No Free Lunch (Death Bonds)

Businessweek does a big article on death bonds (otherwise known as life settlements). A good article, but they miss the key factor that will hold back this asset class.

First an overview. It is funny to see this concept main-stream. We looked at this concept at my prior job and predicted about three years ago that it would grow as a concept. The returns at that stage were quite high. BW explains the basic concept well.

Death bond is shorthand for a gentler term the industry prefers: life settlement-backed security. Whatever the name, it's as macabre an investing concept as Wall Street has ever cooked up. Some 90 million Americans own life insurance, but many of them find the premiums too expensive; others would simply prefer to cash in early. "Life settlements" are arrangements that offer people the chance to sell their policies to investors, who keep paying the premiums until the sellers die and then collect the payout. For the investors it's a ghoulish actuarial gamble: The quicker the death, the more profit is reaped. Most of the transactions are done by small local firms called life settlement providers, which in the past have typically sold the policies to hedge funds. Now, Wall Street sees huge profits in buying policies, throwing them into a pool, dividing the pool into bonds, and selling the bonds to pension funds, college endowments, and other professional investors. If the market develops as Wall Street expects, ordinary mutual funds will soon be able to get in on the action, too.

Here BW forgets to put on its skeptic's glasses and trace the cash...

The truth is, at this early stage, there's no way of knowing how popular death bonds might become. Wall Street's innovation machine has turned out both huge hits and big flops over the years. But the growth of the underlying market for life settlements has been torrid so far. In 2005 about $10 billion worth were transacted, according to Sanford C. Bernstein & Co. (AB ), up from virtually nothing in 2001. Industry analysts say this number rose to $15 billion in 2006, and could double this year, to $30 billion. Over the next few decades, as the ranks of retirees swell, Bernstein predicts that the face value of life settlement deals will top $160 billion a year in today's dollars. Death bonds will never approach the size of the mortgage market, which saw $1.9 trillion of securities issued last year. But if Wall Street achieves its goal of turning most of the life settlements created each year into death bonds, the market could rival the size of today's junk-bond market, where issuance totaled $128 billion in 2006, up from $56 billion in 1996, according to market watcher Dealogic.

This will not happen because life-settlements is a zero-sum game and all the gains for investors are coming at the cost of the insurance companies. In effect, investors are gambling that they are more rational about the payouts than elderly individuals (which they certainly are). That policy holder irrationality benefits the insurance companies and increases their profits. When life settlement providers come in, they are effectively stripping out some of the insurance company profit that was priced into the policy.

So as long as life settlements stay a small percentage of policies, the insurance companies will tolerate it because there is still no advantage in them publicizing the fact to their customers that their cash settlement amounts are too small.

If life settlements start to eat up too much underwriting profit, then the insurance companies will either:

a) raise premiums to make up the reduced profitability and reduce the profitability of the policy to the policy holder


b) selectively raise cash settlements to the customers who are most likely to die and leave the 3rd parties with worse risks (e.g. in this model, the healthy people)

So, while insurance companies are notoriously slow to innovate and so this might run for a while, let's review the relevant facts:

a) returns to life settlement investors are coming directly out of the pocket of the insurance companies b) the insurance companies have the actuarial data that investors don't have c) the insurance companies already have the relationship with the policy-holder

Who is going to win this game in the long run?

Posted on July 23, 2007 and filed under Finance.