A Very Ghoulish Example of How Financial Speculation Hurts Everyone but the Speculators

I bet you didn’t think life insurance policies could be securitized. You would be very wrong:

The bankers plan to buy “life settlements,” life insurance policies that ill and elderly people sell for cash — $400,000 for a $1 million policy, say, depending on the life expectancy of the insured person. Then they plan to “securitize” these policies, in Wall Street jargon, by packaging hundreds or thousands together into bonds. They will then resell those bonds to investors, like big pension funds, who will receive the payouts when people with the insurance die.
The earlier the policyholder dies, the bigger the return — though if people live longer than expected, investors could get poor returns or even lose money.
Either way, Wall Street would profit by pocketing sizable fees for creating the bonds, reselling them and subsequently trading them. But some who have studied life settlements warn that insurers might have to raise premiums in the short term if they end up having to pay out more death claims than they had anticipated.

An investment based on complex mathematical models with no risk for the creators of these products. What could possibly go wrong? I’m sure they’ve done lots of analysis to make sure nothing bad could happen:

To test how different mixes of policies would perform, Mr. Buckler has run computer simulations to show what would happen to returns if people lived significantly longer than expected.
But even with a math whiz calculating every possibility, some risks may not be apparent until after the fact. How can a computer accurately predict what would happen if health reform passed, for example, and better care for a large number of Americans meant that people generally started living longer? Or if a magic-bullet cure for all types of cancer was developed?
If the computer models were wrong, investors could lose a lot of money.

But, wait! It also drives up the cost of a legitimate product, life insurance:

Indeed, what is good for Wall Street could be bad for the insurance industry, and perhaps for customers, too. That is because policyholders often let their life insurance lapse before they die, for a variety of reasons — their children grow up and no longer need the financial protection, or the premiums become too expensive. When that happens, the insurer does not have to make a payout.
But if a policy is purchased and packaged into a security, investors will keep paying the premiums that might have been abandoned; as a result, more policies will stay in force, ensuring more payouts over time and less money for the insurance companies.
“When they set their premiums they were basing them on assumptions that were wrong,” said Neil A. Doherty, a professor at Wharton who has studied life settlements.
Indeed, Mr. Doherty says that in reaction to widespread securitization, insurers most likely would have to raise the premiums on new life policies.
Critics of life settlements believe “this defeats the idea of what life insurance is supposed to be,” said Steven Weisbart, senior vice president and chief economist for the Insurance Information Institute, a trade group. “It’s not an investment product, a gambling product.”

But don’t worry, it’s only estimated to be at least a $500 billion market.
I wonder if there’s a derivatives market for cadavers.

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11 Responses to A Very Ghoulish Example of How Financial Speculation Hurts Everyone but the Speculators

  1. Epicanis says:

    Bonus: Watch health-insurance companies invest in them.
    Something very disturbing about a financial “product” that provides incentive for the owners to have people die earlier…

  2. D. C. Sessions says:

    Indeed, Mr. Doherty says that in reaction to widespread securitization, insurers most likely would have to raise the premiums on new life policies.

    You know, I’m truly impressed by the ability to lose the basic picture in the details. Either the people pushing this are dimmer than a dead firefly or they’re betting that we are.
    Bottom line: the system has premiums as input, payouts as output — and they want to add another set of taps into the money stream. Barring the ability to print money, that requires:
    * Increasing premiums,
    * reducing payouts, or
    * adding another source of funds (e.g. bailouts when it all goes pear-shaped.)

    Someone remind me why this is supposed to be good for anyone except those who are running the tap.

  3. Russell says:

    Pretty obviously, this is good for those who want or might want to sell their life insurance policies.
    The downside, as already pointed out, is that investors largely will be trusting rating agencies and models to evaluate risk. The last year casts a jaundiced eye on that. My general view is that investors who buy risk that goes bad can go into another line of work. Bailouts were required only because the shadow banking industry took on so much of that poorly understood risk and got squeezed. The way to avoid that is to better regulate those financial institutions. But as for the general investor? If he bets badly, that’s tough.

  4. Russell says:

    And how is a market in life insurance securities any more ghoulish than life insurance itself? Once you allow a market mechanism to wager on when one dies, it seems to me you’ve crossed whatever wall the squeamish might want to construct between our mortality and the financial system turning it into yet another risk to be financially manipulated.

  5. Rose Colored Glasses says:

    The life insurance industry would be more profitable if it would learn from the health insurance industry and practice rescission — canceling policies of customers who die.

  6. Eric Juve says:

    The insurance companies could simply make the policies non-transferable to uninterested third parties.

  7. Troublesome Frog says:

    D. C. Sessions:

    Bottom line: the system has premiums as input, payouts as output — and they want to add another set of taps into the money stream.

    That’s a very good way of looking at it. Some people like to say that you can’t make money without doing work, and that these markets are encouraging the belief that if we all just by complicated financial products, we’ll all get rich. I’d argue that the point is more subtle than that. Sure, if you buy the right paper, you can make money without producing anything.
    The point that people are missing is that you can’t make money without *somebody* somewhere down the line producing something, and we certainly can’t all make money with nobody producing anything. Eventually those facts always bite us in the ass.

  8. MichaelE says:

    This kind of thing already exists:
    “A viatical settlement is the sale of a life insurance policy by the policy owner before the policy matures. Such a sale, at a price discounted from the face amount of the policy but usually in excess of the premiums paid or current cash surrender value, provides the seller an immediate cash settlement. Generally, viatical settlements involve insured individuals with a shorter life expectancy. This is a practical way to pay extremely high health insurance premiums that severely ill people with short life expectancy (ex. a person with AIDS) face. A life settlement is a similar transaction but involves insureds with longer life expectancies.
    From the perspective of the investor, purchasing a viatical settlement is similar to buying a zero coupon bond with an uncertain maturity date. The return depends on the seller’s life expectancy and when he or she dies.”
    “A life settlement generally refers to the sale of a life insurance policy by a policyowner for less than the face value of the policy to third party investors.[1] The third party investor(s) plans to profit at death of the insured by collecting more in death benefits that were paid out (e.g., the purchase price, the transactions costs, and premiums). This translates into higher profits the sooner the policy holder dies.[2] A “viatical settlement” is the same as a life settlement except the insured is chronically or terminally ill (as defined by the IRS Code).
    Transactions of this type have been available for Americans since 1911. Aids sufferers created a small market in the 1980’s when their policies were sought out by speculators.The credit crisis has seen a rise of elderly Americans for whom their life-insurance policy is one of their more valuable assets.
    The Economist reports estimates of it being a $18-19 billion market as of June, 2009.” (both passages from Wikipedia)
    If viatical settlements are regulated against, then more families of terminally ill patients will suffer financially.
    However, most insurance companies already have provisions in their policies that allow the insureds to pre-draw a certain portion of their policy’s face value, and then the family receives the remainder after the insured dies. There is usually a small fee of less than $200 and the insured must show that people with their condition live less than 6 months, 12 months, or 18 months (depending on the policy).
    People who have chosen caring and honest insurance agents (yes, we exist) will have someone to ask and learn from if this question arises. People who buy “cheap” life insurance from cable and internet ads get what they pay for.
    If you want cash value from your life policy before you die, then you should buy cash value life insurance. People who believe in “buy term and invest the difference” will not likely be approached for this kind of offer because the chances are about 98% that they will live beyond the end of the term.
    Of course, you could cut out the middle-man: take out a home equity loan yourself (if you have any left) or run up your credit cards (if you have any left) and hope you die so that your life policy can pay off the debt before your famly is out on the street (snark).
    The only thing new here is the fringe money managers who think this can become a viable investment vehicle. Perhaps they don’t believe that at all, but are betting on bailouts when this Ponzi scheme collapses, because, as noted above, the ultimate source of wealth is people who actually create it, as TF and CD said, and get taxed for doing so.
    Has there ever been an economy where the wealth creators were valued rather than vandalized?

  9. Snoof says:

    Has there ever been an economy where the wealth creators were valued rather than vandalized?

    Subsistence farming with a barter economy, maybe? Especially at marginal levels which can’t support banditry/warlords.
    Of course, they’ve got their own problems.

  10. Kaleberg says:

    Actually this is just an extension of the ongoing practice in which companies buy life insurance policies for their employees and then use their cash value to finance executive pensions. (The face value of the insurance is considered income and used in computing bonuses!) Needless to say, this sounded like something out of Gogol and blogged about it at:

  11. peter says:

    I like the comment by troublesome Frog. We have to produce something.
    Although, on some level a service is a product. The problem is life insurance companies as a whole are only interested in one thing… making more money. They don’t care how they do it, which is why some of their actions are so creative and complicated. And in the end, we the consumers are the only ones that get ripped off and pay for it. Two words; Bail Outs!
    Government bail outs specifically. Who cares what happens? The government will bail out these companies anyway. And we are going to pay for it. Oh wait, that already happened.

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