Securitizing life insurance settlements

From NYTimes.com

[Wall Street plans] to buy “life settlements,” life insurance policies that ill and elderly people sell for cash — $400,000 for a $1 million policy, say, depending on the life expectancy of the insured person. Then they plan to “securitize” these policies, in Wall Street jargon, by packaging hundreds or thousands together into bonds. They will 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 — though if people live longer than expected, investors could get poor returns or even lose money. …

The proponents of securitizing life settlements say it would benefit people who want to cash out their policies while they are alive. …

What is good for Wall Street could be bad for the insurance industry, and perhaps for customers, too. 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. When that happens, the insurer does not have to make a payout.

But if a policy is purchased and packaged into a security, investors will keep paying the premiums that might have been abandoned; as a result, more policies will stay in force, ensuring more payouts over time and less money for the insurance companies.

So, the idea is for someone with an insurance policy to sell that policy for cash—thereby collecting at least part of the benefit while still alive. The buyer will then pay the policy premiums until the insured dies, at which point it will collect the settlement amount.

Sounds like a good idea. It may be the case that insurance companies will have to raise their rates because policies that might have been abandoned in the past will no longer be abandoned. Does that make this a bad idea? Abandoned policies are free money to insurance companies—and lost money to the policy holders who abandoned their policies. To the extent that the insurance companies shared that free money with their customers by reducing their rates, some customers got more insurance than they would have otherwise because other customers lost the money they paid on policies that never paid off. Why is that good? It just means that some customers were subsidizing other customers—and the insurance companies. If policies are never abandoned, then they will be priced more accurately.

If this catches on, insurance companies themselves will undoubtedly sell policies that can be cashed out early. I believe they already do, although perhaps they aren't widely used. In the future, perhaps every policy will come with an early cash-out benefit. Then the bankers will have to beat that amount.

That's good. It will pit the insurance companies against the bankers. What may not be good is that the bankers will not be the final buyers of these policies. The policies will be bundled into bonds, the owners of which will be the final buyers. And they won't be able to tell whether the policies they are buying are worth the premiums they are signing up to pay.

Presumably the insurance companies are the experts in that sort of actuarial analysis. They should always do better than bankers and bond purchasers. Of course some insurance companies will low-ball the early pay-out benefits. But customer-owned companies will probably do a fair job for their customer-owners.