Health Insurance Derivatives: The Newest Application of Modern Financial Risk Management

Article excerpt

WE ARE IN the midst of a giant economic, business and financial revolution, particularly with respect to understanding and managing risk and uncertainty. The revolution is worldwide and is an important factor in globalizing markets. This revolution has significantly changed the way businesses and financial firms are managed, the way markets, products, and services are structured and analyzed, and the way economists and financial experts perform their analytical and operating tasks.

According to estimates of the Futures Industry Association, the 1990 volume of exchange-traded financial derivatives was double that of 1985 and almost seven times the 1983 volume. Derivative exchanges spread to the world's major financial centers, such as London, Paris, Tokyo, and Singapore, and in the U.S. from Chicago to New York and Philadelphia. The growth of the over-the-counter (OTC) financial derivatives has been extraordinary. Prior to the 1980s, the primary OTC market was the interbank foreign exchange market, involving forward currency contracts. In the 1980s, the growth in the OTC market was based on innovative financial engineering, resulting in a host of new instruments such as swaps, caps, floors, collars, and swaptions. The International Swap Dealers Association (ISDA) estimates that in 1987 outstanding currency and interest rates swaps totaled almost $1 trillion. By 1990, only three years later, these swaps tripled to close to $3 trillion.

What accounts for this phenomenal growth, and what are some of its effects? First and foremost, the markets in derivatives have grown because these markets present a better and a cheaper way to manage risk and to design useful, innovative products. The main elements of how price risks in agricultural markets could be managed or hedged were well-known many years ago, as was the related price discovery function of futures markets, i.e., as a by-product of markets for future delivery, prices in those markets could be seen by all. People therefore could easily "discover" the market's judgments about future price as well as the prices at which transactions for deferred delivery could be executed today. The ability to do these trades was made accessible to a wide range of people; the market determined the price of the contract, which was the same to all.

The wave of innovation really began once it was recognized that essentially the same analysis and risk management techniques applicable in commodities futures markets were appropriate to financial markets as well. David Meiselman's research more than thirty years ago was path-breaking and was published in his The Term Structure of Interest Rates (Prentice-Hall, 1962).

Risk reduction and management opportunities afforded by derivatives reduce the cost of achieving a desired or optimal level of risk. Risk became something to be managed and controlled and a central matter for sophisticated, responsible management. Price discovery gives ultimate transactors and wealth holders the ability to dispose of some or all of the risk by appropriate buying or selling. In addition, risk can be shifted to those who prefer to carry these risks or who are effectively paid to do so. The result is a more efficient allocation of risk, with resulting overall wealth and income gains that more than compensate for added transactions costs.

These results came in three major phases:

1. In the first phase of the growth of derivative instruments and markets, especially exchange-traded futures, the number and use of these instruments and markets increased enormously, including Treasury bonds of various maturities, foreign exchange, short-term money market instruments such as Euro-dollars and now even the federal funds rate. During this time, there was a parallel development of options markets, first on individual stocks, then options on futures and currencies, and then options on various indexes. The put-call parity conditions tied together the options, spot and futures markets. …