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Wall Street’s Ghoulish New Business

Wall Street’s Ghoulish New Business

Courtesy of Tom Lindmark at But Then What

Those lovable Wall Street ghouls have cooked up a new asset class to securitize — life insurance policies. I am not kidding you, they’re going into the business of buying life insurance policies from sick people, pooling them and then selling the securities to investors.

The NYT has the story:

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.

apple cart and wall streetIf you find that last paragraph confusing, the reason it could upset the insurance companies’ apple cart is that many policyholders let their policies lapse as they get older. For a variety of good reasons they quit paying the premiums. If the policies are bundled into a security, the new owners of the policy will continue to pay the premiums religiously and thus alter the actuarial assumptions of the insurance companies.

This business has been around for some time but it’s always been on the fringes. There are some good arguments in favor of it but at the same time, it’s always seemed just a bit tawdry. Then again, a bunch of guys who flooded the world with fraudulent mortgages probably aren’t too bothered about that.

I guess the contra argument would be that while smaller outfits have been doing this for some time with no apparent ill effects, that’s not a valid argument that there won’t be unforeseen consequences if it’s done on a massive scale. I’m not in the no financial innovation camp but this time I wonder if the benefit is really worth a roll of the dice.

One thing’s for sure. Nothing has changed on Wall Street. Securitization is the Holy Grail and come hell or highwater banks are going to keep on bundling whatever they can find.


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  1. Ghoulish indeed!
     
    The life settlement market is driven by life insurance agents.  The commissions are huge, and hidden from life insurance sellers and their advisors.
     
    First some economic basics:
     
    Life insurance companies have sold policies and until recently, been the only widespread buyers of life policies.  Life insurers are near monopsonies, in that they are the only buyers of life insurance policies.  Sales of life insurance policies by owners include:
     

    Surrender of policy for cash value, the most common sale
    Sale of policy to another related buyer, generally for business purpose, such as a stock purchase agreement, or as part of an employee’s compensation
    Sale to investors in a so-called life settlement transaction

     
    The owner of a life insurance policy can always sell the policy back to the insurer by surrendering it.  From the insurer’s standpoint, they are indifferent about paying the policyowner the cash surrender value or waiting until death to pay the death benefit.  Based on the insurer’s pricing assumptions the present values are equal.
     
    Until three decades ago, all life insurance policies were term insurance or whole life.
    The advent of universal life allowed policyowners to pay an indeterminate premium.
    So long as the insurance charges and operating expenses are met each month, the policy remains in force.  If the cash value hits zero, the policy lapses.
     
    By now you have figured out that this is a natural arbitrage situation.  A life insurance company will pay only the cash surrender value of a policy whereas other buyers might offer substantially more.  How much more depends on the buyer’s assumptions about the present value of remaining payments before they collect the death benefit.
     
    Initially all life settlement transactions were over-the counter deals.  Remember that prior to the opening of the CBOE in 1973, all options transactions were over-the-counter and today a large number of option and derivative transactions are over-the-counter.
     
    Personally, while I wouldn’t want an investor having an interest in my early death owning a life insurance policy on my life, I am indifferent about the expansion of this business.  Individuals looking to sell their life insurance policies should hire a fiduciary consultant for a fee.  Such consultant will insist in full disclosure of all fees and commissions paid to agents and brokers involved in the transactions.  The consultant should also be able to advise the seller on the likely next step, a pitch by the agent for a new life insurance policy to replace the one just sold.
     
     


  2. thank you for the comment, I need to read it again, :-)