Wall Street is Securitizing Life Insurance Policies

The current recession stems from the inability and unwillingness of Wall Street to manage the risks inherent in the securitization of mortgages, both residential and commercial. Now, the new rage is the securitization of life insurance policies. While it may look like the folks at the investment banks haven't learned a thing, the fact is that life insurance policies are better candidates for securitization than mortgages because of a greater amount actuarial experience and greater regulation of life policies.

For those unfamiliar with the intricacies of securitization, it is a relatively simple financial transaction. In the case of mortgages, banks would loan money to home buyers and would have a stream of revenue for years based on the repayment of that loan. The banks then bundled a bunch of mortgage revenue streams together and sold that bundle off to investors. The bank no longer had the loan on its books (enabling it to make further loans), and investors had a new way to generate returns. The whole thing fell apart because it was founded on the belief that house prices were headed ever upward and that there wouldn't be a high rate of defaults and foreclosures due to job loss and such.

Life insurance securitization works in much the same way. An elderly policyholder whose children are grown and secure doesn't need the $1 million policy bought years ago, and he can sell it to the securitizer for perhaps $400,000, and the investors take over the premia (insurance people call these premiums, but clearly their Latin is rusty). That's quite a good deal for the old guy (money to spend before one goes), and the investors will collect a hefty profit when he passes and the policy pays out the $1 million. The sooner the insured goes, the greater that profit will be. With $26 trillion in life policies in force in the US, the market is beyond gargantuan.

Unlike the securitization of no income, no document, 100% mortgages, life insurance policies have a huge actuarial history upon which to draw; indeed, it is decades worth of statistics. Thus, the securitization of these policies is not going to rest on untried mathematical models the way mortgage backed securitizations did. There is, however, a risk that disease could complicate matters. A bad epidemic of flu could cut short thousands of lives. Or medicine could undermine some of the statistics. In the 1980s, many AIDS sufferers bought life policies believing death awaited just a couple of years down the road. Yet, medical breakthroughs made AIDS a manageable condition rather than a death sentence; those life policies took much longer to pay out than expected.

Another ramification of this development is a possible hit to the life insurers' bottom lines. As people get older, they either cancel their excess insurance policies or take a small cash surrender payment. This is good for the insurer, who has collected premium payments for years but doesn't have to make a payment at the end of the deal. With investors keeping policies active that might otherwise have lapsed, life insurers could well see an increase in pay outs that adversely affect their earnings.

The best part of securitizing life insurance policies, in addition to the insured getting cash when it is still useful (that is, before dying), is the fact that life insurance doesn't follow the business cycle very closely. People die at a rather regular rate, and pooling this risk doesn't amplify the risks the way securitizing debt does. And since life insurance is already a regulated industry, the necessary enhancements to make securitization even better for the whole economy are likely to come much easier politically than the regulation of mortgage-backed securities ever was.

In short, the country needs to keep an eye on this activity, but there's no need to panic.

© Copyright 2009 by The Kensington Review, Jeff Myhre, PhD, Editor. No part of this publication may be reproduced without written consent. Produced using Fedora Linux.

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