Friday, May 25, 2007

Livelihood Insurance and Macro Markets

I have been reading Robert Shiller's book, "The New Financial Order:Risk in the 21st Century". As with the previous "Irrational Exuberance", this one is also a very interesting read. It contains some very serious insights and ideas about financial risk mitigation. Shiller proposes six ides for a new financial order - Macro Markets, Livelihood Insurance, Income linked loans, Inequality Insurance, Intergenerational Social Security, and International Agreements for Risk Control.

Macro Markets could easily follow in the footsteps of equity markets, derivative markets, and commodity markets, in the coming years. We could have a market for trading in the economic health of different countries. While the stockmarket represents only a portion of a country's economy, the macro markets can represent the country's economy itself. Its performace can be a predictor of the future expectations of investors and other stakeholders about the prospects of the country's economy.

Macro securities on the GDP of a country would be like any other share, with its value determined by the expected revenue streams or economic growth potential of that country. These securities would give out dividends in proportion to the performance of the country's GDP, reflected in the value of the security. These securities could be issued either by the Government or by private financial Institutions accredited by the country. Macro securities on GDP will thus enable investors to invest directly in the country's economy and its price will represent the value of a claim on the economy. These securities will not have any expiration dates and will be similar to perpetual futures on the index. Apart from national incomes, other macro securities could be issued to cover prices of different categories of real estate in a City or Country, incomes of different occupations etc.

Institutions issuing the security can "invest the proceeds in macro markets representing the national incomes of other countries", thereby "effectively swapping the risk of its national income for the better diversified portfolio of national incomes all over the rest of the world". By selling the security on GDP of a country to foreigners, we would be effectively selling the risk on our economy to a foreigner, thereby facilitating massive risk diversification and risk sharing.

Robert Shiller and Allan Weiss patented macro securities in 1999. To quote from the book about the details of these securities, "These securities are issued and redeemed on demand by a stock exchange or by financial institutions, but only in pairs - an "up macro" designed so that its price moves up when the GDP moves up and a "down macro" whose price moves down when the GDP moves up and vice-versa. Though issued and redeemed in pairs, these securities are traded separately and each finds its own price in the market. Each member of a pair has a separate cash account adjusted according to the specified economic index (eg GDP) being traded, by re-allocating across accounts. Each macro security pays dividend equal to the interest on its cash account."

"Suppose a pair of securities is issued for $200 when the index is 100. The account of the up macro is initially credited with $100 and the account of the dowm macro is also credited with $100. If the index rises to 102, the custodian of the cash account takes $2 from the down macro account, reducing it to $98 and puts them up in the up macro account, so that the balance in the up macro account again equals the index at $102. This action means that, subsequently, the dividends on the up macro security will be higher, and the dividends on the down macro security will be lower. In this way, through subsequent dividends, the holder of the up security will be rewarded by the rise in the index. By anticipating higher dividends, the investors in the up macro security will bid up its price. If on the contrary, the index falls, the investors will quickly bid down the price of the up macro and bid up the price of the down macro, anticipating the changed future dividends. The price of the security need not track the index, but will anticipate the index."

"The price of the up macro will represent a long-term claim on the index, much as a stock is a claim on the future earnings of the company. People wanting to invest in the index can buy the up macro, and those wanting to protect themselves against any risk on the index can buy the down macro. In macro-securities, for every "long" there is a "short". The "shorts" are those exposed to a risk on the index, while the "longs" are the international investors."

A market portfolio consisting of macro securities on the GDPs of all the countries will represent a claim on everything of economic value and would be the "ultimate diversified portfolio".

Similar macro markets can come up for real estate prices for a particular city, wherein homeowners or mortgage lenders can hedge their risks by buying securities for individual cities and home equity insurers will use the markets to offer policies to homeowners.

Another risk mitigation instrument is the Livelihood Insurance. In an age of proliferating technologies and related jobs, there is a need to hedge against any risks posed by the maket to these very specialized livelihoods. This insurance will be vital towards encouraging development of these virgin fields by attracting fresh talent. An individual seeking to make a career in a particular field can purchase livelihood insurance issued for that field, which would insure him against any decline in incomes in that field. The risks he would have had to bear otherwise would now be borne by the insurance company. "The policy would pay him a regular income over the years in the event of a decline. He would pay for this policy by committing to pay as an insurance premium a fraction of his future income over the future years, or by committing to pay a fixed indexed sum per year over the years, or by committing to pay a combination of these two." The investors in the insurance company will of course hold the security so as to profit from any upside in the profession.

Livelihood insurance could cover all the jobs or careers. The employers could issue the insurance as an employee benefit or the unions could issue it for their members. For example, in a market for incomes of medical doctors, those starting out on the profession could be sold insurances by the livelihood insurers and the medical schools or medical associations (who have an interest in the prospering of this profession) could make investments in these markets by buying these macro securities issued by the insurers.

Examples of such risk hedging tools include the $1.865 loan arranged in 1994 by Citibank for Bulgaria, with an interest rate tied to the growth rate of its economy. Higher the growth rate, higher the interest that would have to be paid by Bulgaria. Bulgaria thus managed to transfer some of its economic risks to the diversified portfolio of individual and institutional investors.

The day is not far when kids seeking a career in cricket will venture out into the cricket pitch, armed with an insurance on income from cricket. We could see African countries benefitting enormously from external income linked loans, or Goldman Sachs issuing bonds insuring the future income of celebrities, or Income Tax Act being replaced with an Inequality Insurance Act to usher in a progressive taxation schedule whenever the present inequality levels threatens to get worse. All these will enable risk diversification on a hitherto unimaginable scale besides adding huge liquidity to our financial system.