David Merkel on Life Settlements

Sunday’s NYT piece about life settlements — selling a life insurance policy to a third party, who collects on it when you die — sparked much conversation in the blogosphere. Felix helpfully points out that there’s actually not much news in the story as the market is still minuscule. Still, this is a financial innovation worth discussing in its earlier stages, while there’s still time for legislators/regulators to kill it. It really is a terrible idea, one that will benefit no one besides those running Wall Street’s securitization machine.

But don’t take my word for it. Take David Merkel’s. David (FSA, CFA) is an actuary who spent 17 years working in the insurance industry, and five years outside analyzing it. For the last two years, he has been the Chief Economist and Director of Research for Finacorp Securities. He is the founder and writer of the The Aleph Blog, where he discusses financial, economic and insurance topics.

I sent him a quick e-mail asking for his thoughts. His response is worth quoting in full. I’ve included a few notes to help readers follow along.

I’ve been critical in the past about life settlements business, but in some ways it is back to the future. Back in the mid-19th century there were often no cash values for life insurance policies. If you terminated, you got nothing. It was possible to sell your policy and get something, but because of the doctrine of insurable interest eventually that market was abolished.

[Reader note: in a nutshell, the doctrine of insurable interest is that you can't insure another person's property, someone else's car, house or life, for example. The moral hazard is obvious, and highly problematic: If you insure property that isn't yours, you have an incentive to destroy that property in order to get paid out on the insurance policy.]

It was abolished because it was gambling, and that it created an incentive for the third party to murder the insured. But Elizur Wright campaigned successfully for cash or nonforfeiture values.

That made life a little better for life insurance consumers, who would get something back on surrender, but not usually as much they could get through a sale to a third party, and not nearly the expected present value of the claim, less the unamortized value of the policy acquisition cost. Nonetheless, the market stayed stable until the 1990s, until the life settlements business came along. The doctrine of insurable interest had been weakened by the courts, which I think is bad on public policy grounds. Third parties should not be allowed to gamble on the lives of others.

Now, the life settlements providers might say, “We aren’t gambling. We have the law of large numbers behind us, and we are able to do advanced analyses of the health of insureds that insurance companies can’t legally do. Besides, we offer some insureds, the sick ones, a better deal than they would receive from the insurance companies were they to surrender. Why complain?”

If they are acting like insurance companies with the law of large nambers, let them be regulated as insurance companies. Let their purchase practices be regulated as well. Yes, they offer better deals to sick insureds, but the insureds are giving away a potentially more valuable future claim….It’s a free market, but insureds are not capable of estimating the fair value of a complex insurance claim, and many get cheated.

As to the securitization — [note: packaging multiple life settlements into securities to be sold to investors] — that’s not a problem. Securitization is a tool, and ratings are a tool. Only fools and regulators trust ratings implicitly. Only the credulous buy certificates of a securitization without significant due diligence. This is a game for big boys, and if you are not a big boy, don’t play. If you are a big boy, do your due diligence.

Insurance regulations exist because of a philosophy of big companies knowing more than little people. The same should apply to life settlements and insureds for the same reason.

One last note, if life settlements become widespread, life premiums will rise to reflect the loss of profitabilty, and life reinsurance premiums will rise as well. There’s no free lunch.

This last point is crucial. The investors who want to get in on life settlements will argue that policy-holders get more cash by selling to them as opposed to surrendering the policy to the insurance company for its cash value. That’s true today, but only because life settlements are a small fraction of the market. If they become widespread, insurance companies will have to charge more for their policies up front.

[By the way, one indicator that investors see lots of profits in life settlements is how much they're willing to pay to advertise in Google (GOOG) search results. For keywords that are relevant to "life settlement," investors are bidding $15-$20 per click. Even if you assume a high conversion rate of 1% -- i.e. 1 out of every 100 folks who click on a Google ad end up selling them their insurance policy -- that means these guys are willing to pay up to $2,000 per deal. Compare to e-commerce sites that often can't pay more than a nickel per click and still be profitable.]

Comments

[User241885/(FAMCO)]

The doctrine of insurable interests should be as fundamental to every insurance transaction as compounding is to every financial transaction. Without it, the process does not exist.

Had the credit default swap market had this, there would be little or no issues today as the number of counter-parties and leverage would have been greatly reduced.

Think about it. A pension fund manager buys a bond issue. As owner of the debt, he has an insurable interest in that he wants to see that bond issue performs fully and be repaid at maturity.

Does the hedge fund manager betting against the issuing corporation have an insurable interest? Of course not, he is short the stock and now, thanks to the dimunition of the legal concept of insurable interest, he can effectively short the bonds as well through a CDS contract.

Under this scenario, AIG now is on the hook for a $100MM benefit to every counterparty who bet against the issuing corporation, only one of whom had an insurable interest to begin with, the bond owner.

The concept of an insurable interest should be enforced through out the industry. The whole idea of insurance is to manage risk, not multiply it.

FAMCO

2009 Sep 08 12:08 PM

[Carneades]

I felt like the NY Times was a little late to this story; life settlements have been around for a long time now. They actually present a very compelling investment opportunity for older clients - the rate of return on taking out a policy, paying premiums for a couple years, and selling the policy can be over 500% in a lot of circumstances. Obviously, as life settlements become more widespread, their relative attractiveness will decline due to higher premiums for everyone.

We definitely need to take a pause on this one and resist this post-housing/mortgage collapse tendency to want to over-regulate every sort of financial instrument under the sun. The SEC is already over-stepping it's boundaries and trying to regulate fixed-index annuity products; what sort of logic would make anyone conclude at this point that the SEC needs to be given more powers?

User241885 - you just described the difference between regulated and un-regulated insurance, CDS falling under the latter category

2009 Sep 08 02:12 PM

[levin70]

On the flip side there would have been no liquidity to the CDS market and what it said would never have been available to those savy investors in 2007/2008. The CDS's themselves were not the problem, the problem were the children at AIG who believed they were writing pure profit insurance policies that would never pay out. Houses never go down in value, right? AIG should have been let to go under, problem solved as the children would have been out on the street as a result of their not acting like the adults that they are.

Regards

2009 Sep 08 02:17 PM

[common sense finance]

The critics of this are all wrong. Maybe there is a need for more formal regulation but the bottom line is life settlements offer policyholders more options. If people make money by adding more options how is that bad for the market? No one is forcing anyone to sign anything. I do believe that in most scenarios holding the policy is best for the insured and the industry; But if there are no life settlement options then the only value to the policyholder is to take the cash surrender value. That is letting the insurance carrier have a monopoly on the purchasing of existing life insurance. How is that a free market?

Take the example of the policyholder who purchases the policy to mitigate estate taxes or fund a business succession plan. Then consider that they do not have the need for insurance since either their estate is not taxable any longer or their business plans took them elsewhere. Life Settlements become a legitimate option.

Taking away options for the consumer is bad.

2009 Sep 21 03:52 PM