Mortality-linked securities

The Pensions Institute has an excellent new paper on�Mortality linked Securities and Derivatives. The paper describes the problem (longevity risk) and what conclusions can be drawn from present experience in pensions buyouts and securitisation transactions. They also discuss the pricing of longevity risk in the absence of a liquid mortality-linked capital market. For a complete picture, we'd be interested in the fallout of the present turmoil in the asset-backet securities and credit derivatives space on mortality-linked securities ... �

Wikinomics in finance?

I quite enjoyed reading Wikinomics, although it took far too long. It's an interesting and engaging overview of the latest impacts that mass collaboration has on all sorts of business models. I was particularly surprised to see how many big names were already successfully active in that space. Which begs the question why, apparently, none of them are in the finance industry?

In essence, the Wikinomics principles�consist in Being open, Peering, Sharing and Acting globally. Classifying these as principles implies that they are to be applied diligently and carefully as they might kill off any business model otherwise.�

Much of what being open, peering and sharing stands for appeared to be synonymous to me at first, so let me try to identify the differences. Transparency, or being open, could be seen as a catch-all term for peering and sharing. In the Wikinomics sense, it means to provide some sort of access to one's business model. Peering refers to a non-hierarchical production mode where control can only be exercised in a very limited way (for instance by providing a rule book and/or a platform). Sharing means that control over pieces of intellectual property is given up, implying that others can take advantage of it if they discover profitable ways to do so. Wikinomics impressively demonstrates the application of these principles in a number of industrial settings, mostly dealing with immaterial assets such as engineering knowledge, software, IP and other know-how.�

Those principles of wikinomics seem to be anathema to the domain of finance, though. Historically, this industry is rife with control, secrecy and exclusion. Is it inevitably so, though? I don't think so. It is probably inevitable when it comes to the client relationship (yes, the Swiss perspective) and the deployment of capital, which is exclusive by nature. Also, the characteristic of finance as a regulated industry will constrain the applicability of wikinomics as long as it is not embraced by the regulator.�

When it comes to all other aspects of know-how in finance (risk management, asset management, investment research etc), however, I see no reason why they could not be profitably opened up to wikinomics, especially when there is a premium on transparency in times of crisis. The Tapscotts themselves propose to apply wikinomics to risk management, but unfortunately, they stick rather close to the surface IMHO. It will be interesting to watch IBM Data Governance Council's initiative for XBRL in risk reporting.�

However, without regulatory leadership or at least explicit support, such initiatives are destined to fail or thrive only in un-regulated niches, which are likely to shrink going forward. �A pet project for Ms Schapiro? Here's to hope!

Institutional hedge funds?

Some will find this excessively dogmatic, but I still subscribe to the view that there is no conclusive evidence yet of the need for hedge funds (meaning active absolute return strategies) in the institutional asset management business. To provide such evidence, it would be necessary to demonstrate that hedge funds' risk-adjusted performance after fees is located on the efficient frontier over an entire market cycle, and that would have to hold in the present constellation with relatively huge allocations to the segment.

In my view, hedge funds are perfectly appropriate for private wealth because of individual investors' known disproportionate avoidance of loss. In the case of institutional investors whose equity is subject to volatility of assets and liabilities, absolute return strategies may be net inefficient at best, or they may even create additional asset/liability mismatch and thus be entirely counter-productive if considered from a comprehensive balance sheet risk management perspective.

That being said, the traditional distinction between hedge funds as providers of absolute return strategies on the one hand or alpha engines on the other becomes increasingly blurred. It is therefore advisable to keep a close watch on the industry, especially given the recent competitive pressure on excessive and asymmetrical fees exerted by institutional investors (epn story).

Annuities: a private solution to longevity risk

Its title may appear a bit facetious, but the latest issue of SwissRe's Sigma is anything but. It contains a comprehensive overview of the challenges to capital based retirement provision arising from increasing longevity. The prime focus of the publication is on insurers and insurance products, naturally, but most of its considerations and precepts are directly applicable to non-insurance pensions providers. A very worthwhile read for everyone in the retirement business!

Early birds

There is no more appropriate way to start the first post of the year than by dedicating it to an early bird, even though the year is well advanced already. The early bird in question is Allianz with its European ComPension product, the first product that has been designed with a pan-European pensions market in mind. Meanwhile, we've had a bit of time to look at this interesting solution, which is only the first of several products that are currently under development, as we hear.

European ComPension is a fairly plain-vanilla insurance retirement product that is available through Allianz's international network, but only in France, Italy and Germany for now. Unsurprisingly, it offers only DC solutions, although this entails a guaranteed minimum return in Germany. The pricing reflects the first mover advantage. Assets are invested in one of two new Luxemburg based Allianz Global Investors European Pension funds Dynamic or Balanced which invest in an opportunistic combination of Euro area stocks and bonds.

Given the somewhat moderate pace of the market, I am not sure whether the first mover advantage is really that big in the case in point. European ComPension has obviously been designed from a network perspective so as to not cannibalise the network's incumbent business. As it is our view that the pan-European pensions market has the potential to disrupt insurance networks in that specific segment, it is probably unwise to choose such a development approach.

While the choice of the development approach may be ill advised but comprehensible, it is hard to understand the investment strategy of the funds on offer. The geographic limitation of investments to the Euro area appears to present such a strong impediment to the portfolio's potential efficiency that one may wonder whether this is in line with the Prudent Person Rule at all.