Life Insurance Cost

Wall Street Invests in Life Insurance

October 2, 2009 | Featured

Following the collapse of the mortgage business last year, investment banks on Wall Street started looking for a different way for making money. They think that they just might have found one. Bankers are planning to purchase life settlements. These are life insurance policies elderly and ill people sell for $400,0000 to one $1 million in cash, depending on what the insured person’s life expectancy is.

The bankers plan to securitize the insurance policy. What this means in the jargon of Wall Street, is packaging hundreds or even thousands of these policies together to issue bonds. These bonds will then be resold to investors, such as the large pension funds, who will then receive the death benefits when the insured person dies.

The sooner the policyholders dies, the higher the return will be. If the insured individuals end up living longer than is expected, the investors could wind up with low returns or could even lose money.

Wall Street would end up profiting either way by pocketing the large fees they would receive from creating, reselling and then trading the bonds. However, some experts who have analyzed life settlements are warning that insurance companies in the short term may need to raise premiums if they wind up paying out more in death claims than was anticipated.

The idea of turning life settlements into bonds is still only in the planning stages, but our phones are already ringing off the hook with questions, said Kathleen Tillwitz, who is a DBRS senior vice president. DBRS is the company that provides risk ratings for investments and is in the process of evaluating nine different proposals for the securitization of life insurance from private investors as well as financial firms, which includes Credit Suisse.

One investment banker, who did not have the authority to speak with the news media, said we are hoping after the first offering to get a herd stampeding.

Following the financial meltdown of the economy, the exotic investments that had been created on Wall Street received a lot of the blame. It was an array of financial products and not just sub prime mortgage securities, including structured investment vehicles, credit default swaps and collateralized debt obligations that all proved to be much risker than had been originally anticipated.

The financial collapse gave all of this financial creativity a bad name in general, but it didn’t carry over to Wall Street. While Washington continues to debate the need for increased financial regulation, the investment bankers are busy concocting new financial products.

In addition to proposing that life settlements be securitized, some banks are repackaging some of their poor performing securities into ones with higher ratings, calling them re-remics. These are the re-securitzations of mortgage investment conduits. The investment firm Morgan Stanley states that a minimum of $30 billion of residential re-remics were completed this year.

Financial innovation can theoretically be a good thing in terms of lowering borrowing costs and providing consumers with additional investment opportunities, and in general help the economy to grow and expand. Those in favor of securitizing life settlements claim it would benefit individuals who would like to cash out on their insurance policies during their lifetime. However, others are very dismayed by the quick return of Wall Street to its old ways of chasing after profits with complex new financial products.

James D. Cox, a Duke University professor in corporate and securities law, says it is bittersweet. The sweet part of it is that there are investors who have an interest in the exotic products that underwriters create. The underwriters earn large fees while the rating agencies are getting paid to provide ratings. The bitter part of it is that it’s a return back to the good ole days.

What may be good for Wall Street may end up being bad for both the insurance companies as well as their customers. This is due to the fact that policyholders often end up allowing their life insurance policies to lapse before dying. This happens for a variety of reasons, including children growing up and not needing financial protection any longer, or the insurance premiums get too expensive for seniors to afford. When this occurs, the insurance company isn’t required to pay out.

However, if the insurance policy gets purchased and then gets packaged in with a security, then investors will continue to pay on insurance premiums that may have previously been abandoned. This could result in more policies staying enforced, which would result over time in more payouts and less profits for insurance companies.

Neil A Doherty, who is a Wharton professor who has analyzed life settlements, says when the insurance companies set the premiums they based them on wrong assumptions. He added that insurance companies would probably need to raise the cost of premiums on new life insurance policies if widespread securitization occurs.

Steven Weisbart, who is chief economist and senior vice president at the Insurance Information Institute, states that life settlement critics believe it defeats the major purpose of what life insurance is intended for. It is not an investment or gambling product, he added.

After Mortgages
Wall Street, undeterred by the critics, is racing ahead with their idea for one simple reason. There is $26 trillion worth of life insurance polices that are in force in the U.S. It could be a huge market.

Of course not all life insurance policyholders are going to want to sell their policies. In addition, investors will not be interested in the policies of healthy people because the premiums would have to be paid for too long, which would reduce the profits on their investment.

However, even if just a small fraction of life insurance policy holders were to sell their policies, there are some industry analysts predicting that this market could be a $500 billion one. This would aid Wall Street in offsetting losses in revenue due to the collapse of the market for U.S. residential mortgage securities, which is down from a high of $941 billion in 2005, down to $169 this year so far, according to the firm Dealogic, who tracks financial data.

There are some financial firms on the move and looking to over run their competition. For example, Credit Suisse is effectively building up a financial assembly line of sorts in order to purchase large quantities of life insurance policies and then package and resell them in a similar way that the Wall Street firms packaged and sold sub prime securities.

Credit Suisse purchased a business that does life settlements originations and has also set a group up for structuring deals along with another one for selling products.

The investment firm Goldman Sachs has created a life settlements tradable index, which enables investors to place bets on whether individuals will die sooner than what was planned or live longer that what was expected. Their index is very similar to a stock market index that enables investors to place bets on the market’s overall direction without purchasing stocks.

If Wall Street is successful in turning life insurance policies into securities it would transform this controversial business of purchasing and selling life insurance policies, which on a smaller scale has existed for a few decades, into something much bigger.

Those who defend life settlements make the argument that having a market in place which allows the elderly or ill to sell their life insurance policies for cash is actually a public service. They make the argument that insurance companies only offer a cash surrender value which is typically just a fraction of what the death benefit is when policy holders want to get a cash out, even though they have paid large premium amounts for years.

This is where life settlement companies enter in. Depending on a number of different factors, a life settlement company will pay anywhere from 20-200% more than what the cash surrender value is that the life insurance company will pay.

However the life settlement industry has been haunted by persistent complaints of fraud. State insurance regulators, who are hamstrung by a hodge podge of regulations and laws, have been critical of life settlement brokers for trying to coerce the elderly and ill to take policies out just so they can resell them to the brokers. This type of life insurance is often referred to as stranger-owned.

In 2006, Eliot Spitzer, when he was the attorney general for the state of New York, sued Coventry, which is one of the biggest life settlement companies. He accused the firm of participating in bid rigging with their rivals in order to keep prices low that were offered to individuals who were looking to sell their life insurance policies. This case is still continuing.

Stephan Leimberg, who co-authored a life settlements book, said when testifying last April to a Senate Special Committee on Aging that life settlement predators, if they are left unchecked by regulators, legislators and the life settlement industry, have the means and motive to take advantage and exploit seniors.

Predictions Can Be Tricky
In addition to the problem of fraud, there is another risky potential for investors. That is the possibility that some individuals could end up living a lot longer than was expected.

This risk is not just hypothetical. It occurred during the 1980s when new treatments for AIDS became available and prolonged AIDS patients’ lives. Investors who had purchased their life insurance policies with the expectation that a majority of AIDS victims would most likely die within two years wound up losing money.

Last fall it happened again when the companies that estimate life expectancy found that people were indeed living longer.

Wall Street’s challenge is to find a way to make life insurance policy securities safe and more predictable investments. In order to interest large investors, any securitized bond needs a seal of approval from one of the credit rating agencies which measures the risk level.

Banks are, in many ways, trying to duplicate the sub prime mortgage securities model. These securities became popular after the rating agencies gave them a triple A top tier rating. While an individual mortgage that belonged to a home buyer that had bad credit would be considered to be a risky investment due to the strong possibility of a default, packaging many of these mortgages in a bundle helped to limit the risk. At least that is how the theory went, which depended on the fact that were would not be a lot of defaults occurring all at once.

In retrospect that idea was seriously flawed. However, Wall Street seems convinced they can solve the problem with life settlement policy securities.

This is the reason why Goldman Sachs and Credit Suisse bankers have visited DBRS, a rating agency located in lower Manhattan that is not well known.

In 2008 DBRS published criteria that offer ways of securitizing a life settlements portfolio that minimized the risks.

Interest came flooding in. For example, hedge funds that have purchased life settlements are eager to buy and sell these policies more readily, so they will be able to cash out on the non profitable investments and keep the profitable ones. Wall Street banks, which were beaten down during the recent financial crisis, have been looking for ways to get going once again with their securitization machines.

Ms. Tillwitz, who is a DBRS executive overseeing the project, stated that DBRS spend a period of nine months becoming comfortable with all of the risks that are associated with providing a rate for a life settlements pool.

One question is whether there could be a way to protect against agents committing possible fraud through purchasing life insurance policies and then reselling them to circumvent problems that occurred with sub prime mortgages where some of the brokers made fraudulent loans which ended up in the securities packages there were sold to investors. The question being how could investors have assurance that the life insurance policies were acquired legitimately so that there would not be disputes on the payouts at the time of the original policyholder’s death.

Another question was how to ensure that the policies that were purchased had been obtained legally, since some states prohibit selling the policies until after a period of two to five years?

Risk Spreading
In order to further understand how these risks could be managed, Ms. Tillwitz along with Jan Bucker, a colleague with a PhD degree in nuclear engineering and mathematics wizard, traveled around the world to visit with firms that manage life settlements. Ms Tillwitz stated that they didn’t want to rate deals that ended up blowing up.

So what was their solution? Ideally a life settlements bond would contain policies from individuals that had a range of diseases such as lung cancer, leukemia, heart disease, diabetes, breast cancer and Alzheimer’s. The reason for this is, for example, if there were too many leukemia patients in the security portfolio, and then there was a cure that was developed, the bond’s value would plummet. Another precaution that DBRS would take would be to run a background check on the issuers and include a quality range of life insurers.

Mr. Buckler tested how different policy mixes would perform by running computer simulations in order to demonstrate what would occur to the returns where people lived much longer than had been expected.

However, even with a mathematical wizard calculating all the possibilities, there are some risks that cannot be predicted. How can computers make accurate predictions on what might happen if, for example, health reform were to pass and large numbers of Americans had better care which resulted in people in general living longer? Or what if some sort of magical cure for all forms of cancer was invented?

If these computer models ended up being wrong, the investors might wind up losing lots of money. Some of these assumptions might appear to be unlikely, but effectively that is what occurred with a lot of the sub prime loan securities that had been given triple A ratings.

The investment banks selling the securities tried to lower their risk through doing things like packaging mortgages that came from different regions and had different borrower credit levels. The assumption was that if housing prices fell in one area, for example Florida, which resulted in widespread defaults, it wasn’t likely that the housing prices would end up falling at the same exact time over in another region, such as California for example.

Economists made note of the fact that historically speaking housing prices had dropped on a regional but not national basis. When the housing prices did drop nationwide, the investors ended up losing hundreds and hundreds of billions of dollars.

Moody’s and Standard & Poor’s, who both gave many of the triple A ratings out, after getting burned are now approaching the life settlements issue more cautiously. In the 1990s Standard & Poor’s rated Dignity Partners but has declined to comment on what their plans are regarding life settlements. Moody’s says that financial firms have approached them who are interest in the prospect of securitizing life settlements but state that they haven’t seen a portfolio yet that meets their standards.

Investor Interest
Even with the mortgage debacle still fresh in their minds, there are investors that are intrigued by the idea. One of these investors is Andrew Terrell, who was the co-head at the mortality and longevity desk at Bear Stearn’s. The desk traded life settlements portfolios that were unrated. He later worked at Institutional Life Companies, which was a Goldman’s Sachs’s venture introducing a life settlements trading platform. Mr. Terrell believes that securitized life insurance policies do have a lot of potential and that investors who are looking to spread their investment risks are always on the look out for new types of investments, particularly ones that don’t move in the same direction as the other investments in their portfolio.

Mr. Terrell said it was an interesting asset class due to the fact that is has less correlation to the market as a whole than other types of asset classes.

Some of the academics studying the securitization of life settlements do agree that it appears to be a good idea. There is one difference that they agree on. That is death has no correlation to stocks rising and falling.

Joshua Coval, who is a Harvard Business School professor in finance, states that the risks of these assets are not hard to estimate and for the most part they don’t have exposure to the broader economic risks. He added that tranching and pooling doesn’t amplify the systemic risky of the underlying assets.

In the meantime, the insurance industry is gearing up for a fight. According to Michael Lovendusky, who is associate general counsel and vice president for American Council of Life Insurers, said while mortgage providers have all been tainted by sub prime mortgages, there is also the concern that life insurance companies would all become tarnished by sub prime life settlements.

The insurance industry might find an ally in the government. In April during the Senate committee hearing insurance regulators from the states of Illinois and Florida were among those who were expressing concerns regarding life settlements, arguing that the current regulations were inadequate.

Herb Kohl, Democratic Senator from Wisconsin and the Special Committee on Aging chairman, stated that securitizing life settlements adds yet another element of potential risk to the industry that already needs enhanced regulations, consumer safeguards and more transparency.

DBRS states that they agree that this needs to be looked at carefully. Ms. Tillwitz stated they wanted the life settlements market to flourish safely.

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