The basic idea is this: Suppose an older person has a dire need for cash, and they happen to have a $1 million life insurance policy. A company might come along and offer them $400,000 today in exchange for the policy. This company (or fund) would continue to make the monthly payments, and upon the person's death the fund would collect the entire payout. If the person keels over almost immediately, the fund would have made $600,000. If they live a long time, the fund may end up losing money because the monthly payments add up to more than their profit at the time of the person's death.
Now, if you know how insurance works you can spot the flaw in this idea. The insurance company, naturally, has worked this all out so that they are likely to make a small profit. Otherwise, this insurance company would not be in business, right? So they've done all the math and worked out all the probabilities so that -- in all likelihood -- they will take in more money from the monthly payments than they'll pay out at the time of death. If you don't take in more money than you're paying out, then you don't have a business.
Now, as an individual who's buying life insurance, you don't really care that you might wind up paying out more money, over a long period of time, than your family would ever receive. What you are actually purchasing, in a given month, is peace of mind. You're paying the bill in order to protect your family. Nobody wants to get gouged, but it's the nature of the insurance business that they're probably going to make a profit from you.
Okay, fine. But why in the hell would a disinterested third party want to assume those monthly payments, knowing that these payments will -- probabilistically speaking -- be more than the eventual return?
This is what certain Germans should be asking themselves. The German newspaper Spiegel recently ran the article Investing in Death: Betting on US Life Expectancy Proves Risky:
Deutsche Bank and other financial institutions manage complex funds that buy up Americans' life insurance policies and pay their premiums in return for their payouts. But angry German investors are finding that Americans aren't dying as quickly as expected -- and that only the bankers are making a buck....
The "db Kompass Life" fund buys up life insurance policies of Americans and assumes responsibility for paying their future premiums. When a policyholder dies, the entire payout from the policy goes to the fund. And since everybody dies, it would seem to be a fairly crisis-proof investment.
Actually, it would seem to be not so much crisis-proof as profit-proof, at least during normal times. The only way such a fund would make money is if people started dying, en masse, earlier than predicted. Such a fund would only soar during pandemic, massive warfare, or an economic catastrophe dire enough to kill thousands from cold, heat, and hunger. Meanwhile, a new category of cancer drugs or a new heart medication could cause the fund to tank.
(These funds, by the way, will cause life insurance premiums to rise for everyone. This is because people often cancel a life insurance policy once their kids are grown or the house is paid off or whatever. But once a policy has been bought by a fund, it will not be canceled. The cancellations are a financial boon to the insurance industry, since it never has to make a payout. Without those helpful cancellations, higher premiums will have to be charged in order to make up the difference.)
Wall Street makes a ton of money just packaging things and charging fees and commissions, which is risk-free. They made a slew of money off bundling up risky mortgages and passing them off to the big money and the dumb money. And they'll make huge profits bundling up life insurance policies and securitizing those, too. As reported in the New York Times:
Undeterred, Wall Street is racing ahead for a simple reason: With $26 trillion of life insurance policies in force in the United States, the market could be huge....
But even if a small fraction of policy holders do sell them, some in the industry predict the market could reach $500 billion. That would help Wall Street offset the loss of revenue from the collapse of the United States residential mortgage securities market, to $169 billion so far this year from a peak of $941 billion in 2005, according to Dealogic, a firm that tracks financial data.
The key thing to understand here is that Wall Street doesn't have to fleece the sheep itself. It's more like Wall Street collects a finder's fee for delivering sheep to the shearer; the finder's fee is otherwise known as "fees and commissions." They earn a steady income just by creatively shuffling paper, right up until their Next Big Idea blows up and leaves pension plans, 401k's, and European banks in smithereens. Wall Street's problem, at the moment, is that they're in dire need of a new way to shuffle paper.
Our old friends at Goldman Sachs have gone one better than merely packaging "life funds" (how's that for Orwellian?). Goldman has created a way to gamble on US life expectancies, without the gambler even having to join one of these funds:
Goldman Sachs has developed a tradable index of life settlements, enabling investors to bet on whether people will live longer than expected or die sooner than planned. The index is similar to tradable stock market indices that allow investors to bet on the overall direction of the market without buying stocks.
Boy, that should be an interesting thing to watch. Considering the insider trading that went on just before 9/11, the Goldman Death Index could foretell a very nasty event. Some big player might get wind of a widespread, mutated H1N1 in China and go long the Death Index before the news hits the Western press, which we would see as an inexplicable price spike. Or someone might know about a terrorist event about to occur in a major city, and might buy a slew of call options on the Death Index. As my friend pointed out, a speculator could take a "pro-Reaper" position or short the Reaper. Major pro-Reaper moves would signal something very bad coming down the pike.
I'll leave you with an excerpt from Wall Street Vultures Betting on Death:
The rating agency involved in the ” early death investments,” DBRS, employs a “mathematics whiz” who has created computer models to manage the risk of investing in life-insurance securitizations. The risk being, of course, people living longer than expected.
The math whiz, Jan Buckler, also has a PH.D. in nuclear engineering and she has devised a scheme of packaging the bond instruments based on the type of disease to lower the risk. She recommends bundling policies with a mix of certain diseases such as leukemia, lung cancer, heart disease, breast cancer, diabetes and Alzheimer’s. The theory is, if too many people with breast cancer are in the securitization bundle and a cure is developed, the value of the bond would drop.
Wall Street is betting against a cure for cancer.
Sarah Palin was looking for her death panels in the wrong place.
On your original analysis of the life insurance policies, it's not as unprofitable as you might imagine. First, the purchaser of the policy isn't paying full face value for them, as you pointed out. And second, they're only picking up the monthly payments at some point in the life of the policy. So if the policy purchaser's actuarial data is better than the issuer's, perhaps due to having more modern data, then they can make a profit. More likely is that both the policy purchaser and issuer will make a profit, because the person who sold their policy gets a discounted amount and paid monthly for a period of time. Depending on the original policy holder's current circumstances, it's even possible for this to be a win-win-win situation.
ReplyDeleteThe issue of people living longer than expected is not new. When effective AIDS drugs came online, a lot of these policy purchasers lost money. It's likely that this business is high risk, high payoff.
The Goldman Sachs index that you talk about is pure betting, though, as so many modern derivatives are. At least options on securities, debt, and commodities are connected to something, and you may end up owning those somethings (or having to provide them to a buyer depending on which side of the deal you're on). And the same goes with futures on the same.
But when you start to have options on futures and futures on options you're moving further away from the goods. And since you can purchase and sell options on stock indexes, where you're never dealing directly with the underlying goods, you're now in the realm of pure betting.
I think it's high time we took a step back and started regulating these derivatives more heavily. They can create a nest of dependencies that are difficult to analyze and understand, creating a case where there are massive cascading failures or the government has to step in.
Yes, you're right of course, if a fund purchases a policy at a steep enough discount, or if they only purchase the policies of sick people, they can clearly make a profit.
ReplyDeleteHowever, Deutsche Bank's fund wasn't making any money. I assume there is competition to purchase policies, so that you can't buy it at an enormous discount. I'm not sure how a big bank can select those likely to die soon, either. Db apparently couldn't escape the actuarial math, because they weren't returning anything to their investors.
My theory (as I described) is that Wall Street doesn't need profitable investments the same way that we do; they have arbitrage of various sorts, fees, and commissions. But if they do turn a profit on these life funds I doubt it will be win-win-win, I'm betting it comes from the policy holder or their family.