Sunday, September 06, 2009

Life Insurance Settlements

I read an interesting article last night on about securitizing life insurance settlements. The gist of the process is this: you have an elderly person, say, 72 years old, who needs money badly. This person, let's call her Ethel, has a life insurance policy that will pay $2mm when she dies, but it costs her $50k a year to keep current. According to actuarial tables, Ethel is expected to live to age 77. Now, the life insurance company will "settle" the policy with her - they'll give her cash right now. How much? In the NY Times example, it's a mere $58,000. Ethel is getting screwed.

Enter the evil "Wall Street," who seeks to profit from the death of average Americans - as critics will claim. Wall Street is now acting as an intermediary to try to get Ethel something closer to the theoretical value of her policy. The securities firm buys Ethel's policy from her, giving her more money up front ($215,000 in the Times example) than the insurance company would have given her, and then continues to pay her policy. The firm turns those policies into securities or even packages them with other policies, like Rose and Marvin's life insurance settlements, and sells them to investors. The investor pays the policy until the original policy holder dies, at which point the investor receives the value of the policy. It's really not as hard as it sounds - to simplify - you need cash badly, I have cash, so I buy your policy from you, and take it over. I decide how much to pay you for the policy based on the end value of the policy and your expected life span.

Now, it's debatable whether life insurance policies should be able to be settled at all. It's pretty clear to me, though, that if you have been making payments into a policy as you age, but you now need money, you should have the right to "cash out" your policy for whatever it's "worth." Critics will immediately jump on the securitization process facilitated by Wall Street as another attempt by Big Money to profit off the ill fates of innocent Americans - even incentivizing the security holder to cheer for the early death of the policy holder. This last part is unequivocally true - life insurance settlements are worth more when the policy holder dies earlier. However, the whole point of the securitization process is that the insurance company was not giving Ethel a fair value for her policy! Instead, let investors take the risk of the policy, and price Ethel's policy at a "fairer" value. A life insurance policy is no different from a bond - the problem is we don't know the maturity date. Let investors make a market on what the fair expectation of that maturity date is! This is exactly what insurance companies do, only they don't compensate you fairly.

Yves Smith at NakedCapitalism wrote today about a potential ill effect from the securitization process:

"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."

This is an interesting observation, although a commenter on Yves's post notes that insurance companies have gotten better at pricing policies to "abandonment," so that this theoretical "loss" that the insurance company suffers is smaller, and already priced in.

In today's "Evil Wall Street" era, the temptation is to crucify Wall Street for ideas like the securitization of life insurance settlements, but all the process does is make the value paid to the policyholder more competitive. The claim that this process will result in a pseudo "tax" for other policy holders because insurance companies will be forced to raise rates is a red herring - it ignores the fact that the benefit of the "tax" was already paid to our hero, Ethel.



Anonymous said...

Regardless of how you feel about the securitization of life insurance from a moral level -- the bigger question is: Are these securities good investments? Part of the problem is that the insurance companies are planning on underpaying vast numbers of policy holders (as in your 58k example). This new practice of securitization does not, as some suggest, pit Wall St. against mom and pop America. This practice pits Wall St. against the life insurance business by transferring profit from insurance companies to banks. (Clearly, no one loses sleep over who loses in this scenario -- but it is worth noting that this could create a crisis in the insurance business)

Kid Dynamite said...

actually, I'm not sure I care if these securities are good investments... And the transfer of profits is from insurance companies to the end purchaser of the security - which isn't necessarily a bank - it could very well be an investor like me.

The reason is doesn't matter if the securities are good investments is because comparing these securities to MBS and suggesting that a similar meltdown is imminent is bunk reasoning - the problem with MBS was massive underestimation of risk combined with massive leverage. With life insurance settlements, you can certainly be wrong about your actuarial table, but everyone dies eventually. As long as you limit leverage, you can't cause a catastrophic meltdown

Daniel said...

There is a very simple solution for this, the consumer buys whole life insurance. Sacrifice and pay more now and have the policy "paid" by a certain date and this isn't a problem. Call it enforced savings, call it whatever you want, but it works. But people don't want to "save" and defer instant gratification. And FA's don't like it because it diverts dollars that they want to collect fees on for "managing." I could go on and on. But smart people do this. Oh, I forgot, that's another problem....

HyunChard said...

Friendly advice, you should put the money you would have spent on extra life insurance policies into your savings each month, where it can be used if and when you need it, no strings attached.