Arbitrage Discovered

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Webster's New World College Dictionary defines "arbitrage" as "a simultaneous purchase and sale in two separate financial markets in order to profit from a price difference existing between them," but who reads dictionaries, come on.   The practical definition of "arbitrage," at least in the marketing of financial products, is "a thing we think we can make money doing, keep your fingers crossed." So when someone comes to you and offers you a thing called a "Fixed Price Arbitrage Life Insurance Contract," he's not actually offering you the ability to buy and sell the same thing at different prices, locking in a risk-free profit. It's not actually an arbitrage.

EXCEPT NO HOLY GOD IT IS THIS IS AMAZING:

Life insurance is a popular savings product in France, and typically the customer allocates their money among different investment funds offered by the insurer. But this contract was not typical: prices for the funds were published each Friday, and clients were allowed to switch funds at those prices anytime before the next price was published, even if markets moved in the meantime.

L’Abeille Vie called this an arbitrage, but really it was a gift. Is the stock market up this week? Just call your broker to buy it at last week’s price and pocket the difference.

That's from Dan McCrum at FT Alphaville, and while I suspect that most of my readers who enjoy a good derivatives-mispricing yarn also read Alphaville, I figured I'd point it out here because it is the best of all derivatives-mispricing yarns, and I would hate for anyone to miss it. So go read him, and/or the French magazine -- aptly named "Challenges" -- that first reported this. 

L'Abeille Vie, the insurer that offered this contract, is now part of Aviva. And one policyholder named Max-Hervé George has a contract worth -- well, it's hard to say, probably a hundred million euros, Aviva has sort of stopped replying to his letters. (He has to trade by registered letter, because the contract is nuts, and because they want him to go away.) There are lawsuits. The point is, if he does have a hundred million euros, and he can get more than 68 percent annual returns on the contract (as his family did from 1997 through 2007), and if he can also add more capital (as he apparently can!), then over the next few decades he can grow this contract until it's worth an arbitrary amount of money. Aviva, on the other hand, is not worth an arbitrary amount of money. It has a net asset value of about 12 billion euros.  

Also George is 25 years old. The contract terminates upon his death. Actuarially speaking, that's many years of compound growth. There is discussion on Twitter about whether Aviva has a fiduciary duty to, well, I mean, you know. That's another free financial-thriller plot for you.

What will happen to Max-Hervé George? Aviva might prevail in the lawsuits, but it doesn't sound like it. It sounds like they wrote a contract and got it very wrong. So that leaves the option of Aviva settling with him. How much should he take in a settlement? Well, how much is his claim worth? Conservatively, I would ballpark it at an infinite amount of money. (No, fine, it's actuarially bounded, call it a few hundred trillion euros -- McCrum's math goes out to 234 billion by 2030, when George is only 40.) Obviously Aviva can't give him an infinite amount of money, but certainly his claim on Aviva's assets -- in expectation -- dwarfs the claims of all other policyholders and bondholders and shareholders and whatever. So, you know, he should settle for no less than all of Aviva. McCrum's post is titled "Meet the man who could own Aviva France."

How did this happen? The explanation seems to be that these things were invented ages ago, when markets moved slowly and no one had up-to-date information, so a week's lookback option wasn't worth all that much to a regular person. Now, what with the computers and such, a week's lookback option is worth a guaranteed 68 percent annual return. Who says financial innovation never did anything for regular people?

I am fascinated by Joseph Caramadre, who a few years back discovered a different insurance arbitrage: Insurers were offering a product that paid you, when you died, the greater of (1) the amount you put in and (2) the return on some risky investment. So he'd buy two of those -- one long the risky investment, one short the risky investment -- and be guaranteed a big profit. The catch is you have to die, but he solved this by enlisting dying patients in AIDS hospices to put their names on the contracts. This was distasteful, and also criminal (he's in prison now), but it was also a surprise to the insurers. They offered a financial arbitrage, but they charged a price for it that made sense on actuarial grounds; he messed with their actuarial expectations.

But Max-Hervé George didn't mess with any expectations. Aviva had to expect exactly this. This is nuts independent of actuarial assumptions. Aviva knew it was offering an arbitrage at its expense. The name of the thing is "Fixed Price Arbitrage Life Insurance Contract." That just means, "We have made a horrible mistake, would you like to buy it?" The answer is yes, all day long. 

  1. Webster's is a little weird on this point. I quoted definition 1 in the text, but definition 2 is "a buying of a large number of shares in a corporation in anticipation of, and with the expectation of making a profit from, a merger or takeover." That normally goes by the name "merger arbitrage," or the delightfully paradoxical "risk arbitrage"; in my idiolect you can't just call it "arbitrage." But you see why Webster's would put it there, because otherwise "merger arbitrage" becomes incomprehensible.

  2. IFRS net asset value of 298 pence per share as of Oct. 30, 2014, times 2,952.1 million shares (per Bloomberg), times 1.3775 euros per pound, gets about 12.1 billion euros of NAV. Aviva also cites "economic capital surplus" of 7.9 billion pounds, or about 10.9 billion euros.

  3. It says: "Aviva France strongly contests this compensation claim and believes that the Court will rule against the speculative and excessive compensation levels being sought."

  4. George's lawyer says there are "no fewer than 64 decisions which are unfavourable to Aviva."

  5. Except the other holders of this policy! Who exist, though most of them have settled, apparently for relative peanuts.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net