of the world would have liked.  Reinsurance brokers are the insurance industry's version of investment bankers and it was only a matter of time, I thought, before Goldman became a reinsurance broker who offered their clients good advice but something much greater - the ability to underwrite and either hold or distribute the risk. 

First off, I believe this is an enormous move and one that WILL be looked back on some years from now.  At a time when the market for "market risk", or beta, is in chaos, they are going into a market that is completely uncorrelated.  Usually, when the markets are afraid of eating apples, because they may be poison, Wall Street decides to just sell less apples.  Goldman is looking to sell oranges, and it may turn out to be huge for them.   Plus there are a lot of other phenomena going on that could make this huge if it is just going into this and only this insurance market.

That aside, lets look at some thoughts, questions, and concerns I have:

• Basically, this index allows one party to bet that a cohort of 65 year olds dies early and the other party that it lives long. Life insurance companies don't like it when people die - it means they have to pay a benefit.  They would love to be able to hedge this risk efficiently.  The US government, which has to pay social security until a person dies, would love to be able to actively hedge the risk that they keep on keepin' on, and this would be a means to do it.  Pension plans too.  So essentially this market will be a trade between the government and pension plans and insurers and reinsurers - very interesting, potentially VERY lucrative, and very likely to raise eyebrows at some point in time.
• The life tables currently used, have a five year delay in the mortality data built in, this is due to the time it takes to gather, analyze, group, and publish the data.  Although insurance companies may gather and use their data the ones published by the CDC and the SSA contain the most widespread and public mortality data.  The real-time nature of such an index could have enormous changes on the index. 
• The fact that this is an index along with the need for liquidity for insurance risk immediately make be think that an ETF-based product somewhere down the line.
• THIS NEXT POINT IS VERY SIGNIFICANT.  Goldman is also very busy in the market for "life settlements".  This is where people can cash in their life insurance policy now and forfeit their right to a benefit later.  Another article elaborates:
  

  "The index also could help manage risk in a burgeoning business market that, in effect, makes hedges on death itself. The business is referred to as "life settlements."

  The way it works is a firm pays the holder of a life-insurance policy a lump sum for the policy now, takes over paying the premiums for as long as the insured person lives, then collects the benefits -- generally worth far more than the firm paid -- when the person dies. The firm keeps some of the policies in its own portfolio. It sells others to institutional investors.

  In April, Goldman Sachs, Credit Suisse Group and Bear Stearns Cos. helped form the Institutional Life Markets Association to lobby against efforts to restrict the business. If successful, Wall Street firms could buy policies directly and squeeze out the middlemen. This year, Cantor Fitzgerald LP set up an Internet-based exchange for those who want to sell or buy policy rights.

  Life settlements stir objections, and not only because they make some people squeamish. Some state regulators have called life-settlement terms unfavorable in some cases to policyholders. They have also charged that certain arrangements flout the spirit of laws designed to keep speculators from taking out policies on strangers."
  
  In a time when costs are soaring, lending is contracting, and assets are deflating, many ordinary Americans still own one big asset and don't know it - life insurance.  They see it as an expense, since many have to pay premiums and never get to experience the benefits.  Life insurance is also somewhat exempted from creditor claims due to bankruptcy.  Some see this being the way for the credit happy American to have one more dance or try to pay off loans if in credit trouble.  If this is the case, this will be a HUGE market as we all know.  If you thought subprime was shady - this takes the cake. 

• Who are these 46,290 people?  They could be potentially the most valuable senior citizens on this planet.  Isn't it somewhat disconcerting that so much money will change hands based on whether someone's Grandmother dies of cancer.  Even though I believe it to be unlikely and very difficult given the amount that would have to be done, who has the list with names of these people?  In the old model, the insurance company - the person with specific names - was interested in its client living, and the government just in a general cohort.  This flips it around.  46,000 people is not all that many and we have no idea the scale of how such a market will trade.  I'm not implying that someone is going to kill these people to make a buck, but they have never had the incentive to before. 
• The website mentions there will be many subindexes and I believe they will breakdown by at least sex and cause of death or health problem.  The cause of death is most interesting due to all the talk of Universal Health Care - and Goldman's proximity to Washington. 

This news was announced on a quiet Friday in December.   I suspect that Goldman's foray (amongst other firms I'm sure) into the insurance fields will be a popular discussion in the near future as it has political, financial, and moral strings ramifications at a very tumultuous time.