Insurance Update: Bonds. Death Bonds. 

• Marlene Y. Satter

September’s financial news seemed more suitable for Halloween, with headlines about the "macabre" subject of "death bonds" cropping up everywhere from mainstream media to the blogosphere. The gist of many of the stories was that Wall Street had come up with a new way to court disaster—by first buying, then bundling life insurance policies into bonds and then selling them off to investors. The tone, particularly in blogs, was highly critical, implying that such a product would lead to all kinds of catastrophes, from meltdown to murder.

Such sinister aspirations attributed to firms securitizing life insurance settlements seem more the stuff of melodrama than finance—although the potential for abuse surely does exist. But the idea is hardly new; not only have there been previous rumblings about "death bonds" (the cover story of BusinessWeek in July of 2007, for instance), but quite a bit of research regarding pitfalls and benefits has been done on the topic since settlements were first devised in the 1980s, so HIV/AIDs patients could pull money out of their policies in order to cover current expenses for care and personal needs.

The process itself is fairly simple: People whose needs have changed since they bought large life insurance policies can get a large up-front cash settlement, rather than simply surrendering their policies back to the insurer for their cash value. An investment firm offers that cash, and takes over ownership of the policies and payment of the premiums; the sellers remain covered, although their own beneficiaries will no longer receive a death benefit. The investment firm then bundles those policies together into bonds and sells them to investors, who reap their rewards when the insureds pass away.

While such investments might indeed be "new and imaginative ways to profit from people dying," as one report put it, are they necessarily a bad thing? After all, the ability to sell a policy for a hefty up-front sum can mean all the difference if one needs it to pay for uncovered medical care or some other emergency—say, to avoid foreclosure.

Then there’s the unintended effect on the life insurance industry itself. Should business boom, policies could end up costing more for the person who actually wants coverage. With $26 trillion in life insurance policies currently in force, there’s the potential for a massive market for securitized settlements. Even though most people won’t want to join in the rush, and many people every year allow policies to lapse for various reasons, the law of unintended consequences says that if too many policies are kept in force the cost of payouts will go up.

Insurance companies, of course, base their rates on actuarial tables that calculate not only how many people will die each year at which age, but also on how many policies will lapse each year, thus not requiring death benefits to be paid. Should more people pursue life settlements instead of allowing their policies to lapse, the cost of payouts will rise– requiring higher premiums to cover the additional expense to the insurer.

That’s not the only factor in rising costs. Stranger-owned life insurance (STOLI) plays a part in the potential for abuse. (See "If A Stranger Calls," IA, May 2008) When a person buys a policy, it’s usually because she wants to protect an insurable interest—say, her husband’s insurable interest in her, or her children’s, or that of a business partner. STOLI, in contrast, is a policy owned by someone with no connection to the insured—such as an investment firm that solicits elderly individuals to sell their life insurance policies to the firm in exchange for a life settlement, or even to purchase life insurance policies on themselves for the express purpose of receiving a life settlement from the firm. While STOLI is illegal in many states, and laws are in place in numerous jurisdictions to discourage the practice, the potential exists for abuse.

• • 11/4/2009 4:34:40 PM
  • Stuart Egrin
  • Insurance Update: Bonds. Death Bonds.
  • Marlene, thank you for writing a balanced article. Just because a policyowner may want to sell their policy does not necessarily mean that there is a willing buyer for that particular policy. This is because the transaction will be based upon, among other things, the health and life expectancy of the insured, the face amount of the policy, the premium required to keep the policy in place, the amount of cash value in the policy, if any, the type of policy (e.g. universal life or whole life), the insurer and their rating, etc. Typically a life settlement involves an insured who is at least age 65 or older who is NOT terminally ill with a life expectancy over 24 months to less than 240 months. In this age group the lapse rate is generally very low to begin with. So if these policies are settled and kept in force until maturity (death claim) there should not be any measurable difference to the insurer or their claims experience. Please note that insurance companies in-fact profit by having policies lapse (thus the reason for lapse-based pricing) or surrender. The economic value of the policy is only recognized by price discovery through the settlement process. The economic value can be 3-5 times the surrender value. The "O" in STOLI is for origination. Origination of a life policy can only take place with a life insurance agent and a life insurance company directly involved. The settlement broker can not settle a policy that hasn't been issued. The potential for any abuse in any area of financial services exists as recent headlines had shown. However if the claim that the settlement industry is solely responsible for STOLI then I suggest you go back to the "O" and think through how the policy could have possibly been issued in the first place. The legitimate life settlement industry participants are against STOLI as it is a violation of long-standing insurable interest laws. Consumers need to be made aware of STOLI and to stay away from it. Life insurance agents and companies need to be more diligent in not allowing these policies to get originated.