Next bubble - securitizing life insurance policies?

Even as the sub-prime mortgage bubble with its exotic CDS, CDOs, and SIVs fades away, Wall Street appears ready with the next big investment opportunity - buying, bundling, packaging, securitizing, and selling life insurance policies - or "stranger-owned life insurance"! The $26 trillion life insurance market in the US provides ample opportunities for the development of a market in these derivative securities.



The Wall Street banks could "securitize" the hundreds or thousands of policies it purchases (directly or through a SIV "life" settlement company) from individuals (who volunteer to sell their policies in return for cash) by packaging them together into bonds, and then resell those bonds to investors, like big pension funds, who will receive the payouts when people with the insurance die. The earlier the policyholder dies, the bigger the return (the periodic premium payout is minimal) — though if people live longer than expected, investors could get poor returns or even lose money. As NYT reports, either way, Wall Street and rating agencies would profit by pocketing sizable fees for creating the bonds, reselling them, rating issues, and then trading them.

However, in the event of a bubble blowing up in these securities, settlement companies could end up over-paying for insurance policies and become saddled with derivative securities whose underlying is worth less than the cost incurred in purchasing them. Advances in health care could increase the life expectancies of a category of patients, thereby forcing the investors in these securities to take huge losses (as they are denied the payout when the patient outlives the policy). And insurance companies could end up with payouts that would cripple them.

This could also end up unsettling the insurance industry itself. That is because policyholders often let their life insurance lapse before they die, for a variety of reasons — their children grow up and no longer need the financial protection, or the premiums become too expensive - and the insurer does not have to make a payout. Now, if a policy is sold and packaged into a security, policies will stay in force and cause more payouts over time. Insurance companies will be forced into increasing their already high premiums or regulating the industry more stringently.

A life insurer is betting that the insured person stays alive as long as possible, preferably outlive the policy. The insured person has hedged against the eventuality of his untimely death by purchasing life insurance. By buying out an individual's life insurance policy, the "life" settlement company ends up betting that the individual dies at the earliest. In the final analysis, instead of providing a hedge against death, life insurance (or atleast the part of it getting sold) becomes yet another instrument for financial speculation.

Like all previous such investment bubbles, this too presents ample avenues for conflicts of interests and incentive distortions. The one big difference would be that unlike all previous bubbles, these market distortions are likely to cause human fatalities. Consider this extreme scenario. Assume an individual has both life and health insurance coverage. Desperate for cash, he sells off his life insurance, which is purchased by a Wall Street investment bank, which also has some form of exposure (say, share holding interest) in a health insurance provider.

Given the windfall that comes with a premature death of the individual, it is clearly in the interest of the investment bank and its health insurance provider partner to be negligent on the provision of health insurance to the individual. Another example is the possible emergence of life settlement brokers who will coerce or incentivize the ill and elderly to take out life insurance policies with the sole purpose of selling them back to them.