Is Wall Street About to Ruin Another Financial Product? (Life Settlements Edition)

The Japanese approach regulation very differently from the way Americans do. First, just about nothing is codified in writing. Lawyers are few and far between (by design, the bar exam is difficult to pass). If you try to get an opinion on whether a new idea will pass muster, you are certain not to get a crisp answer. One reason is the Japanese have somevery different fundamental ideas. The Anglo-Saxon construct is that something is permitted or it isn’t. The Japanese, by contrast, will tolerate new products that are provided by firms that are in their good graces if the activity stays at a low level. If it becomes significant, it becomes subject to official study, and that is often a death sentence.

This is not as nutty an idea as it may seem. Risky activities, if kept to a modest scale, can address needs of select customer groups, and if the purveyors have to operate the business on a contained basis, they will hopefully focus on the best quality customers, thus limiting the exposure of their firm (and by extension, the financial system). Consider subprime loans. Even though that product has fallen into disrepute, there was a portion of the market that was worth serving. In fact, FHA loans, which have 3% downpayments, were the original subprime and had a very good track record on defaults (the product that has shown big losses was a zero down payment offering that the FHA had asked to shut down).

Why the disparity in results? The FHA did borrower screening. The FHA lost market share to private sector subprime lenders because their process was faster and less demanding (and people who would have failed FHA standards did get credit). Similarly, not for profit mortgage lenders have seen default rates similar to those of prime borrowers, when they serve subprime customers.

Wall Street has its eyes on another potential hot new market, and appears likely again to screw up what was a good product for customers.

The life settlement business is one where investors buy life insurance policies from holders who need the dough, say someone sick or elderly, at a much better rate than what the insurance company offers as a cash settlement value. The investor then continues to make payments and is gambling that the insured party will die on or ahead of schedule (as determined by actuarial tables).

On a small scale, this is a useful service to people who are in a bind. But the ramp up that Wall Street intends, of marketing the idea more aggressively and securitizing the policies, is likely to put all life insurance customers at a disadvantage.

The big reason is that many policies lapse (as in the owner of the policy fails to make payments. Those lapses are included in current pricing models. Investors will not miss payments, which means insurance providers will pay out more often than in the past on life insurance policies, which in turn means their profits will deteriorate, which means they will raise rates on everyone.

A second concern is fraud, that some life settlement companies have gotten people to enter into insurance contracts for the sole purpose of on-selling them.

From the New York Times:

After the mortgage business imploded last year, Wall Street investment banks began searching for another big idea…

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…..

The idea is still in the planning stages. But already “our phones have been ringing off the hook with inquiries,” says Kathleen Tillwitz, a senior vice president at DBRS, which gives risk ratings to investments and is reviewing nine proposals for life-insurance securitizations from private investors and financial firms, including Credit Suisse.

“We’re hoping to get a herd stampeding after the first offering,” said one investment banker not authorized to speak to the news media.

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  1. The Big Electron

    Wall Street making more money if the Americans are dying quicker? Hey… what can go wrong here????

  2. LeeAnne

    The criminal financial industry entitled to profit from your death?

    This will be the death of capitalism. Its them or us.

  3. A^2

    Yves — The article in the Times gets some fundamental things wrong and misses a number of key points.

    1. Life insurance companies no longer price polices to abandonment. While they used to make a significant amount of their profit when elderly or ill policy holders could no longer keep up payments and thereby lost there coverage, they’ve seen this life settlement business coming for a long time and made the shift to protect themselves.

    2. The life settlement industry (some place it near $150 billion per year currently) has very little transparency. As much as the industry has tried to clean up its image (they have lots of glitzy conferences, snazzy websites, and materials trying to make it seem on the up and up) its interests remain completely counter to the original policy holder. Simply, they bet against the lives of the insured. The industry makes a big deal of moving away from “viatical” (basically death bed) policies, but in fact all settlements are viatical.

    3. While information about the industry remains imperfect and scarce the best estimates suggest that at the end of the sale the insured ends up on average with a measly 5% – 17% of the face value of the policy. This business spreads lots of fees around to everybody in the supply chain.
    While it has changed a bit originators used to pull in as much as 4% of the policy face value as commission on the sale.

    4. Public health organizations, schools of public health, and even public policy groups view life settlements as a predatory business and have refused to cooperate with the industry.

    5. They’ve begun to spend lots of money on medical and actuarial models, but these have the kind of black swan waiting to happen characteristics that would make Nassim Taleb’s hair stand on end.

    6. Its one thing for Goldman Sachs to bet against their clients positions and perhaps we can expect them to bet against their lives as well, but a few months back the Fed bought $8+ billion of life settlements off of AIG’s balance sheet in a single tranche! Sure, they got them at a good discount, but now the Federal Reserve has assets on its balance sheet that bet directly against the lives of citizens and taxpayers. How has the system come to this?

    How do pension funds justify betting against the lives of their members to match assets to liabilities?

    Ethically, this makes the worst of sub-prime lending and securitization look like something from Mr. Rodger’s Neighborhood.

    I could get more specific offline – it only gets worse.

    1. BC

      “the Fed bought $8+ billion of life settlements off of AIG’s balance sheet in a single tranche! Sure, they got them at a good discount, but now the Federal Reserve has assets on its balance sheet that bet directly against the lives of citizens and taxpayers.”

      I would just love to see this as a leading headline on one of the nightly news shows, followed up by a more in depth story on PBS Newshour and/or 60 MInutes.

      It might give more traction to the movement to audit and regulate the Fed (though with the state of regulation in US today, that’s not a source of comfort).

  4. Skippy

    Depravity knows no bounds. I find it interesting that the great human die off (see boomer’s exit) is just below the horizon.

    Skippy…Here in Australia there is a law against opportunism during times of disaster, man made or natural.

  5. attempter

    Collateral death obligations. This may be the most repulsive example yet, simply on an aesthetic level. And of course it carries all the normal malignity of imposing a tax on the real economy (i.e. the real people of America) and seeking to blow up a new bubble.

    I’d love to see even the most ardent market fundamentalist explain how this “innovation” actually creates any value, or does anything other than impose a tax and collect rent.

    (For anybody who’s interested, I wrote a blog post on this.)

  6. Siggy

    Life settlement contracts should be barred from securitization.

    The contract itself is valid when the insured is in need of substantial financial support in the short run. Beyond that need, the securitization of life contracts serves no productive purpose.

    The life settlement contract can take a variety of forms, however, it seems to me that the buyer of the policy should be the one who makes the continuing premium payments.

    Imagine an insurance industry that undertakes to write very large policies. It then creates a Life Settlement subsidiary that solicits policy sales from the recent policy originations. Now we have origination to distribute and once the policy is securitized we have a break in the chain of liability.

    Given the vast amount of data that the rating agencies have for this type of contract, I wonder, how will they concoct a methodology for handicapping the probability of life term and what the appropriate expected value of a face value certain may be?

    There is a hubris about this that is appalling.

  7. AnonymousMonetarist

    The value of a life settlement, to an investor, is driven by its’ duration … that is when the policy matures.

    This duration is estimated in purchaser’s pricing models by life expectancies garnered principally from 5 LE companies : FASANO, AVS, 21st Services, EMSI and Midwest Medical.

    Over that time the LE underwriting companies have ‘increased’ their underwriting models several times resulting in a ‘value destruction’ from the investor’s viewpoint that has rivaled the recent devastation of equity markets.

    Deutsche, for example, has bought a ton, at least a few billion in face. They need to repackage these and farm them off to bagholders.

    To illustrate what level of FAIL past purchases are at please consider the following:

    For example let us suppose a purchaser was considering a 1,000,000 policy with a 7% premium to face on an optimized illustration (showing the minimum premium to keep the policy in force over a LE+2 horizon) with a 21st LE(Life Expectancy) certificate (50%) of 60 months. A purchaser might value that policy at (in the competitive environment from 2003-2007) $300,000 realizing a 9% yield to LE and a 11.64% IRR if the policy were to mature at 60 months.

    Now obviously one would not expect the insured of the policy purchased to meet his/her maker as the egg-timer rang, the thesis of the business is that if you purchase enough policies you will achieve maturities over your portfolio resembling a normalized curve and that if you base your purchases on a duration (LE) of 50% – that is the midpoint of a normalized curve, half of all folks in a similar population to your insured will have ‘matured’ at this date, – you will overall meet your desired yield.

    So let’s say you made that purchase in 2003. Unfortunately you may have discovered that shortly thereafter 21st modified their underwriting tables and if you ordered an updated LE on this insured in 2004, their 50% LE would now be 85 months..

    That would be troublesome because it would imply that with a new duration of 85 months the yield to LE is 3.28% and the IRR is 4.49% at your already paid purchase price. Even worse in fact since with a longer duration the premium to face on an optimized illustration would increase – as an insured gets older their COI(Cost of Insurance) increases.

    As the years went by however that 85 would be time-adjusted, not on a 1:1 basis however so that in the year 2007 perhaps a new 21st LE might be down to a 50% of say 55 months.

    Unfortunately with the recent ‘increase’ in the 21st LE underwriting tables enacted in Nov 2008 to apply the 2008 VBT as opposed to the 2001 VBT that LE may very well be back up to 85 months. (21st services LE is the most commonly used.)

    I think you’re getting the general drift as to how investors’ have made out on this asset class. Simply put the investors are maturing faster than the insureds…

    Furthermore, the underwriting tables are based on distributions due to ‘large numbers’ … any individual institution would have to buy every life settlement in existence in order to achieve that sampling number ( although Moody’s did put out an ‘analysis’ saying you could hit a ‘diversified’ sample and achieve a ‘normal’ distribution of maturities with a portfolio of about 250 files … no comment necessary on the veracity of that).

    Fraud in life settlements from folks that create policies to sell them is a problem in part because insurers do little to scrub the policy for insurable interest when the policy is entered into or comes out of its’ C&S period… they are happy to take the premiums against the risk of a DB that they often have hedged … for example some insurers have less than 10% exposure.

    The industry is opaque and does result in large fees for the intermediaries often in aggregate more than what the insured receives for their policy.

  8. jest

    i’m surprised the health insurers aren’t big buyers of this stuff. it’d be a piece of cake to buy a sick grandma’s policy, then rescind the coverage, wait for her to die, and cash the check.

    the next step seems like it would be securitized health insurance. if you thought getting money from your HMO was hell now… *shudders*

    ^ the “free market” at work.

  9. Rednomore

    On this issue, it would seem to me that Wall Street is actually wearing the white hat. The crooks here, if there are crooks to be identified are the insurance companies themselves. Turing a valuable risk mitigation tool such as life insurance into an “investment” product is the rip off that never should have been allowed. Would you buy auto insurance that builds cash value if your agent said it was an investment? I don’t think so. How about if the so-called investment was transparent, revealing first year commissions of 94% of premiums and 6% each year thereafter?

    Securitization or not, investor purchases of senior’s permanent life policies rid elderly balance sheets of a negative cash flow product at a time in life when they need their assets working for them. And by paying far more than the abysmally low ROI cash value, the only loser here, as pointed out, are the insurance companies themselves.

    Yet the insurance industry does not have a monopoly on blame. With Fed mandated artificially low interest rates for more than a decade, insurance companies were forced out on the risk spectrum, chasing higher yields to meet their obligations. Their requests for, and acceptance of TARP money came not from projected losses from life settlements, but from actual losses in equities and real estate.

    Permanent cash value life is the only scam here. Life settlements can turn millions of seniors from victims to winners. The involvement of Wall Street to make more money available to more people is the kind of financial innovation we all should welcome.

  10. NRS

    Does anyone really believe that Life Insurance Companies with so many of their assets tied up in mortgages and real estate are really solvent? Scam upon Scam.

  11. Kid Dynamite

    I know hating Wall Street is the new black, but there’s not much to hate here… all Wall Street is doing is enabling poor old Ethel to get a fairer price for her policy than the lowball bid the insurance company is willing to pay her for it.

  12. TonyForesta

    Betting on bundles of death? Talk about a moral hazard. Is there no pit in hell Wall Street shades will not exploit for profit?

  13. Antonis Polemitis

    This is a business that does not make any sense whatsoever at scale.

    Life settlements is a zero-sum game between the insurer and the insured. If a third party investor can make money on a risk and time-adjusted basis in buying a policy either the insurer or the insured have left money on the table.

    Running an origination, securitization and investment business to mediate between the insurer and the insured just imposes a (significant) tax on the transaction without any benefits that could not be achieved between the two principal parties directly.

    As long as life settlements impacted a small fraction of policies, it is tolerable for the insurance companies.

    But if it ever scaled up, you would imagine that the insurers could bid against and arb away the profits of the life settlements industry all day long as they have:

    a) better underwriting data
    b) far lower cost of customer acquisition, funding, etc

    1. Kid Dynamite

      @Antonis – but that’s the point – if the life insurance settlements industry ends up getting arbed out by the insurers themselves, then the consumer has won big, by getting much more than they would have previously gotten.

      1. Antonis Polemitis

        @Kid Dynamite

        I kindof but not completely agree that the consumer, in aggregate, wins. If the market for life insurance was somewhat competitive which I believe it was, then the benefit that life insurance companies received from the customers not maximizing their economic interest would be reflected in lower premiums for everyone.

        So technically, sophisticated consumers lose (higher premiums in the future) and less sophisticated consumers win (they take full advantage of their policy). So I am not sure there is any benefit in aggregate to consumers

        But if that is the social objective (which sounds perfectly reasonable to me) then the least expensive way to achieve that is to regulatorily require life insurance companies to handle surrender values in a more economically fair way.

        Getting there via building an origination->securitization->investment structure to arb contracts and which will ultimately collapse and get arbed away by the contracting parties has to be about the most conceivably expensive way to accomplish this.

        1. Kid Dynamite

          excellent point. And this is why this topic is so interesting – it makes fiscal conservatives like me advocate policies of redistribution of wealth, because my free market sense overwhelms my fiscal conservative sense (i want the sale process of the policy to be as open as possible, thus, have it securitized, not just let the insurance company buy it back)… similarly, liberals mostly think this is a wall street ripoff scheme, and rail against the plan, when in reality it’s another redistribution of wealth, which they are so often in favor of.

          1. Antonis Polemitis

            i have no objection to open markets and the ability for people to sell their contracts.

            My objection is more pragmatic -> it just does not seem like a good product for the participants to sink vast amounts of capital into building an ‘industry’ that can be arbed away so easily.

            Anyway, all well and good for them, until Merrill needs another bailout in 2016 after finding itself on the wrong side of this trade in a big way. lol

  14. Ginger Yellow

    “This may be the most repulsive example yet, simply on an aesthetic level. ”

    I don’t know about that. Several years back there was a securitisation of crematoria. One of the “strengths” of the deal was that grieving people don’t usually shop around for funeral services, so profit margins are high.

  15. daveg

    Honestly, I could see the “life settlement” investment community lobbying, ever so subltely, against things like increase public funding for medical breakthrough in the name of the “free market” as such breakthroughs would hurt their industry and bottom line.

    Mark my words, given enough time and enough money this will happen.

  16. dd

    Think this solves all healthcare reform issues: health insurance companies purchase life insurance “bonds” matched to their health insurance pool, deny health insurance coverage and collect on the life insurance. Health insurance is now a self-fund operation supported by the insured’s death.

  17. JohnM

    It was agreed by the Supreme Court that this is an asset. An asset can be sold versus in the past lapsed or taken for a suboptimal cash value. As we know investing is a risk in any asset. If an investor wants to take the risk in this regard then the seller can make a profit. Insurance companies still get the premiums which they have programmed from the start. This is a capital system and all involved gain in a honest transaction. The securitization is based on strict rules by the rating agencies. Regulations is coming. Most transact with integrity. What makes it bad is human weakness and we’ll always have some degree of that in investments and life. This doesn’t make the option bad for consumers or investors.

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