Have financial wizards found a way to outwit Death?

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We can't beat the Grim Reaper, but soon we may be able to hedge against his capriciousness.

Those never-sleeping derivatives wizards in their investment-bank workshops are now reported to be devising ingenious ways of speculating on how long people will live.

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Sounds a little callous? Not really. These mortality derivatives' aren't punts on a single individual coming to an untimely end. Instead, the payoffs are linked to death rates among large groups of people something that could be very useful for balancing risks

The obvious customers for these instruments are pension funds. If you think about it in trading terms, pension funds are short longevity. If their members live for longer than expected, they have to pay pensions for longer and so make a loss.

Given that longevity is increasing dramatically in the Western world at a time when many pension funds already face funding problems, that risk is becoming a huge headache for trustees. A tool that lets them hedge that risk would be a major breakthrough.

The biggest stumbling block is finding someone to take the opposite side of the trade ie someone who is prepared to bet that life expectancy won't increase as fast as pension funds fear. Initially, these people are likely to be speculators. But there may be natural, non-speculative counterparties who need a hedge of their own and could be paired with the pension funds.

After all, it's not hard to think of companies who are naturally long longevity and might want protection against life expectancy expanding less than anticipated. For example, retirement-home builders and owners make more money if their tenants live longer. Pharmaceuticals gain if the elderly and infirm stay alive, because they can sell them medications. Life insurers have to pay out if people die younger than expected. There's clearly a great deal of potential here.

While mortality derivatives may sound quite radical, the concept isn't new. Recent years have seen a wave of catastrophe bonds, issued to help insure against deaths and losses from disasters such as earthquakes.

Swiss Re and Axa took the principle further with extreme-mortality bonds. These make a profit for the issuer if there's a sudden spike in the death rate and thus can be used to hedge an insurer against a range of high-impact, low-probability events such as a bird flu pandemic.

Even a longevity bond for pension funds has been tried before: BNP Paribas launched the idea in 2004. But the cost of getting someone to take on the longevity risk and the unwillingness of pension funds to dabble in the new products meant that the bank was unable to sell a single one.

But it seems likely that the products under development due for launch next year will do better. Even within two years, derivatives markets have become far more sophisticated, while pension funds are willing to look at more complex instruments as they struggle to fix their finances. David Blake, professor of pension economics at City University, reckons that the mortality derivatives market could eventually outstrip that for credit derivatives, which currently has a notional value of $26trn.

Unlike the CPDOs we wrote about last week which merely seem to add risk to the system there are clearly huge benefits in mortality derivatives. We're inclined to give them a cautious thumbs-up. That said, we still have some reservations about the way they'll develop.

Given the speed with which new risks are sliced and diced in the derivatives market these days, we imagine that longevity risk could quickly be parceled up into collateralized debt obligation (CDO)-style pools surely to be dubbed collateralized death obligations. These could then be heavily leveraged to juice up returns. And some of them would undoubtedly find its way into the hands of yield-hungry investors who would have little understanding of the risks that they're taking and could suffer big losses.

Something like that may be inevitable. The fast-expanding derivatives market shows every sign of being a bubble and we're at the stage of the cycle where recklessness rules. It would be unfortunate if an excellent idea such as mortality derivatives were to appear at just the wrong moment and end up discredited by association when the bubble bursts.

Turning to the stock markets

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In London, the FTSE 100 ended 20 points lower, at 6,140. Pub operator Enterprise Inns was the main riser, up 3% at 1,205p, as the EU went back on plans to allow alcohol and cigarettes to be bought anywhere in Europe without paying domestic tax. For a full market report, see: London market close.

Elsewhere in Europe,the Paris CAC-40 closed down 27 points at 5,424, whilst the German DAX-30 ended 1 point lower, at 6,475. US markets were closed for Thanksgiving Day.

In Asia, the Nikkei 225 slid 179 points to 15,734, after the Japanese government cut its outlook for the economy for the first time in nearly two years.

The price of crude oil was a little lower in New York this morning, trading at around $59 a barrel, whilst Brent Spot was at $58.90.

Spot gold was higher, trading at around $633 an ounce.

And in London this morning, bad news for retailers as research group Mintel warned that UK retail sales may grow by no more than 1% on last year, due to consumer caution.

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